Chapter 1: Regulations of Firms and Individuals - C. Regulations of Investment Advisers Flashcards
Definition: Investment Adviser
An investment adviser (IA) is a person or firm that is paid a fee to advise others, either directly or indirectly (through publications or writings), as to the advisability and merit of purchasing or selling securities. Also included in the definition is any firm that, in the regular course of business issues reports or analyses concerning securities and charges for such information. Investment advisers are also known as asset managers, investment counselors, investment managers, portfolio managers, wealth managers, and financial planners.
Exclusions from definition of investment adviser
- Banks, savings institutions, or trust companies;
- Broker/dealers or their agents whose advice is incidental to their normal business practice and who receive no special compensation for this advice;
- Employees of investment advisers who are registered as investment adviser representatives;
- Publishers, their employees, and columnists of newspapers, magazines, or business periodicals but only if the advice is not tailored to the individual needs of a specific client or being used to promote particular securities;
- Any person so designated by the state administrator or exempted by the SEC; or
- Professionals, such as lawyers, accountants, teachers, and engineers, whose investment advice is an incidental portion of their business practice. One way to remember this exemption is to remember the word “LATE,” which is an acronym for Lawyers, Accountants, Teachers and Engineers.
Registration as an investment adviser
The National Securities Markets Improvement Act of 1996 was passed in order to eliminate the dual registration of investment advisers at both the federal and state levels. Before this Act, dual registration was required. Now, an investment adviser is registered at the federal level or at the state level, never both.
Based on the value of assets under management (AUM), the Act imposes the following registration requirements for advisers:
- If less than $100 million, register only at the state level (note: if SEC registered RIA and AUM fall to $90 million or less, the adviser must register with the state);
- If between $100 million and $110 million, advisers are permitted, but not required, to register with the SEC; and
- If at least $110 million, must register with the SEC (known as federally registered advisers).
An adviser to an Investment Company under the Investment Company Act of 1940 is always considered a federal covered adviser regardless of how many assets they have under management.
Although federal advisers do not register with the state, they may be required to notify each state in which they conduct business and pay a state filing fee. This is called a notice filing and may not only require a fee to the state, but may also require the federal covered adviser to sign a “consent to service of process,” enabling the administrator to serve any action on the adviser. If the investment adviser cannot be located, this consent allows the administrator to receive the action on the investment adviser’s behalf. This has the same legal effect as directly serving the adviser.
Federal covered advisers must adhere to federal laws regarding issues such as bonding, financial capital, and recordkeeping. The only applicable state requirement for a federal covered adviser is to register its representatives with the state as investment adviser representatives. On the other hand, state covered advisers must follow the USA regarding all these issues.
The registration of an investment adviser automatically constitutes the registration of any partners or officers that are associated with the firm at the time of its registration.
Changes to Investment Adviser Registration Requirements
The Dodd Frank Act raised the threshold for adviser registration. It allows investment advisers managing more than $100 million of assets to register with the SEC. At $110 million, the investment adviser is required to register with the SEC and can remain registered with the SEC as long as the assets do not fall below $90 million.
In addition, the SEC requires that advisers for private equity and certain hedge funds be registered if assets under management (AUM) are in excess of $150,000.
Form ADV
The SEC registration process requires filing of Form ADV (Adviser). Form ADV currently has 2 parts:
- Part 1 pertains to general information about the adviser, such as name, address, business, and whether the adviser has been sanctioned for violating the securities or any other laws. It also asks questions that would allow the SEC to determine whether to grant an application for registration, or to deny or revoke a registration.
- Part 2, or a written brochure, must be delivered to clients prior to issuing a contract and then offered to them annually. This part of the Form ADV contains information about business practices, fees, and conflicts of interest the adviser may have with its clients. ADV Part 2 brochure portion must be written in plain English so that it can be understood by the investor and must not contain terminology that may be confusing.
Exemption from Registration as an Investment Adviser
Investment advisers are exempt from registration if they have no place of business in the state, and if
- Their only clients in the state are other investment advisers, broker/dealers, banks, trust companies and other financial institutions, insurance companies, investment companies, employee benefit plans (with assets of at least $1 million), or government agencies; or
- They solicit no more than 5 retail clients (other than those qualified in the paragraph above) in that state in the preceding 12-month period. This is referred to as the de minimis exemption. De minimis is a Latin term that is used when a trivial situation is of such little consequence that the law or rule does not apply.
Brochure Rule
The SEC requires that investment advisers (IAs) registered under the Act disseminate certain information or other records to clients or prospective clients as appropriate for the protection of investors. Prospective clients must be provided with full disclosure of information at least 48 hours prior to entering into an advisory contract. Alternatively, it may be furnished at the signing of the contract only if the customer is given a free-look period of 5 business days during which they may opt out of the contract without cost.
This information is provided by means of the Investment Adviser Brochure. This brochure may satisfy all or part of the reporting requirement, at the discretion of the administrator. In order to satisfy minimum reporting requirements, it must contain all the information required in Part 2 of Form ADV, which is required for IA registration. Form ADV Part 2 can be used instead of the investment adviser brochure.
Within 120 days of the fiscal year end, a registered adviser must deliver or offer to each client a copy of the current brochure. A summary of the changes must be provided to the customer along with the offer to send the new brochure. If, however, there have been no changes in the last year, no summary is required.
The offer must be done in writing, and if the client accepts the offer, the adviser must send the brochure to the client without charge within 7 days of the notification of the acceptance. Although delivery is required within 120 days, if the adviser is using Form ADV Part 2 instead of the brochure, the form must be updated within 90 days of the fiscal year-end.
Form ADV Part 2B is used to provide information to clients and prospects that pertains to the investment adviser representative. It is a disclosure document concerning the representative’s background and any disciplinary action taken against the representative.
Advisers are not required to deliver a brochure if they enter into a contract with an investment company or for impersonal investment advice (any written or oral communications about investing not directed at any specific client situation). Furthermore, if an adviser charges less than $500 a year under a contract, the brochure is not required.
Some investment advisory firms sponsor wrap accounts, in which the customer pays a fee that covers execution of securities transactions as well as advisory services. In these cases, the investment adviser must furnish a wrap fee brochure (Schedule H) that details all the fees and features of the wrap account and includes, at a minimum, all the information required in Part 2 of Form ADV.
It is important to disclose to the customer that buying the services in the “a la carte” format may be cheaper than paying the wrap fee.
