3 - Investment Advisers

Question 1

What three activities define an investment adviser?

Answer 1

An investment adviser must:

1. provide securities advice;
2. as a part of a regular, ongoing business; and
3. receive compensation for such services. This includes financial planners, pension consultants, and sports & entertainment representatives if the above criteria are met.

Question 2

Who is excluded from the definition of investment adviser, even if the three investment adviser criteria are met?

Answer 2

1. an investment adviser representative;
2. a bank, savings institution, or trust company;
3. a lawyer, accountant, teacher, or engineer (“LATE”) who gives investment advice that is solely incidental to the practice of his profession; but, if any of these professionals hold themselves out as offering investment advice the exclusion is lost;
4. a broker-dealer or its agent whose advisory services are:
   a. solely incidental to the conduct of its brokerage business and
   b who receives no special compensation for them;
5. a publisher of any bona fide media publication, in whatever form, that renders general investment advice (i.e. does not take into account the specific investment situation of any client);
6. any person that is a federal covered adviser;
7. an adviser to a family office; or
8. such other persons as the Administrator may by rule or order designate

Question 3

Define investment adviser

Answer 3

An investment adviser:

1. provides investment advice,
2. as part of an ongoing business, and
3. receives compensation for such advice. Think of the investment adviser as a firm.

Question 4

Define investment adviser representative

Answer 4

An investment adviser representative (IAR) is a natural person who solicits or renders advice regarding securities or manages the accounts or portfolios of clients, solicits new customers, or supervises IARs.

Question 5

An investment adviser has an office in the state. Does it have to register in the state?

Answer 5

Yes. An investment adviser with a physical office in the state must register in the state.

Question 6

Do federal covered advisers register in any state?

Answer 6

No. Federal covered advisers register with the SEC.

Question 7

Do investment advisers under contract to manage an investment company register with the state or the SEC?

Answer 7

The SEC. Investment advisers under contract to manage an investment company are federal covered investment advisers and register with the SEC.

Question 8

What four professionals are excluded from the definition of investment adviser, provided the advice is rendered incidentally to their profession?

Answer 8

Lawyers, accountants, teachers, and engineers (LATE). The exclusion is lost if any of these professionals charges specifically for investment advice. Note: the exclusion is NOT available to economists.

Question 9

Do supervisors of investment adviser representatives need to register as investment adviser representatives?

Answer 9

Yes. Supervisors of investment adviser representatives must register even if the supervisor never speaks with clients.

Question 10

Do investment adviser representatives register at the state or federal level?

Answer 10

Investment adviser representatives always register at the state level, even if the investment adviser they work for registered at the federal level.

Question 11

When does the registration of federal covered investment advisers expire?

Answer 11

The registration of a federal covered investment adviser does not expire. The registration remains effective until withdrawn, cancelled, revoked, or suspended by the SEC.

Question 12

When does the registration of state covered investment advisers expire?

Answer 12

The registration of a state covered investment adviser expires each December 31.

Question 13

What is the state de minimis exemption for investment advisers?

Answer 13

Investment advisers are exempt from registering at the state level if it has no office in the state, or if it solicits business from five or fewer retail clients in the state and is registered in another state.

Question 14

What are the requirements for an investment advisory contract?

Answer 14

1. Must be in writing;
2. Compensation must based on assets under management (except in limited circumstances when it can be based on percentage of capital gains, performance of the portfolio);
3. No assignment to another investment adviser or investment adviser representative without the customer’s consent;
4. Notification for changes in majority interests in a partnership (does not apply to corporation);
5. No stipulations waiving compliance with the Uniform Securities Act.

Question 15

When can an investment adviser assess a performance fee?

Answer 15

An IA can charge a performance fee only to “qualified clients”, defined as clients with at least $1 million in assets with the firm or at least $2 million in net worth.

Question 16

What is the brochure rule?

Answer 16

A rule requiring that every investment advisory client receive a disclosure statement (an “investor brochure”) containing all information that is found in form ADV Part II. This rule applies to federal covered and state investment advisers.

Question 17

What are the rules under the Investment Adviser’s Act of 1940 when an investment adviser has custody of client funds?

Answer 17

The client securities must be segregated and properly marked; client funds must be deposited in separate bank accounts; the investment adviser must notify the client as to the place and manner in which the funds and securities are being maintained; an itemized list of such funds and securities must be delivered to the client at least every three months; such funds and securities must be verified annually by an independent CPA on a surprise basis.

Question 18

When must an investment brochure be delivered to a client entering into an investment advisory contract?

Answer 18

Clients must receive the brochure: (1) at least 48 hours before signing the investment advisory contract, or (2) at the time the contract is signed, provided, that the customer can cancel the contract within 5 days without penalty.

Question 19

When must a balance sheet be included in an investor brochure (disclosure statement)?

Answer 19

A balance sheet must be included in an investor brochure if:

1. the investment adviser has custody of client funds and securities; or
2. the investment adviser collects pre-payment of fees ($500 at least six months in advance). In these circumstances the balance sheet must also be included in Form ADV II.

Question 20

What investment advisory customers are excepted from the brochure rule?

Answer 20

Certain clients are not required to receive an investor brochure. These include:

1. investment company clients;
2. clients for impersonal advisory services; or
3. clients that are charged a fee of less than $500.

Question 21

Performance fee arrangements contingent on capital gains or other appreciation in a client’s account are prohibited, except for contracts with which types of client?

Answer 21

1. Registered investment companies; and
2. Persons with $1 million under the adviser’s management or a net worth of at least $2 million (also called “qualified” clients).

Question 22

What constitutes custody of client funds and securities?

Answer 22

Custody includes:

1. the temporary possession of clients’ funds or securities, or
2. when an investment adviser can dispense client funds without the client’s consent.

Question 23

What are the criteria for an investment adviser to properly maintain custody of client funds and securities?

Answer 23

To maintain custody of client funds and securities an investment adviser must:

1. segregate and identify all customer securities;
2. establish a separate account for each client’s funds;
3. notify the client of the location of its funds;
4. send a quarterly report to the customer detailing what securities and funds for which the investment adviser is maintains custody;
5. submit to surprise annual audits by a CPA; and
6. promptly notify the Administrator on Form ADV of the custody arrangement.

Question 24

What is a wrap fee program?

Answer 24

A program under which a client is charged a single fee (often a percentage of assets under management) for both 1) investment advisory services and 2) brokerage for executing securities transactions.

Question 25

What is not considered custody of client funds and securities?

Answer 25

1. An investment adviser with discretionary authority is not considered to have custody of client funds.
2. The pre-payment of fees is not considered custody of a client funds or securities.

Question 26

An investment adviser must disclose financial impairment to clients under what circumstances?

Answer 26

Financial impairment must be disclosed if the investment adviser has:

1. discretionary authority;
2. custody of client funds or securities; or
3. received pre-payment of fees ($500 at least six months in advance).

Question 27

Are investment advisers permitted to provide investment advice to clients who do not share their financial information or investment objectives?

Answer 27

No. An investment adviser cannot provide such advice because it will be unable to make suitable recommendations to the client.

Question 28

When may an investment adviser representative exercise discretion in effecting a transaction for his customer’s account?

Answer 28

An investment adviser representative must have written authority to use his own discretion in making investment decisions for the client regarding selection of securities, whether to buy or sell, and the number of shares. Decisions relating solely to time and price are not considered discretion. Oral discretionary authority is permissible for the initial transaction in a customer’s account, but written authority must be granted within the first 10 business days after the date of the first transaction.

Question 29

Is an investment adviser permitted to provide his client with third party reports and recommendations?

Answer 29

Yes, provided the adviser discloses that the report or recommendation was prepared by a third party. No disclosure is required when the adviser uses various research materials to make client recommendations.

Question 30

What is an unreasonable advisory fee?

Answer 30

An unreasonable advisory fee is one that is unreasonable in relation to fees charged by other advisers for similar services.