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SECTION ONE
DEFINING WHO’S WHO
CHAPTER 2
THE INVESTMENT ADVISER
ОглавлениеONE OF THE MOST complicated, confusing, and misunderstood subjects in the financial services industry is the role, registration, and regulation of the investment adviser. Whether your firm is a large organization managing assets for multiple mutual funds or a one-person investment consultant on Main Street, many of your responsibilities and liabilities are determined by whether or not you or your firm are legally required to be registered as an investment adviser.
There are many benefits to being an RIA. It is the only way you can legally charge fees, whether an hourly rate, a flat fee, or a percentage of assets under management. It allows you legally to provide a wider range of services and financial planning recommendations, which can increase your revenues and market penetration. Finally, this license can be a big advantage when it comes to attracting more sophisticated and upscale clients.
The confusion starts with how to spell adviser. English teachers have long favored the use of “advisor.” Then, in 1940, Congress opted for adviser with its passage of the Investment Advisers Act. Over the next half century, a dual spelling system – adviser vs. advisor – fought it out in the legal and popular press. In the end, many journalists yielded to Congress. Bloomberg Press style now conforms to that of Congress and uses only the adviser spelling. As Congress has yet to pass an “advisery” rule, that word remains true to its original form and is spelled “advisory.”
This chapter makes the whole subject more clear and offers strategies for avoiding common but dangerous land mines. Look for two main things in this chapter and how their application will affect you and your practice:
1. The definition of investment adviser on both federal and state levels. Does your firm fit that definition, or are you and your firm exempt or excluded from having to register?
2. If your firm is an investment adviser, are you responsible to the SEC, your state, or both for oversight? The 1996 Investment Advisers Supervision Coordination Act created a distinction between large RIAs, which must be registered with the SEC, and smaller firms, which must be registered with state securities administrators. How does this legislation affect your practice?
Firm and Individual Registration
IT IS IMPORTANT TO DIFFERENTIATE at the outset between firm and individual registration. Large investment advisers are typically corporations who retain individuals who are investment adviser representatives or associated persons. These are the people who are actually meeting with clients and giving investment advice. Sometimes an RIA is an unincorporated sole proprietor. Both the large corporate entity and the unincorporated sole proprietor are considered to be the RIA or the “firm.” However, only when a sole proprietor is registered as an RIA is the individual person an RIA. This distinction is frequently misunderstood and used erroneously in the industry where it is not uncommon to hear individuals say they are RIAs when in fact it is their corporation that is the RIA and the individuals are technically representatives or associated persons of the firm. In this book, when using the phrase “registering as an RIA,” it means either the individual must register as an RIA or affiliate with an RIA.
The distinction between individual and firm registration becomes important under recent legislation which requires large RIAs, typically corporations managing institutional assets, to register solely with the SEC. Smaller RIAs and individuals who are RIA representatives must register with state securities administrators. This legislation was designed to eliminate the old system of dual state and federal registration for firms. However, as you will see later in this chapter, it is possible to own a firm or be part of a firm that is registered with the SEC, but be an individual who is required to be registered with a state as an RIA representative.
Penalties for failing to register with the SEC as an investment adviser are horrifying. In addition to fines of up to $10,000, there is also the felony penalty of up to five years in jail. 20 These penalties apply per case. Simultaneously violating state investment adviser laws can increase the fines and jail time. Failing to register can also make all contracts advisers have with their clients void and unenforceable. This means clients do not have to pay the fees owed to the adviser, and the adviser may have to refund fees previously paid.
Definition
IN 1940, CONGRESS ENACTED the Investment Advisers Act and authorized the SEC to regulate a business that then consisted primarily of advising institutional investors. Since the Act has not kept up with the current business climate, one of the problems financial services providers have today is applying retail situations to definitions that were designed for institutional advisers and their clients.
Use the following brief summary and chart as your guideline. You, or your firm, must register with the SEC if you meet the definition of Investment Adviser, have more than $30 million of assets under management, and are neither excluded nor exempted from registration.
The term “investment adviser” is defined in Section 202(a)(11) of the Advisers Act to mean:
[A]ny 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; but does not include:
a. A bank or any bank holding company as defined in the Bank Holding Company Act of 1956, which is not an investment company, b. Any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession, c. Any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore,
You must register with the SEC if:
• You meet the definition of Investment Adviser21, and
• You have more than $30 million of assets under management, and
• You are not among the following who are excluded from the Definition:22
– banks
– broker/dealers, lawyers, accountants, teachers, and others whose advice about securities is incidental to their business
– certain publishers, or
• You are not among the following and others who are exempted from registration:23
– Your principal place of business is in one state, and you give no advice regarding securities on a listed national exchange
– Your clients are limited to insurance companies
– You had fewer than 15 clients in the preceding 12 months and do not hold yourself out as an investment adviser.
d. A publisher of any bona fide newspaper, news magazine, business or financial publication of general and regular circulation, e. Any person whose advice, analyses, or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States, or securities issued or guaranteed by Corporations in which the United States has a direct or indirect interest which shall have been designated by the Secretary of the Treasury, pursuant to Section 3(a)(12) of the Securities Exchange Act of 1934, as exempted securities for the purposes of that Act, or f. Such other persons not within the intent of this paragraph, as the commission may designate by rules and regulations or order.
The SEC, in Release No. IA-1092, has adopted a three-pronged test to determine whether a firm or individual person needs to be registered as an investment adviser. The release also looked at financial planning activities and how they apply to the Act. Although this Release applies to SEC RIAs, many states will use the same analysis. Persons need to be an RIA or affiliated with one if they:
• Provide advice, issue reports, or analyze securities • Are in the business of providing such services
• Provide such services for compensation.
As few people reading this book are excluded from the “in the business” element, it will simplify matters to focus on three words: compensation, advice, and securities. Each of these words is construed very broadly by the SEC. COMPENSATION Receiving any economic benefit from any source is, according to the SEC, compensation. Contrary to popular opinion, it is not necessary for the benefit to be a separate fee directly related to the investment advice or financial plan. Nor is it necessary for this to be a commission from the sale of securities. It has been determined that the receipt of commissions from a client’s insurance product or other investment is sufficient to satisfy the compensation test.24 In short, any fees for plans, commissions from product sales, or remuneration from any source is compensation.
DILEMMA
GEORGE, A LIFE INSURANCE salesperson, holds himself out to be an estate planner. In performing his services, he reviews a client’s balance sheet and makes recommendations for specific insurance products. At a meeting with Mr. and Mrs. Client, he makes the following recommendation: “Since your ABC stock has been underperforming for the last five years, I recommend selling that stock and placing the proceeds in a whole life insurance policy.” George receives no fees for investment advice and no commission from the sale of the ABC stock. He will, however, receive commissions from the sale of the whole life insurance policy.
Question: Has George received compensation under the rule and is he required to be an RIA?
Answer: Yes. George gave advice regarding securities and he was compensated by an insurance commission. George has just committed a felony, could be facing five years in jail, and probably does not even know it. George could eliminate this problem completely either by registering as an investment adviser or by limiting all his recommendations to insurance and avoiding any advice about securities.
ADVICE is also interpreted broadly by the SEC. It is not unusual to find planners or consultants trying to avoid registering as an Investment Adviser by not giving specific investment advice. Instead of recommending the client buy the XYZ mutual fund, they will just recommend generic balanced mutual funds. The SEC, however, has found giving general advice about securities is sufficient to trigger the registration requirement; the advice need not be specific.25 The giving of advice need not constitute the primary or even major activity in order to satisfy that part of the test.26 The SEC envisioned that in order for most financial planners to do their jobs properly, they must discuss both the pros and cons of a particular investment with their clients.27 It is difficult to imagine any financial planner doing a good job without making some comments regarding the client’s savings and investment strategy. If planners fail to discuss securities with their clients, they would probably be breaching their fiduciary duty.
The following have been found to fit the requirements of advice:
1. Analyses or valuations of particular securities, or securities markets in general, even without specific buy, hold, or sell recommendations.28
2. Market timing recommendations concerning the time to move a percentage of assets into a category of investments such as mutual funds or foreign stocks.29
3. Advising clients on the choice or retention of another investment adviser (a solicitor) or serving as a person who evaluates investment advisers.30
4. Providing statistical or historical data about securities that incorporate the writer’s judgments.31
DILEMMA
TOM, A CFP LICENSEE with a large brokerage firm, does not hold himself out to be a financial planner, although he does do financial planning incidental to his business as a broker. To build a client base, he has developed a seminar entitled “Financial Planning for the 21st Century.” This seminar is offered to current and prospective clients for the nominal fee of $25. The fee was designed to cover the cost of renting a hotel room, refreshments, and printing a 100-page workbook. During the seminar, Tom reviews all aspects of financial planning, including how to evaluate stocks and bonds and what to look for in investment purchases. He does not give anyone individual advice regarding securities at the seminar, but he may meet with them privately later.
Question: Is Tom giving advice regarding securities for which he is compensated, and must he register as an investment adviser; or does he fit into one of the exclusions?
Answer: Tom would be required to register. Even though the modest fee for attending the class was used only to cover Tom’s expenses and Tom did not make a profit, it is still considered compensation. Furthermore, Tom does not fit into the broker-dealer exclusion because the activities of giving a seminar are not considered to be incidental to his brokerage business.
SECURITIES Once again, the SEC has construed the word “security” in the widest possible sense. The legal definition of a security is quite lengthy and includes any scheme involving the investment of money in a common enterprise with profits to come solely from the efforts of others.32 It includes all sorts of investments that most people never consider to be securities, such as certificates of deposit, notes, and mortgages. There are only two exclusions under the definition: annuities and life insurance.
Exclusions and Exemptions
THE INVESTMENT ADVISERS ACT and numerous rules, regulations, and releases have defined not only who is required to register but also who is not. Note: there is a big difference between exemptions and exclusions. Those persons or entities who are exempt from registering must still follow the laws; for example, anti-fraud provisions. This group consists of those few advisers who limit their clients to insurance companies, have fewer than 15 clients or limit their practice to one state, and do not give advice regarding nationally listed securities. However, those who are excluded from registration are not considered to be investment advisers and therefore need not follow the anti-fraud or other provisions.33
Three excluded categories are pertinent to this section: certain professionals, broker-dealers, and exempted advisers.
PROFESSIONALS Some professionals, including accountants, lawyers, engineers, and teachers, are excluded from the Act. At first glance, these exclusions may look promising, but when you delve more deeply into the statutes you will notice the exclusions only work if these professionals are giving securities advice solely incidental to the practice of their profession. Qualifying for this exclusion may be extremely difficult, because financial planning is rarely solely incidental to these professions. The SEC looks at three different factors when determining if a professional can be excluded:34
• Does the professional hold himself out as an investment adviser or financial planner? • Is the investment advice reasonably related to the professional services rendered?
• Is the professional’s fee for investment advisory services structured differently from the schedule for professional services?
DILEMMA
CARLA CPA HAS A regular accounting practice and also advertises that she is available for financial planning services. She makes a detailed evaluation and comparison of investment alternatives. She may recommend specific no-load funds or even direct her client to an investment adviser. She is well known for her investing expertise and clients will frequently ask her questions about trading specific securities.
Question: Should Carla register?
Answer: Yes. She is in the business of giving advice about securities, and she is receiving compensation. Furthermore, she holds herself out as a planner. Accounting firms have only recently begun to take this law seriously. Consequently, now more and more accountants are registering, realizing they can no longer rely on the solely incidental to exclusion.
DILEMMA
IN SOME CITIES it is becoming a common practice for local law firms to serve as trustees and provide investment advice to the trust.
Question: Are these attorneys, who are acting as trustees, providing investment advice solely incidental to their profession as attorneys?
Answer: No. Without even looking at the conflict of interest issues, there is no question that these law firms would also need to be registered investment advisers, as this activity is not incidental to the practice of law.
Another group of professionals, banks, and publishers of news articles are also excluded from the registration requirements. In order for publishers to be excluded, they must meet the following test: • The publication is of a general and impersonal nature, in that the advice provided is not adapted to any specific portfolio or any client’s particular needs; • The publication is bona fide or genuine; and • The publication is of general and regular circulation. It is not timed to specific market activity or to events affecting or having the ability to affect the securities industry.35
DILEMMA
CHARLIE WANTS TO give stock tips and general investment advice over the telephone using a 900 number.
Question: Does he have to register as an RIA?
Answer: If Charlie can fit his activities into the criteria listed for the publisher’s exclusion, he does not have to register. However, if he is giving individual advice, he will need to be an RIA or affiliated with one.36
BROKER-DEALERS The Act also excludes any broker-dealer, or its registered representatives, who provide investment advice solely incidental to the conduct of their business as broker-dealers and who receive no special compensation for the advice. Note there are two requirements in order for registered representatives to fit the broker-dealer exclusion. Their investment advisory services must be solely incidental to their conduct as brokers and they must receive no special compensation for them. This completely eliminates the possibility of stockbrokers preparing a financial plan and charging a fee for it, unless they are RIAs.37 In addition, the giving of investment advice must be done with the broker-dealer’s approval. Consequently, registered representatives of broker-dealers who are performing their financial planning services completely independent of their broker-dealers are not allowed to claim the broker-dealer exclusion.38
It has been found permissible for broker-dealers and their registered representatives to distribute to customers periodic market reports or analysis containing investment advice, provided there is no special charge for the reports and rendering this advice is solely incidental to the conduct of the broker-dealer’s securities business.39 The SEC has also indicated that investment advice offered as part of an overall financial plan for the client is not considered “solely incidental” to the brokerage business, whereas investment advice on individual securities transactions is.40
DILEMMA
ROGER IS A REGISTERED representative with Abundant Profits Broker-Dealer. Roger assists clients in choosing an investment adviser, and Roger monitors the adviser’s performance on a continuing basis. Frequently the adviser is given discretionary authority over the client’s funds and is required to funnel all securities transactions through the broker-dealer so Roger will receive a commission.
Question: Does Roger have to register as an investment adviser?
Answer: Yes. Such activity is outside the scope of normal brokerage operations.41
In summary, to fit into the broker-dealer exclusion, securities and insurance professionals are bound by the following rules:
• They cannot hold themselves out to the public as financial planners or investment advisers, or as persons providing those services. Instead they must hold themselves out as securities or financial services professionals, stockbrokers, or insurance agents.
• They can provide investment advice only in the capacity of registered representative of their broker-dealer, under the broker-dealer’s control, knowledge, and approval.
• They must disclose their dual capacities of both securities and insurance product sales when dealing with any client or potential client.
• They are not allowed to charge nor receive any clearly definable fee other than normal and customary commissions for the provision of any investment advisory service.
• Finally, the brokerage and insurance commissions charged to clients who obtain brokerage and insurance services are based on the same factors as those used to determine the commissions for clients who obtain only one of the services.42
DILEMMA
SALLY STOCKBROKER does not hold herself out as a financial planner, nor is her broker-dealer a registered investment adviser. However, as a service to her clients, she uses the firm’s computer system to do estate planning projections, retirement projections, and asset allocation models. After gathering the data from the computer, she makes written recommendations to purchase specific investment products in line with the clients’ goals.
Question: Does Sally qualify under the broker-dealer exclusion and not have to be an RIA?
Answer: Sally, or her firm, should register as an investment adviser. It seems the services she is performing are beyond those incidental to a stockbroker. They have definitely moved into the financial planning area as defined by the SEC, particularly because she is providing clients with a written plan. In short, if she is doing planning, she must register.
EXEMPTED ADVISERS The following advisers are exempt from registering even if they fit the definition of investment adviser.
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20
Investment Advisers Act of 1940 § 217.
21
Section 202(a)(11).
22
Section 202(a)(11)(A) through (F).
23
Section 203(b).
24
Investment Advisers Act Release No. IA-1092 (October 8, 1987).
25
Thomas P. Lemke and Gerald T. Lins, Regulation of Investment Advisers (New York: Clark Boardman Callaghan, 1996), 1-5.
26
Ibid., 1-4.
27
Investment Advisers Act Release No. IA-1092 (October 8, 1987).
28
Lemke and Lins, 1-6.
29
Ibid.
30
Eli P. Bernzweig, The Financial Planner’s Legal Guide (Englewood Cliffs, N.J.: Prentice-Hall,1986), 30.
31
Ibid.
32
Ibid., (citing SEC v. T.W. Howey Co., 328 U.S. 293 (1946)).
33
Ibid., 34.
34
Lemke and Lins, 1-8.
35
Lowe v. SEC, 472 U.S. 181 (1995).
36
Mr. Alfred A. Zurl, 1995 SEC No-Action letter; and Mr. Hugh A. Hoffman, 1995 SEC No-Action letter.
37
Investment Advisers Act Release No. 1092 (October 8, 1987).
38
Ibid.
39
Bernzweig, 35.
40
Lemke and Lins, 1-9 (citing IA Release No. 471 (1975)).
41
Bernzweig, 36 (citing FPC Securities Corp., [1974- 75 Transfer Binder] Para. 80,072, CCH Federal Securities Law Reporter (September 9, 1974)).
42
The author is grateful to John McGovern, formerly of Nathan & Lewis Securities, for providing assistance with this section.