The Investment Advisor’s Compliance Guide, 3rd Edition

By Les Abromovitz

The Investment Advisor's Compliance Guide, 3rd 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. It can be used as basic training for new Investment Advisor Representatives (IARs), as well as seasoned professionals. Best of all, it's in plain English and will be helpful to both SEC and state-registered investment advisors (RIAs), as well as IARs. This title:

• Covers the SEC's new marketing rule effective November, 2022, including new rules on advertising
• Identifies investment advisors' fiduciary duties, including the Investment Advisers Act's requirement to seek best execution for their clients
• Explains the registered investment advisor (RIA) registration requirements with either the Securities and Exchange Commission or state regulators
• Describes how to deal with client complaints as well as how to meet and exceed client expectations, as well as advice on how to deal with senior investors
• Provides the latest guidance from the NASSA, including the latest NASAA adviser's guide and model rules
• Helps Chief Compliance Officers to identify situations that may subject them to personal liability
• Provides advice on Form ADV, the form used by investment advisers to register with both the Securities and Exchange Commission (“SEC”) and state securities authorities, including how misstatements on Form ADV can lead to serious compliance issues
• Describes how to deal with client complaints as well as how to meet and exceed client expectations, as well as advice on how to deal with senior investors

New in the 2023 Edition:

• A new chapters on the SEC's Marketing Rule, including the use of testimonials, endorsements, third-party ratings, and performance advertising
• Analysis of the SEC's new strategic plan for fiscal years 2022 through 2026, including the goals of protecting families against fraud and manipulation, developing a robust regulatory framework, and supporting a skilled workforce that is diverse and inclusive
• Personal liability issues facing Chief Compliance Officers (CCOs), including a discussion of the the SEC Commissioner's 2022 personal liability analysis and the National Society of Compliance Professionals (NSCP)'s Firm and CCO Liability Framework to provide guidance to CCOs
• Update on the SEC's 2022 Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Conflicts of Interest
• Impact of the pandemic on RIAs' compliance obligations
• The use and misuse of today's top social media platforms
• How new forms of communication can create compliance problems
• Form CRS and Regulation Best Interest compliance issues
• New discussion of senior clients, including coverage of the NASAA Model Act to Protect Vulnerable Adults from Financial Exploitation

Topics Covered:

• The SEC's new marketing rule, including discussion of advertising services
• Registration requirements for Investment Advisor Representatives
• The anti-fraud provisions of the Investment Advisers Act, including disclosure of conflicts of interest
• The code of ethics rule, including the purpose of the rule and insider trading
• Filing and updating of Form ADV
• Client communication and miscommunication, including the use of social media
• Analysis of the Investment Advisers Act's “Compliance Program Rule,” which requires advisors registered with the SEC to adopt and implement written compliance policies and procedures
• Issues related to fee miscalculations, including SEC warnings to about correctly aggregating household assets for purposes of fee calculations and over-billing of advisory fees
• Requirements for advisory contracts, including language to include in those contracts
• Fiduc

• Language: English
• Publisher: The National Underwriter Company
• Release date: Jan 25, 2023
• ISBN: 9781954096936

Book preview

The Investment Advisor’s

Compliance Guide, 3rd Edition

Les Abromovitz, J.D.

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ACKNOWLEDGMENT

My wife of forty-eight years, Hedy, has suffered through another of my books while giving me enormous support. She now knows more about RIA compliance than she ever wanted to know.

In addition, I would like to thank Sue Gruesser of ALM Media for spearheading this manuscript.

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ABOUT THE AUTHOR

Les Abromovitz, J.D., is an attorney, who has handled consulting and writing projects for leading compliance and regulatory consulting firms for twenty years. He has conducted thousands of advertising reviews of websites, marketing materials, social media communications, presentations, brochures, books, blogs, newsletters, proposals, radio programs, commercials, videos, white papers, and performance advertising.

Les is the author of THE INVESTMENT ADVISOR’S COMPLIANCE GUIDE (1st and 2nd Editions) and GROWING WITHIN THE LINES: THE INVESTMENT ADVISER’S ADVERTISING AND MARKETING COMPLIANCE GUIDE. Both books were published by ALM Global, LLC.

Les has also written about compliance for numerous professional publications. His articles have been published by RIA Compliance Group, Foreside Insights, National Compliance Services, Inc., NCS Regulatory Compliance, ACA Global, Financial Planning, TD Ameritrade, Pershing, Fidelity, Securities Training Corp., Financial Services Institute, MoneyTrack.org, Boomer Market Advisor, RIABIZ.com, Investments & Wealth Monitor, National Society of Compliance Professionals, ThinkAdvisor, Financial Advisor IQ, Society of Corporate Compliance and Ethics, JD Supra, BoardIQ, AIMA Journal and Forbes.com.

Les has been the author, co-author, technical editor, and ghostwriter of several investment, retirement, personal finance, legal, insurance, and business books for publishers such as McGraw-Hill, John Wiley & Sons, and Dearborn Trade. Les has also created courses, podcasts, and training modules for financial services professionals, as well as consumers. In addition, he was the associate producer of a public television series dealing with personal finance.

In addition to his legal background, Les was a state insurance regulator for two years. He received his B.A. from the University of Pittsburgh and his J.D. from Duquesne University School of Law. Les is a member of the Pennsylvania bar. He and his wife, Hedy, split their time between Pittsburgh, Pennsylvania, and Boca Raton, Florida.

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INTRODUCTION

Investment advisors have a difficult job, even in the best of times. To say the least, the last few years have been challenging. Registered Investment Advisors (RIAs) and their clients have been dealing with the pandemic, supply chain issues, market volatility, skyrocketing inflation, and a host of other challenges. In addition, advisory personnel may have experienced lengthy periods where they could not come to the office or meet in person with clients. In fact, some of those clients who were once on track to retire may now be years away from achieving that financial objective.

Chief Compliance Officers (CCOs) have also faced difficulties arising from the new normal. Many of them wear multiple hats in their organizations, and being CCO is not their only job. During periods of economic uncertainty, clients often need more attention. CCOs with other responsibilities may turn their attention away from their compliance duties. This is especially dangerous if the potential for misconduct increases due to declines in fees derived from assets under management.

Giving short shrift to compliance is particularly dangerous in the current regulatory environment. The SEC will be keeping a close watch on RIAs’ compliance with the Marketing Rule. On November 4, 2022, SEC-registered investment advisors were required to be fully compliant with the Marketing Rule. Changing technology and new forms of communication will also prompt regulatory oversight. Other regulatory changes are forthcoming related to cybersecurity and private funds.

On August 24, 2022, the SEC circulated its draft strategic plan for fiscal years 2022 through 2026. The strategic plan warned that in order to protect working families and everyday investors, the SEC will strive to keep markets free of fraud, manipulation and other misconduct. The SEC’s strategic plan seeks to accomplish this goal through its rulemaking, as well as through its enforcement and examination programs.

According to the SEC, enforcement is about following the facts and the law, wherever they may lead. It also means bringing cases in accordance with the SEC’s mission, whether it be deceptive conduct by registered or private funds, offering or accounting frauds, insider trading, market manipulation, failures to act in retail investors’ best interests when making a recommendation, reporting violations, best execution, breach of fiduciary duty, and any other form of misconduct.

Whether the market is booming or floundering, and no matter which political party is in charge, securities regulators expect RIAs to be compliant. In extreme cases, regulators will find that the firm’s CCO is personally liability for compliance problems. Those actions can result in stiff sanctions against the firm and its CCO. They may face fines, censure, and reputational damage. In some instances, RIAs are ordered to hire a compliance consulting firm to help them correct their compliance problems. CCOs may even find themselves barred from holding certain positions in the industry. In addition, compliance mistakes can haunt a firm for years to come and may result in more frequent examinations by regulators.

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.

THE INVESTMENT ADVISOR’S COMPLIANCE GUIDE provides practical advice on how CCOs and RIAs, whether they are SEC or state registered, can improve their compliance programs. 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. Although this task may seem to be overwhelming at times, RIAs can benefit from a methodical approach like the one Ted Lasso suggested in the acclaimed series, Ted Lasso. In the series, Ted Lasso is an American football coach who takes over the helm of a British football team, even though he knows nothing about soccer. As Lasso and his assistant coach walk home after coaching their first game, his second-in-command moans, I hate losing. Lasso’s answer is Bird by bird, coach.

The quote is a reference to a book about writing entitled, Bird by Bird. In that book, the author tells a story about her brother who procrastinated on a school project about birds until the last minute. Her father advised the overwhelmed boy, Bird by bird, buddy. Just take it bird by bird. CCOs can follow that advice as they whip their compliance programs into shape. THE INVESTMENT ADVISOR’S COMPLIANCE GUIDE will help RIAs and CCOs deal with their compliance obligations, bird by bird.

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Chapter 1

Regulatory Oversight of Investment Advisors

1.1 Registered Investment Advisors

According to William Birdthistle, Director of the SEC’s Division of Investment Management, approximately 46 million individuals currently receive services from Registered Investment Advisors (RIAs). At the time of his speech to the IAA Investment Adviser Compliance Conference on March 3, 2022, Birdthistle said that the roughly 15,000 RIAs reported more than $110 trillion in Regulatory Assets Under Management (RAUM). Assets in separately managed accounts and private funds totaled $43 trillion and $18 trillion respectively.¹

The Investment Adviser Industry Snapshot 2022, reported that small advisors are the backbone of the advisory community. Over eighty-eight percent of advisors are small businesses that employ fifty or fewer people. The median advisor operates from a single office and services mostly individual clients. The median advisor has eight employees and $412 million under discretionary management.

On May 17, 2022, SEC Chair, Gary Gensler, testified at a hearing before the Subcommittee on Financial Services and General Government U.S. House Appropriations Committee.² His testimony can help RIAs and broker-dealers to understand where examinations may be headed, so they can improve their compliance program and target any weaknesses that currently exist.

Gensler’s testimony demonstrates the magnitude of the SEC’s mission, which is to:

Protect investors;

Maintain fair, orderly, and efficient markets; and

Facilitate capital formation.

Roughly half of the SEC’s staff members work in the Enforcement and Examinations divisions. The Division of Examinations serves as the eyes and ears of the SEC and conducts about 3,000 exams per year. Gensler testified that about fifteen percent of SEC-registered advisors were examined in Fiscal Year 2020 and Fiscal Year 2021.

According to Gensler, the productivity of the Division of Examinations can be attributed in part to the use of remote exams during the pandemic. Gensler noted, however, that there is no substitute for on-site exams, and the SEC needs additional funding to accomplish that objective. In his testimony, Gensler said that he expects the demands upon the Division of Examinations to escalate due to evolving markets, a heightened geopolitical environment, and increased attention paid to cyber risks.

Gensler testified that the Division of Investment Management oversees the investment companies and advisors stewarding the nest eggs for millions of American investors. It now oversees the life savings of more than 106 million American investors. The number of RIAs has grown from 12,000 in 2016 to 15,000. The number of RIA clients has also increased seventy percent from thirty-two million in 2016 to fifty-five million in 2021. Gensler attributed this growth to the dramatic increase in robo-advisors and other firms utilizing algorithms and models to provide investment advice directly to investors through separately managed accounts.

The Division of Investment Management also oversees Exchange Traded Funds (ETFs) and private fund advisors. The number of private funds managed by RIAs has risen to 50,000. To justify his request for additional resources, Gensler also pointed to the Division’s responsibilities related to increasingly complex filings in innovative areas such as crypto, thematic index funds, and Environmental, Social, and Governance. Gensler noted that in 2021, there were forty-five filings that referred to crypto in their summary prospectuses. Two years earlier, there were six filings.

Aside from requesting funding for additional staffing and other resources, Gensler requested budget increases to improve the SEC’s technology. Additional funding will give the SEC more capacity to investigate misconduct and accelerate enforcement actions. It will also strengthen the SEC’s litigation support and bolster the capabilities of the Crypto Assets and Cyber Unit. The funding is also needed, so the SEC can investigate the tens of thousands of tips, complaints, and referrals received from the public.

As we will see throughout this book, the SEC is not the only one needing more funding. Chief Compliance Officers (CCOs) of RIAs and broker-dealers should look at their own budget to determine if they are allocating sufficient resources to address the regulatory challenges on the horizon.

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¹ William Birdthistle, Remarks at the IAA Investment Adviser Compliance Conference, March 3, 2022, available online at https://www.sec.gov/news/speech/birdthistle-remarks-iaa-investment-adviser-compliance-conference-030322.

² Testimony at Hearing before the Subcommittee on Financial Services and General Government U.S. House Appropriations Committee, available online at https://www.sec.gov/news/testimony/gensler-testimony-fsgg-subcommittee.

1.2 Basic Training for RIAs and IARs

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 giving investment advice. 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 the Chapter 25, advisors should not use the initials RIA or IAR after their names. Securities regulators frequently 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 and adviser in the same sentence, and it’s not a typo.

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.³ 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. And as most of us know, there seem to be new forms of social media each day. This is one reason why the Adopting Release for the Marketing Rule does not refer to any specific forms of social media, such as LinkedIn or Facebook.

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 Marketing 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.

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³ The Evolution of Advice: Digital Investment Advisers as Fiduciaries, page 12, https://www.jdsupra.com/legalnews/the-evolution-of-advice-digital-61151/.

1.3 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 (RAUM).

Subject to certain exceptions, RIAs with RAUM 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. This exception does not, however, give a firm the option to register with the SEC if they conduct multi-state marketing.

Generally, an investment advisor with its principal office and place of business in New York will be required to register with the SEC if it has more than $25 million in regulatory assets under management. The Commission also oversees all investment advisors in Wyoming.

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.

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1.4 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.⁴ 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.

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.

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⁴ Welcome to the Investment Adviser Public Disclosure website, available online at https://adviserinfo.sec.gov/.

1.5 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.

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1.6 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. Here is an overview of the exemptions:

Domestic banks (as defined in Section 202(a)(2) of the Investment Advisers Act) and bank holding companies (as defined in the Bank Holding Company Act of 1956). In no-action letters, the SEC has advised that the exclusion is not available to credit unions, non-U.S. banks, and RIA subsidiaries of banks or bank holding companies.

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-dealers, and they do not receive any special compensation for their advisory services.

Publishers of bona fide newspapers, news magazines, and business or financial publications of general and regular circulation.⁵ To qualify for this exclusion from registration, the Supreme Court said a publication must satisfy three elements: (1) the publication must offer only impersonal advice, which means the advice is not tailored to the individual needs of a specific client, group of clients, or portfolio; (2) the publication must be bona fide, which means it contains disinterested commentary and analysis rather than promotional material disseminated by someone touting particular securities, lists of stocks that are 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.

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, such as FNMA and GNMA.

Any nationally recognized statistical rating organization, unless it engages in issuing recommendations regarding purchasing, selling, or holding securities or in managing assets, consisting in whole or in part of securities, on behalf of others.

Any family office, as defined by rule, regulation, or order of the SEC.

Obviously, the devil is in the details when determining whether registration is required as we will see with family offices.

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⁵ See Lowe v. Securities and Exchange Commission, 472 U.S. 181 (1985).

1.7 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 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 registration under the Investment Advisers Act 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.

The SEC has stated that the family office exclusion does not extend to family offices serving more than one family. It also does not apply to situations where several families have established separate family offices with the same or substantially the same employees.

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1.8 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.⁶

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, many RIAs 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. CCOs should look at their own budget to determine if they are allocating sufficient resources to address the regulatory challenges on the horizon. Compliance budgets may need to increase if the RIA expands its product or service offerings or hires more IARs. 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 often 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. Ultimately, most state-registered advisors hope to grow their assets and become SEC-registered down the road.

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⁶ 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

2.1 SEC or State Registration

When individuals decide to start an RIA, they must register with either the SEC or the securities regulator in their home state. Most new advisors will be managing less than $100 million in Regulatory Assets Under Management (RAUM), so they will be state registered. Certain advisors will also be state-registered, because they do not manage assets directly. They charge hourly fees or a monthly retainer, so they will remain state registered for as long as they utilize that business model.

RIAs that manage in excess of $100 million are required to register with the SEC. RIAs must also register with the SEC if their principal place of business is in a state that does not conduct examinations of advisors or does not have an investment advisor statute. In addition, RIAs serving as an investment advisor for a registered investment company should be SEC registered. In this situation, SEC registration is required, even if the registered investment company has under $100 million in assets.

RIAs must do more than just register with the SEC. They must notice file in states where they do business. Typically, states do not require RIAs to notice file if the firm has fewer than five clients and does not maintain a place of business in the state.

The $100 million RAUM threshold for SEC registration was not always the case. In 2011, Section 410 of the Dodd-Frank Act raised the threshold from $25 million to $100 million. In 2011, thousands of RIAs switched from SEC to state registration when Section 410 of the Dodd-Frank Act raised the 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. By that time, however, the RIA is likely to have more than $100 million in RAUM. Advisors are required to assess their eligibility for SEC registration annually.

There is also an exemption for RIAs that provide advisory services through the Internet. In its Risk Alert dated November 9, 2021, the SEC’s Division of Examinations stated that there is no standard industry nomenclature to describe RIAs that provide electronic advisory services. In its Risk Alert, the SEC used the term robo-advisor in lieu of Internet advisor. The Risk Alert demonstrated that robo-advisors have their own compliance problems, which we will discuss in later chapters.¹ The Investment Adviser Industry Snapshot 2022 reported that 232 firms filed Form ADV using the Internet advisor exemption. The average Internet advisor had a staff of just nine non-clerical personnel.

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¹ Observations from Examinations