Module 4 Flashcards
Describe and apply the restrictions on the ability of investment advisers to engage in principal and agency transactions with their clients.
Section 206(3) makes it unlawful for any investment adviser
“acting as principal for his own account, knowingly to sell any security to or
purchase any security from a client,
or acting as broker for a person other than such client, knowingly to effect
any sale or purchase of any security for the account of such client,
without disclosing to such client in writing before the completion of such
transaction the capacity in which he is acting and obtaining the consent of the
client to such transaction.”
Principal transactions may lead to abuses such as price manipulation or the
placing of unwanted securities into client accounts (“dumping”).
They could also involve “cherry picking,” in which the adviser seeks to
purchase from a client a security that the adviser believes is poised to increase
in value (or to sell a security that is poised to decrease in value).
Section 206(3) does not, however, prohibit principal or agency transactions
between an IA and its client(s).
It does, however, erect a “speedbump” – disclosure and consent requirements –
that directly deal with the conflicts of interest involved in such transactions.
Section 206(3) (cont.)
The disclosure of the adviser’s capacity (i.e., principal or broker) must be
provided in writing.
The adviser must obtain the client’s consent to the transaction “before the
completion of the transaction.”
The Advisers Act, however, does not define when a transaction is “completed” for
purposes of Section 206(3).
The completion of the transaction is the time of the settlement of the transaction,
not the time of the entry of the transaction.
Describe the IAA’s definition of “advertisement” and apply the IAA’s restrictions on advertising by investment advisers.
“Advertisement” is defined generally to include any “notice, circular, letter or other
written communication addressed to more than one person, or any notice or
other announcement in any publication, or by radio or television which offers
…any … investment advisory service with regard to securities. See rule
206(4)-1(b).
This rule makes it unlawful for an investment adviser to publish, circulate or
distribute any advertisement that:
(1) Refers to any testimonial concerning the IA or its services;
(2) Refers to any “past specific recommendation” of the IA that was or would
have been profitable;
(3) Represents that any graph, chart, formula or other device being offered can
and in and of itself be used to determine which securities to buy or sell, etc.,
without prominently disclosing the limitations/difficulties;
(4) States that any service will be furnished free unless it is unconditionally free;
(5) Contains any untrue statement of a material fact or is otherwise false or
misleading
Describe and apply the IAA’s restrictions on investment advisers’ maintaining “custody” of their clients’ assets.
A registered adviser with custody of client funds or securities (“client assets”) is
required by rule 206(4)-2 to establish a set of controls to safeguard those client
assets.
Custody means “holding, directly or indirectly, client funds or securities, or having
any authority to obtain possession of them.” An adviser also has custody if an
affiliate has custody of its client funds or securities in connection with advisory
services it provides to clients.
Custody includes:
(1) Physical possession of client funds or securities;
(2) Any arrangement under which an adviser is permitted or authorized to
withdraw client funds or securities (such as check-writing authority or the ability
to deduct fees from client assets); and
(3) Any capacity that gives an adviser or its supervised person legal ownership of
or access to client funds or securities (such as acting as general partner or trustee
of a pooled investment vehicle).
The custody rule deems it a fraudulent practice for an adviser to have “custody” of a client’s funds or
securities, unless the adviser meets several conditions:
1. A qualified custodian (QC) (i.e., bank, BD or FCM) maintains those funds and securities in a
separate account for each client in the client’s name, or in accounts that contain only the client’s
funds and securities under the advise’s name as agent or trustee.
2. The adviser must notify its client if it opens an account for the client at a QC, provide the QC’s
name and address, and urge the client to compare the QC’s account statement with the adviser’s
account statement.
3. Adviser must have a reasonable belief that the QC sends an account statement to the client,
at least quarterly, identifying the funds and securities, all amounts, and all transactions.
4. Independent verification (surprise exams) by an independent public accountant at least
annually.
Exception to Deduct Fees. An adviser that has custody solely because it has authority to deduct
advisory fees directly from client accounts is not required to undergo a surprise examination.
5. Pooled Investment Vehicles. If the adviser is the general partner of a limited partnership (or holds
a similar position with another form of pooled investment vehicle such as a hedge fund) the adviser
has two alternatives to complying with the custody rule.
(A) Audit Approach. If the pool’s financial statements are audited by an independent public
accountant that is registered with, and subject to regular inspection by, the Public Company
Accounting Oversight Board (“PCAOB”), and the audited statements are distributed to the pool’s
investors: (i)The adviser is deemed to have complied with the annual surprise examination
requirement; (ii) Custodial account statements need not be delivered to clients, and there is no
obligation to send a notice when they make an investment; and (iii) The adviser may self-custody
certain privately issued securities
Describe and apply the IAA’s restrictions on political contributions by investment advisers.
Rule 206(4)-5 applies to SEC-registered IAs, certain “exempt reporting advisers”
and foreign private advisers who provide – or seek to provide – investment
advisory services to state and municipal governments.
The rule prohibits an adviser from receiving compensation for providing
advisory services to a government client (or to an investment vehicle in which a
government entity invests) for two years after the adviser or one of its executives
makes a political contribution to certain candidates for public office.
The rule is designed to curtail adviser participation in so-called “pay to play
activities” in which political contributions are made to influence the award of
advisory contracts or investment in funds managed by the adviser.
The rule doesn’t prohibit an adviser from providing advisory services to a
government client, even after triggering the two-year time out.
Rather, the rule prohibits the adviser from receiving compensation for providing
advisory services to the government client during the two-year time out.
Applies to contributions to any government official who, at the time of the
contribution is (a) an incumbent, (b) a candidate or (c) a successful candidate for
elective state or municipal office, if the office is responsible for or can influence the
outcome of, the hiring of an investment adviser by the government entity
Applies to contributions greater than $350 per election to an elected official or
candidate for whom the person is entitled to vote, or greater than $150 per
election for an elected official or candidate for whom the person cannot vote.
Describe and apply the IAA’s rules relating to proxy voting.
Whether an IA has authority to vote proxies on behalf of its clients depends on the
scope of the advisory contract. Many contracts call for the adviser to vote client
proxies.
An adviser that exercises voting authority over client securities must – consistent
with its fiduciary duty – vote in the best interest of its clients.
The rule requires advisers with proxy voting authority to
1. Adopt and implement policies and procedures reasonably designed to
ensure that the adviser votes in the clients’ best interests, and must
specifically address how conflicts of interest that may arise between the
adviser and the client are addressed.
2. Describe their voting policies and procedures to clients, deliver a copy of the
policies and procedures to clients upon request, and inform clients how they
can obtain information on how the adviser voted their securities.
3. Keep records relating to voting client securities.
Describe and apply the IAA’s “compliance” rule.
This rule requires each registered adviser to establish an internal compliance
program administered by a chief compliance officer (CCO) that addresses the
adviser’s fiduciary and other obligations under the IAA.
RIAs must adopt and implement written policies and procedures reasonably
designed to prevent violations of the IAA by the adviser and its personnel.
Each RIA must designate a CCO (which should be knowledgeable about the Act
and have authority to develop and enforce the compliance policies and
procedures.) The CCO can be an employee or a 3d party, and need not be so
engaged on a full-time basis.
The policies and procedures must be tailored to the operations of the adviser.
They should cover the following areas:
1. Portfolio management processes (e.g., allocations; disclosures; restrictions)
2. Trading practices (e.g., best execution, soft dollar arrangements)
3. Proprietary trading and personal trading activities of supervised persons
4. Accuracy of disclosures to clients, investors, regulators (e.g., ads)
5. Safeguarding client assets from theft or inappropriate use.
6. Accurate and secure recordkeeping
7. Marketing of advisory services, including use of solicitors
8. Processes to value client holdings and assess fees based thereon
9. Safeguarding privacy protection of client records/information
10. Business continuity plans
The RIA must annually review the adequacy and effectiveness of the compliance
policies and procedures.
Describe and apply the IAA’s code of ethics rule.
IAA Rule 204A-1 – applies to IAs registered or required to be registered
Requires such advisers to establish, maintain and enforce written codes of
ethics that reflect the advisers’ fiduciary duties to their clients.
The codes of ethics must include a minimum standard of conduct for the
adviser’s supervised persons.
The rule doesn’t specify what the minimum standard should be, but the code
should convey the value that the adviser places on ethical conduct.
The code must require supervised persons to comply with the federal securities
laws.
The code must require each of the adviser’s “access persons” to
(a) Make initial and annual reports of their (and their immediate family
members’) securities holdings; and
(b) Make quarterly reports of all of their (and their immediate family members’)
securities transactions to the adviser’s chief compliance officer (CCO).
Access persons make recommendations to clients or have access to
recommendations before they become public.
Describe and apply the IAA’s restrictions on certain contractual provisions.
Section 205 of the IAA addresses these concerns by prohibiting certain investment
advisers (registered or required to be registered) from entering into or performing
any investment advisory contract if the contract:
(1) Provides for compensation to the adviser on the basis of a share of capital
gains on or capital appreciation of any portion of a client’s funds. (Certain
exceptions apply for ”fulcrum fees” and contracts with BDCs, “sophisticated
clients,” 3(c)(7) funds and non-U.S. residents).
(2) fails to provide that no assignment of the advisory contract shall be made by
the adviser without the consent of the client; or
(3) fails to provide that the investment adviser, if a partnership, will notify the client
of any change in the membership of the partnership within a reasonable time
after the change.
What 2 aspects make up Section 206(3).
“acting as principal for his own account, knowingly to sell any security to or
purchase any security from a client,
or acting as broker for a person other than such client, knowingly to effect
any sale or purchase of any security for the account of such client,
without disclosing to such client in writing before the completion of such
transaction the capacity in which he is acting and obtaining the consent of the
client to such transaction.”
What role does the CCO play in the code of ethics?
The CCO must review all securities transactions and holdings reports to identify
conflicts of interest and preventing misconduct by access persons, e.g., insider
trading, scalping or front-running.
The CCO should assess whether access persons are trading in their own
accounts the same securities they trade for their clients and, if so, whether the
clients are receiving equal or lesser terms
The code must also require the CCO to pre-approve investments by access
persons in IPOs and limited (private) offerings, e.g., most hedge funds and private
funds.
The rule requires that the code of ethics must require all supervised
persons to promptly report violations of the cose to the CCO.
