The Investment Advisor’s Compliance Guide, 2nd Edition

By Les Abromovitz

Given the current activities of SEC and state securities regulators, as well as the changing business and communication landscapes, investment advisors today must keep current with developments affecting compliance at all levels and in all jurisdictions. The Investment Advisor’s Compliance Guide, 2nd Edition delivers a concise yet comprehensive explanation of the rules and how they affect the work you do on a daily basis—no matter where you’re registered. The completely enhanced and updated Investment Advisor’s Compliance Guide, 2nd Edition, provides highly practical guidance covering all of today’s compliance issues, including: •The DOL’s new fiduciary rule •RIA advertising, including the use of client testimonials, credentials, and performance results •The use of today’s top social media platforms •Client communications, including disclosures •Recent ethical decisions Designed to go far beyond basic compliance rules, The Investment Advisor’s Compliance Guide, 2nd Edition, will also help advisors avoid compliance issues, deal with client complaints, and grow their business with the confidence that their actions are well suited to withstand the strictest scrutiny from clients and regulators alike. The expert author, Les Abromovitz, J.D., has extensive experience handling compliance consulting assignments for Registered Investment Advisers (RIAs). In The Investment Advisor’s Compliance Guide, 2nd Edition, he has created a completely up-to-date, reader-friendly, go-to-resource for investment advisors, vital for veterans but also a powerful training tool for those new to the field. .

• Language: English
• Publisher: The National Underwriter Company
• Release date: Feb 17, 2017
• ISBN: 9781941627945

Book preview

Index

Introduction

As a result of the Presidential election in November 2016 and the change in administration, many experts have questioned whether the DOL’s Fiduciary Rule will remain in its current form or exist at all. Some experts have even suggested that provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) may be overturned. Even if Registered Investment Advisors (RIAs) are subject to fewer rules, however, the existing regulations will still be enforced. Furthermore, examiners will still deal harshly with violations of the current rules governing RIAs. In addition, state securities regulators will continue working diligently to enforce securities laws and regulations.

Most investment advisors started or joined RIAs so they could act in the best interests of their clients instead of operating in a sales-oriented environment. These investment advisors are committed to fulfilling their fiduciary duty and making full disclosure to all of their clients. Their goal is doing what’s right for their clients and abiding by the rules established by the SEC and state securities regulators. Very few of them are looking for ways to circumvent the rules.

The late director, Sydney Pollack, was enchanted by screenwriter David Rayfiel’s line, You think not getting caught in a lie is the same thing as telling the truth. Pollack used the line in four films, including Three Days of the Condor. Hopefully, Investment Advisor Representatives (IARs) understand that not getting caught by examiners is not the same as doing the right thing for their clients. When it comes to compliance, the mission of an RIA should be to create a culture where everyone associated with the firm is committed to complying with all of the applicable rules and regulations. Nevertheless, there are a few IARs who worry more about getting caught than doing the right thing.

The purpose of this book is to help RIAs and IARs understand their compliance obligations. From a compliance perspective, it is no longer business as usual. The regulatory climate has changed dramatically over the years because of statutes like the Dodd-Frank Act and the SEC rules implementing the law. It is imperative that everyone associated with an RIA understands these rules, not just the people responsible for compliance at an advisory firm. Another goal is to encourage members of an RIA to view compliance more positively and to realize that it can improve their relationship with clients.

The SEC and state securities regulators have shown an increasing willingness to crack down on the person in charge of compliance. The SEC has assessed fines of hundreds of thousands of dollars against RIAs’ Chief Compliance Officers (CCOs) and principals. Their firms also paid steep fines.

In October 2016, the SEC announced a record 868 enforcement actions brought during the fiscal year that ended on September 30.¹ Of those actions, 160 cases were brought against investment advisors or investment companies. The Commission brought eight enforcement actions that were connected to private equity advisors. In addition, the SEC sanctioned thirteen RIAs for spreading false claims that were made by an investment management firm about its strategy. The Commission also penalized RIAs for steering clients toward more expensive mutual funds.

With so much at stake, advisory firms must stay on top of their compliance obligations. Even innocent mistakes can result in sanctions against a firm. Aside from the financial impact of fines, these compliance mistakes can undermine an RIA’s reputation in the community.

Furthermore, compliance mistakes can follow advisors for years to come.

THE INVESTMENT ADVISOR’S COMPLIANCE GUIDE will help you avoid those kinds of irreparable mistakes. The book can also ensure that IARs and all associated persons understand the firm’s fiduciary obligations. Reading this book can help them think like a fiduciary, rather than focusing on their own interests.

This book can provide basic training for seasoned IARs and newbies. Most of them would much rather be giving investment advice or courting new clients. Without an understanding of compliance, however, they may be courting trouble. THE INVESTMENT ADVISOR’S COMPLIANCE GUIDE can also help registered representatives, CPAs, and insurance agents who are thinking about starting or joining an RIA.

Whether the market is booming or floundering, and no matter which political party is in charge, securities regulators expect RIAs to be compliant. Firms will often spend a great deal of time and money in an effort to comply with the many rules and regulations. Some RIAs will need to hire a full time CCO to be in charge of compliance, as well as others to assist that individual. Many will engage compliance consulting firms to guide them through the complex regulations that govern RIAs.

Though the cost of compliance may be high, the potential losses from noncompliance are much higher. As one executive for a compliance consulting firm said, It is far less expensive to keep you out of trouble than to get you out of trouble. The goal of THE INVESTMENT ADVISOR’S COMPLIANCE GUIDE is to help you to avoid run-ins with securities regulators, because getting you out of trouble may be impossible.

Endnote

1.    SEC Press Release 2016-212, SEC Announces Enforcement Results for FY 2016, October 11, 2016.

Chapter 1

Regulatory Oversight of Investment Advisors

It is an interesting and challenging time to be a Registered Investment Advisor (RIA). According to an article in The Wall Street Journal published on October 20, 2016, the number of RIAs has grown over the past two years to 12,000.¹ Although the SEC is allocating more examiners to oversee investment advisors, the ranks of RIAs has climbed 17 percent over the past two years. The SEC is considering whether to have third parties conduct examinations of RIAs instead of firms being examined by teams dispatched from the SEC’s Office of Compliance Inspections and Examinations (OCIE).²

The Wall Street Journal article observed that RIAs will manage more than $70 trillion of assets by the end of this fiscal year, which is up from $28 trillion ten years ago. Marc Wyatt, director of the OCIE, said the SEC is allocating more resources to keep up with the growing number of RIAs. Some experts believe that more financial advisors will migrate from broker-dealers to RIA channels because of the Department of Labor’s new Fiduciary Rule.

In The Wall Street Journal on November 1, 2016, Jean Eaglesham reported that the SEC has failed to examine thousands of the money managers it oversees, even though the Commission’s annual spending has doubled to roughly $315 million in fiscal year 2016.³ A sizeable number of RIAs have never undergone an on-site examination, even though former SEC chair, Mary Jo White, called inspections the greatest protection her agency can offer to retail investors. Wyatt said that the number of exams of RIAs increased by one-fifth in the year ending September 30. He also took note of the SEC’s specific initiatives to address high-risk conduct by newly-registered advisors and those never examined previously. About 500 RIAs become SEC-registered every year.

Although state securities regulators oversee more RIAs since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) in 2010, they might not have the money to hire enough examiners. Some states are wrestling with drops in tax revenue and large budget shortfalls. Therefore, state securities agencies may not receive the funds needed to enforce rules and regulations that apply to RIAs. In some states, regulatory oversight is not a high priority.

Eaglesham observed that there are sharp differences in efficiency, expertise, and procedures across the SEC’s twelve offices. Each RIA examiner reviewed an average of 4.6 firms in fiscal 2015, which was almost double the 2.4 average of the slowest office. Red flags sometimes go undetected, especially among the smaller SEC-registered firms.⁴

Whether a firm is regulated by the SEC or state securities regulators, it is imperative that RIAs adhere to their compliance obligations. To ensure compliance, RIAs and Investment Advisor Representatives (IARs) must fully understand what those obligations are. To that end, it is important to explain some of the basics.

For instance, Registered Investment Advisor or RIA refers to the firm, not the individual. Quite often, financial professionals will incorrectly refer to themselves as registered investment advisors, which is the term that describes the firm itself. An IAR is the individual who is actually giving the advice. Adding to the confusion, the term Investment Advisor might apply to either the firm or the individual. As we will see in Chapter 24, advisors should not use the initials, RIA, or IAR, after their names. Securities regulators take the position that investors will mistakenly believe those initials are a designation earned by the investment advisor, which is not the case.

Often, this book will use RIA to describe any advisory firm registered with either the SEC or state securities regulators. In this book, investment advisor is spelled with an or, not an er. Nevertheless, the key statute governing RIAs is the Investment Advisers Act of 1940. When referring to the act itself or a rule that interprets this law, advisor will be spelled with an er as it appears in the legislation, speech, article, or quote. Therefore, you might see advisor spelled as adviser in the same sentence.

Though the Investment Advisers Act was passed in 1940, it has withstood the test of time. According to a white paper from the Morgan Lewis law firm published in October 2016, the Advisers Act is a flexible and technologically neutral regulatory regime that has accommodated technological change, innovation in products and services, and evolving business models.⁵ The decades-old statute, along with new rules and regulatory guidance, must now deal with emerging compliance issues such as robo-advisors, cybersecurity, cloud-based books and records, and social media.

The rules enacted since the statute was passed implement and interpret the Investment Advisers Act. The language in a statute usually provides a broad framework for the act, and rules help to clarify what Congress’ intent was in passing the law. For example, the SEC passed rules to clarify Section 206 of the Investment Advisers Act. Rule 206(4)-1, the Advertising Rule, delineates what types of advertisements are prohibited. Rule 206(4)-2 spells out an RIA’s obligations when the firm takes custody of a client’s funds or securities. These rules, and several others, bring clarity to an RIA’s obligations arising from Section 206.

Impact of the Dodd-Frank Act on RIAs

The regulatory climate for RIAs was significantly impacted by the Dodd-Frank Act, which was signed into law on July 21, 2010. The threshold for SEC jurisdiction over RIAs was increased to $100 million in regulatory assets under management.

Subject to certain exceptions, RIAs with regulatory assets under management of less than $100 million are regulated by the states. Each state imposes different registration requirements on an RIA that conducts business there. As a result, an RIA may be required to register in many different states. Because these registration requirements may be unduly burdensome, the Dodd-Frank Act provided relief to an RIA that must register in at least fifteen states. A firm meeting that description has the option of being registered with the SEC. The SEC has retained jurisdiction over the so-called mid-sized investment advisors in New York, since that state does not conduct examinations of RIAs. The Commission also oversees all investment advisors in Wyoming.

The Dodd-Frank Act did not resolve the issue of whether all financial services professionals should be held to a fiduciary standard. The law authorized the SEC to impose a fiduciary duty on registered representatives who provide investment advice to clients. Although the SEC recommended that broker-dealers be subject to the same fiduciary standard as RIAs, it is not certain that this harmonization of regulation will occur anytime soon. With the election of President Trump, experts have predicted that the SEC will not enact a uniform fiduciary standard for brokers and IARs. For now, brokers, IARs and certain financial professionals are subject to the Department of Labor’s Fiduciary Rule when they make recommendations relating to an investor’s qualified retirement savings plan. This is separate and distinct from any fiduciary rule promulgated by the SEC.

As a result of the Dodd-Frank Act, the definition of qualified client described in Rule 205-3 under the Investment Advisers Act was changed. Effective on September 19, 2011, the SEC issued an order raising two of the three thresholds that determine whether an RIA is permitted to charge its clients performance fees. As we will see in Chapter 14, an investment advisor registered with the SEC may not charge incentive or performance-based fees unless the person is a qualified client. State-registered investment advisors may face different restrictions if they intend to charge performance fees. The threshold was adjusted for inflation on June 14, 2016.⁶ The accredited investor definition is also likely to be expanded. That definition determines which investors are permitted to participate in private placements.

The Dodd-Frank Act gave the SEC the authority to pay financial rewards to whistleblowers that provide new and timely information about securities law violations. Among the many eligibility requirements, the whistleblower’s information must lead to a successful SEC enforcement action resulting in more than $1 million in monetary sanctions.

Publicly Available Information for Investors

The goal of regulatory reform is to protect investors. The Investment Adviser Public Disclosure (IAPD) website enables investors to electronically access information regarding firms, as well as the individuals working for RIAs. The online system is connected to FINRA’s BrokerCheck® database, which discloses registered representatives’ disciplinary record.

Investors can visit the IAPD website to obtain a great deal of information regarding IARs and the firms for whom they work. The IAPD website offers this advice to investors:

You can search for an Investment Adviser firm on this website and view the registration or reporting form (Form ADV) that the adviser filed. This website will also search FINRA’s BrokerCheck system and indicate whether an entity is a Brokerage firm. Investment advisers file Form ADV to register with the SEC and/or the states. Some advisers that do not have to register with the SEC or the states (Exempt Reporting Advisers) must nonetheless complete some of the questions in Form ADV for purposes of reporting to the SEC and/or the states. Form ADV contains information about an investment adviser and its business operations. Additionally, it contains disclosure about certain disciplinary events involving the adviser and its key personnel.

You can also search for an individual investment adviser representative and view that individual’s professional background and conduct, including current registrations, employment history, and disclosures about certain disciplinary events involving the individual. The information about investment adviser representatives that appears on this website is collected from individual Investment Adviser Representatives, Investment Adviser firm(s), and/or securities regulator(s) as part of the securities industry’s registration and licensing process. Individuals that are Registered Representatives of a Brokerage firm that are listed in FINRA’s BrokerCheck system will also appear in search results.⁷

Because of the IAPD website and a wealth of additional online information, investors can easily conduct due diligence of the RIAs and IARs they wish to engage. Accordingly, it is imperative that RIAs and IARs play by the rules and keep their reputations intact.

Definition of an Investment Advisor

Section 202 of the Investment Advisers Act defines an investment advisor as:

any 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.

The definition uses the word person, even though the investment adviser in the act refers to the firm and not the individual.

To satisfy the aforementioned definition, the person must receive compensation, which is interpreted broadly. Compensation does not need to be labeled as an advisory fee nor does it have to be received directly from a client. In addition, although the person must be engaged in the business of advising others, it does not need to be the individual’s sole or principal business activity.

The Investment Advisers Act and its rules govern the conduct of RIAs. Many states incorporate provisions of that federal statute and the related rules into their own laws governing RIAs. Blue Sky laws refer to state statutes regulating securities.

The Utah Department of Commerce Division of Securities provides a very simple explanation of what constitutes an investment advisor on its website:⁸

What is an Investment Adviser? An Investment Adviser is simply someone who provides advice on securities for compensation. However, Investment Advisers can render that advice in numerous ways, including:

•    issuing reports or analysis on securities;

•    making recommendations to buy or sell securities;

•    managing a client’s securities portfolio;

•    preparing financial plans that involve securities recommendations; or

•    managing an investment fund that allows for the investment in securities.

The definition of investment advisor is similar in other states.

Exemptions from Registering as an Investment Advisor

When Congress passed the Investment Advisers Act, it identified a number of specific groups that were exempted from complying with the statute. As a general rule, these groups are not required to register and are not subject to the regulations imposed by the Investment Advisers Act. The SEC’s Division of Investment Management summarized certain exemptions from registration in its publication, General Information on the Regulation of Investment Advisers:

•    Domestic banks (defined in Section 202(a) (2) of the Advisers Act) and bank holding companies (defined in the Bank Holding Company Act of 1956). Savings and loan institutions, federal savings banks, foreign banks, and credit unions do not fall within this exclusion.

•    Lawyers, accountants, engineers, and teachers if their performance of advisory services is solely incidental to their professions.

•    Brokers and dealers if their performance of advisory services is solely incidental to the conduct of their business as brokers and dealers, and they do not receive any special compensation for their advisory services. This exclusion is not available to a registered representative acting as a financial planner outside the scope of his employment with the broker employer.

•    Publishers of bona fide newspapers, news magazines, and business or financial publications of general and regular circulation. Under a decision of the United States Supreme Court, to enable a publisher to qualify for this exclusion, a publication must satisfy three elements: (1) the publication must offer only impersonal advice, i.e., advice not tailored to the individual needs of a specific client, group of clients, or portfolio; (2) the publication must be bona fide, containing disinterested commentary and analysis rather than promotional material disseminated by someone touting particular securities, advertised lists of stocks sure to go up, or information distributed as an incident to personalized investment services; and (3) the publication must be of general and regular circulation rather than issued from time to time in response to episodic market activity or events affecting the securities industry. See Lowe v. Securities and Exchange Commission, 472 U.S. 181 (1985).

•    Persons and firms whose advice, analyses, or reports are related only to securities that are direct obligations of, or obligations guaranteed by, the United States, or by certain U.S. government-sponsored corporations designated by the Secretary of the Treasury (e.g., FNMA, GNMA).⁹

The above exclusions are found in 202(a)(11)(A)-(E) of the Investment Advisers Act.

Family Offices

Family offices are entities that are set up by wealthy families to manage their wealth and to provide various services to family members. The family office assists with important services such as estate planning, charitable giving, and tax guidance.

Until the passage of the Dodd-Frank Act, an investment advisor was not required to be registered if the firm had fewer than fifteen clients. The Dodd-Frank Act repealed the fifteen client exemption from registration. Historically, family offices were exempt from registration under the Investment Advisers Act because they fell within the exemption afforded to investment advisors with fewer than fifteen clients. Nevertheless, Dodd-Frank also required the SEC to define family offices, so they would still be exempt from regulation under the Investment Advisers Act.

Pursuant to the SEC’s definition, family offices are excluded from Investment Advisers Act regulation if:

•    they only provide advice to family clients;

•    the company providing the advice is owned by and exclusively controlled by family members; and

•    the family office does not hold itself out to the public as an investment advisor.

Family offices not covered by the above exclusion had to be registered by March 30, 2012.¹⁰

The Big Picture

In any regulatory or economic environment, compliance is extremely important. Even if the threat of a compliance examination by securities regulators is remote, disobeying the rules can have serious implications. Lori A. Richards, the former director of the OCIE, warned RIAs about the potential pitfalls of noncompliance in her December 2, 2008 open letter to CEOs of SEC-registered firms:

During this time of financial and market turmoil, the Office of Compliance Inspections and Examinations of the Securities and Exchange Commission reminds leaders of SEC-registered firms, including broker-dealers, investment advisers, investment companies and transfer agents, of the critical role played by your firm’s compliance programs in helping to meet your obligations under the securities laws. Your firm’s compliance function is critical to assure that your operations comply with the law and rules for industry participation and to ensure that the interests of your customers, clients and shareholders are protected. Moreover, compliance is a vital control function that helps to protect the firm from conduct that could negatively impact the firm’s business and its reputation.

While many firms are considering reductions and cost-cutting measures, we remind you of your firm’s legal obligation to maintain an adequate compliance program reasonably designed to achieve compliance with the law.¹¹

At the time of Richards’ speech, the United States was in the middle of the worst economic downturn since the Great Depression. RIAs found their income slashed as the value of portfolios plummeted. Most RIAs earn the bulk of their fees based on a percentage of clients’ assets under management. Because of this decline in their income, RIAs may have reacted by cutting their compliance budgets. As we will see later, examiners may look at an RIA’s compliance budget to determine whether it is adequate in view of the firm’s business model.

Tough economic times are no excuse for an RIA being lax in fulfilling its compliance obligations. Failure to comply with rules and regulations may lead to misconduct that will severely damage a firm’s reputation and standing in the community. Many disciplinary events must be disclosed to existing and prospective clients in the RIA’s disclosure brochure. Furthermore, the SEC or state securities regulators may bring enforcement actions against RIAs that commit serious compliance violations. Aside from fines and other penalties imposed on RIAs that break the rules, it is not uncommon for the Commission to require firms to post a copy of the SEC’s order on their websites.

Prospective clients are likely to avoid an RIA that has an SEC order rebuking the firm on its website. Few prospective clients will hire an RIA after conducting an Internet search of the firm and reading that order or seeing other negative publicity. Attracting new clients is difficult enough for RIAs without having to explain compliance violations and disciplinary action taken by securities regulators. Repeat offenders are likely to be sanctioned even more severely. Furthermore, they will be viewed as posing a risk to investors and are likely to be examined more frequently than other RIAs.

The rules for state-registered investment advisors do not always mirror the SEC’s regulations. Even if state rules are less burdensome, it might be wise for an RIA to go further as a best practice. For example, a state-registered firm should consider adopting a code of ethics, even if it is not required to do so. All SEC-registered firms are required to adopt a code of ethics.

Endnotes

1.    Lisa Beilfuss, SEC Sharpens Focus on Registered Investment Advisers, Wall Street Journal, October 20, 2016.

2.    Id.

3.    Jean Eaglesham, A Visit From the SEC? Doesn’t Happen for Thousands of Money Managers, Wall Street Journal, November 1, 2016.

4.    Id.

5.    Jennifer L. Klass and Eris L. Perelman, The Evolution of Advice: Digital Investment Advisers as Fiduciaries, Morgan Lewis Whitepaper October, 2016, www.morganlewis.com/pubs/the-evolution-of-advice-digital-investment-advisers-as-fiduciaries.

6.    SEC Release No. IA-4421, Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 under the Investment Advisers Act of 1940, June 14, 2016.

7.    Welcome to the Investment Adviser Public Disclosure website, https://www.adviserinfo.sec.gov/.

8.    http://www.securities.utah.gov/industry/license_investadviser.html.

9.    SEC, General Information on the Regulation of Investment Advisers, last modified on March 11, 2011, available on line at: https://www.sec.gov/divisions/investment/iaregulation/memoia.htm.

10.  17 C.F.R. §275.202(a)(11)(g)-1.

11.  SEC, Open Letter to CEOs of SEC-Registered Firms, December 2, 2008. Available online at: https://www.sec.gov/about/offices/ocie/ceoletter.htm.

Chapter 2

Differences between State and SEC Regulation of Investment Advisors

According to the 2016 Evolution Revolution, an annual joint study from the Investment Adviser Association (IAA) and National Regulatory Services which was compiled from Form ADV Part 1 data, there are 11,847 federally registered advisors.¹ Based on April 8, 2016 data, the number of SEC-registered investment advisors grew by 3.3 percent during 2015.

In 2011, thousands of RIAs switched from SEC to state registration when Section 410 of the Dodd-Frank Act raised the asset under management threshold from $25 million to $100 million. As we saw in Chapter 1, RIAs managing less than $100 million may choose to become or remain SEC-registered if they are required to register with fifteen or more states. Prior to the Dodd-Frank Act, this option was not available unless an advisor had to register in at least thirty states.

An RIA relying on the multi-state advisor exemption must withdraw from SEC registration when it is no longer required to be registered in at least fifteen states. Advisors are required to assess their eligibility for SEC registration annually.²

Regulatory Assets under Management

The Form ADV instructions refer to regulatory assets under management, instead of the traditional term, assets under management. Regulatory assets under management include securities portfolios for which RIAs provide continuous and regular supervisory or management services.

Assets must be included in the calculation, even if they are:

•    family or proprietary assets;

•    assets managed without compensation of any kind; or

•    assets of foreign clients.

The instructions for Form ADV require an RIA to calculate its regulatory assets under management on a gross basis. An RIA may not deduct any unpaid outstanding loans or other accrued liabilities. An RIA should not deduct securities purchased on margin when calculating regulatory assets under management. The SEC’s rationale is that it does not matter if a client has borrowed money to invest in some of its regulatory assets under management.

The SEC’s intent was to provide a uniform method for calculating assets under management to maintain consistency for registration purposes and risk assessment. Using a uniform method for calculating assets under management prevents RIAs from excluding assets in order to avoid registration or to remain state registered. In addition, the uniform method is intended to prevent inconsistent application of the Investment Advisers Act to RIAs managing the same amount of assets. Nevertheless, in this book, we will generally refer to assets under management (AUM), since that term is more familiar to advisors.

SEC Versus State Registration

The rules implementing the Dodd-Frank Act created a buffer zone for mid-sized advisors with AUM that fluctuate around the $100 million threshold. The rules also permit advisors to wait until their assets hit $110 million before the firm must register with the Commission. Once registered, however, RIAs need not withdraw registration until the firm’s AUM fall below $90 million.

The National Securities Markets Improvement Act of 1996 (NSMIA) established the parameters for regulatory oversight, so the SEC and the states would not infringe on each other’s jurisdictions. Prior to the Dodd-Frank Act, the SEC was usually responsible for overseeing RIAs with AUM that exceeded $25 million. Now that the AUM threshold is $100 million, the SEC has jurisdiction over large advisory firms while states oversee most small and mid-sized advisors.

Despite NSMIA, SEC-registered investment advisors may be required to provide state securities regulators with copies of documents filed with the Commission, a process referred to as notice-filing. An SEC-registered investment advisor must notice-file in the state where its principal office is located and in other states where the firm has an office. An SEC-registered firm must also notice-file when it has more clients in that state than the cap established for that jurisdiction. In most states, an RIA with more than five clients must notice-file in that jurisdiction, even though it has no office there.

De Minimis Exemption

NSMIA amended the Investment Advisers Act to include a new provision, which is commonly referred to as the "national de minimis standard." This standard can be found in Section 222(d) of the Investment Advisers Act.³ The national de minimis standard makes state investment advisor registration or licensing statutes inapplicable to advisors with no place of business in a particular state and fewer than six clients who are residents there. Suppose a Pittsburgh-based RIA is registered in Pennsylvania but one of its biggest clients moves to Florida. Because there is a national de minimis standard, the RIA may not need to register in Florida.

Based upon the de minimis standard, a state may not require registration, licensing, or qualification of an investment advisor if the firm:

•    does not have a place of business in the state; and

•    has had fewer than six clients who are residents of the state during the preceding twelve month period.

If that Pittsburgh-based RIA does open a Florida office or has six clients in the state, the firm must register there. It is important to note that this is a rolling twelve-month period, not a calendar year. An RIA that has six or more clients in several states must register in each of them.

In certain states such as Texas, registration is required before an RIA takes on its first client. If the RIA does not have an office in Texas and has fewer than six clients, however, a full registration is not required. The RIA need only make a special notice filing. In the Frequently Asked Questions (FAQs) section of the Texas State Securities Board’s website, registration staff addressed the de minimis issue:

1.A.9. Didn’t NSMIA create a national de minimis exemption from investment adviser registration?

Yes. See Section 18a of the Investment Advisers Act of 1940. If an investment adviser does not have a place of business (See FAQ 1.A.10) located in Texas and, during the preceding 12 month period, had no more than five clients (See FAQ 1.A.11) who are Texas residents, the investment adviser is not required to register with the Texas Securities Commissioner. See Rule 116.1(b)(2)(A)(iv). However, a notice filing and fee are required. See Rule 116.1(b)(2)(C) and FAQ 1.A.12. This is satisfied by filing Form ADV through the IARD system for the firm as well as filing Form U4 for each investment adviser representative through the CRD system.⁴

Oversight of State-Registered Investment Advisors

The North American Securities Administrators Association (NASAA) is an organization comprised of securities administrators in the fifty states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, the provinces and territories of Canada, and Mexico. Among its other responsibilities, NASAA formulates model rules that are used by legislators in drafting securities legislation. In addition, each state’s securities regulators frequently use the NASAA’s model rules as the framework for their own regulations.

In NASAA’s Investment Adviser Guide, the organization pointed out that some prohibited practices should be obvious and others are not. For example, it should be obvious that RIAs may not engage in any activity that acts as a fraud or deceit on clients. NASAA’s Investment Adviser Guide⁵ advised that RIAs should avoid the following practices:

•    Acting as an issuer or affiliate of a securities issuer

•    Recommending unregistered, non-exempt securities or the use of unlicensed broker-dealers

•    Charging unreasonable fees

•    Using contracts and contractual language, like hedge clauses, which seek to limit or negate an advisor’s legal liability

•    Limiting a client’s ability to pursue a civil case