Series 65 Unit 9 Regulation of investment advisers including state-registered and federal covered advisers

investment adviser

investment adviser means 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 a part of a regular business, issues or promulgates analyses or reports concerning securities

person

an individual (a natural person) a corporation, a partnership, an association, a joint-stock company, a trust where the interests of the beneficiaries are evidenced by a security, an unincorporated organization, a government, or a political subdivision of a government"

3 nonpersons

1. a ,minor

2. a deceased individual

3. an individual declared mentally incompetent by the courts

Practice Question

A person is basically anyone that can open an account. The test would be looking for you to choose an answer to a question such as this:

Which of the following is included in the definition of a person?

A. A minor

B. The National Hockey League

C. A deceased person

D. A person whom the courts have declared to be mentally incompetent

Answer: B. Odd to think of the NHL as a person, but they would be included in the USA's definition. That is why such questions are much easier if you just remember the three nonpersons.

the definition of investment adviser is sometimes referred to as the three prong test, that is as long as the person involved:

1. gives advice to others on securities

2. does so as part of a regular business activity

3. receives compensation for performing this activity

some of the specifically mentioned nonsecurities investments include:

commodities

collectibles, such as coins or stamps

precious metals, such as gold and silver

real estate

Practice Question

A person giving advice on which of the following investments would be deemed to be giving advice on securities?

A. Gold

B. Common stock

C. Rental real estate

D. Rare stamps

Answer: B. Common stock is a security; the others are considered nonsecurities.

a person is in the business of providing advice and meets the second prong defining one as an investment adviser if he:

gives advice on a regular basis such that it constitutes a business activity conducted with some regularity

although the frequency of the activity is a factor, it is not the only determinant in whether one is giving advice

providing advice does not have to be the person's principal activity; and advertises investment advisory services and presents himself to the public as an investment adviser or as one who provides investment advice

compensation

a person who receives any economic benefit as a result of providing investment advice meets the third prong

compensation includes advisory fees, commissions, or other types of fees relating to the service rendered and can be directly or indirectly paid

there are two criteria specified in the Investment Advisers Act of 1940 that must be met in order to use the term to describe the nature of the IA's business:

the IA's principal business must be giving investment advice; this basically excludes financial planners and others for whom investment advice is only a part of what they do

provide investment supervisory services

Practice Question

Which of the following investment advisers would be permitted to use the term investment counsel?

A. A Certified Financial Planner (CFP®), offering a wide range of services to her clients, including tax planning, estate planning, and insurance planning, as well as investment advice

B. A professional providing a market timing service with an annual subscription fee of $495 (this service attempts to maximize profits by suggesting entry and exit points for over 100 listed stocks)

C. A firm whose exclusive business is placing their client's assets into model portfolios which are monitored on a daily basis

D. All of these

Answer: C. In order to use the term investment counsel, 2 criteria must be met—the principal business must be giving investment advice and the adviser must provide investment supervisory services. Running model portfolios for clients with daily monitoring would meet both requirements. The financial planner is not principally in the business of offering investment advice because she describes her service as offering a wide range of services, of which advice is only one part. The exam frequently uses that wording to indicate that advice is not the principal activity. While the market timing publisher's principal business activity may be offering advice, nothing about the description indicates that individual client accounts are being monitored.

financial planners

financial planners who make recommendations regarding a person's financial resources or perform analyses that concern securities are investment advisers if such services are performed as part of a business and for compensation

under this interpretation, the SEC holds that there is no such thing as a comprehensive financial plan that does not involve securities

pension consultants

consultants who advise employee benefit plans on how to fund their plans with securities are also considered investment advisers by the SEC

in addition, the SEC considers pension consultants who advise employee benefit plans on the selection, performance, and retention of investment managers to be investment advisers

sports and entertainment representatives

persons who provide financially related services to entertainers and athletes that include advice related to investing, tax planning, budgeting, and money management are also investment advisers

as earnings for these celebrities continue to climb, more and more of them use personal managers to handle all of their finances, and those individuals or firms are generally going to be considered investment advisers

exclusion

excluded from, or not included in, a definition

for example, if a person is excluded from the definition of an investment adviser, that person is not subject to provisions of state or federal law that refer to investment advisers

exemption

not being subject to the registration provisions of the acts even though that person meets the definition

for example, a person defined as an investment adviser can be exempt from state registration requirements as an investment adviser because that person enjoys an exemption from state registration under the Uniform Securities Act

an example we'll cover shortly is the case of an investment adviser with no place of business in the state whose only clients in the state are institutions

federal covered investment adviser

investment advisers who are solely under federal jurisdiction and are specifically excluded from the definition of investment adviser in the Uniform Securities Act

because they are not defined as investment advisers under state law, they do not register on the state level

under USA there are seven primary exclusions from the definition of an investment adviser:

1. any bank and bank holding company, savings institution, or trust company

2. any lawyer, accountant, teacher, or engineer whose advice is solely incidental to the practice of their profession

3. any broker-dealer whose performance of such services is solely incidental to the conduct of its business as a broker-dealer and who receives no special compensation

4. publishers of any bona fide newspaper, news magazine, or business or financial publication of general and regular circulation

5. certain individuals who are employed by investment advisers

6. any person who is a federal covered adviser

7. any other person the administrator specifies

Practice Question

The Uniform Securities Act excludes certain persons from the definition of an investment adviser if their performance of advisory services is solely incidental to their professions. This exclusion would apply to all of the following except

A. an accountant.

B. an economist.

C. an electrical engineer.

D. a college professor teaching a course on economics.

Answer: B. As long as the activity is incidental to the professional practice, and no separate fee for the advice is charged, the act specifically excludes accountants, lawyers, any professional engineer (aeronautical, civil, mechanical, or other), and teachers. Economists are not included in this listing (most economists are not teachers).

exemptions available under the Investment Advisers Act of 1940 (federal law):

intrastate advisers (only within one state)

advisers to insurance companies

investment advisers exempt from registration with the state administrator are those who have no place of business in the state but are registered in another state, provided their only clients in the state are:

broker-dealers registered under the act

other investment advisers

institutional investors

existing clients who are not residents but are temporarily in the state

limited to five or fewer clients, other than those listed above, resident in the state during the preceding 12 months (called the de minimis exemption)

any others the administrator exempts by rule or order

Private Fund Investment Advisers Registration Act of 2010 provides the following new exemptions from registration:

an exemption for advisers solely to private funds—this exemption applies as long as that investment adviser's total assets under management (AUM) in the United States, without regard to the number or type of private funds, is less than $150 million (the private fund adviser exemption)

an exemption for certain non-U.S. advisers with no place of business in the United States and minimal assets under management (less than $25 million) attributable to U.S. clients and investors (the foreign private adviser exemption)

an exemption for advisers solely to venture capital funds (the venture capital fund exception)

a qualified client is a person that:

has at least $1.1 million in assets under management with the investment adviser immediately after entering into the advisory contract (AUM test)

has a net worth (in the case of a natural person client, together with assets held jointly with a spouse) that the investment adviser reasonably believes is in excess of $2.2 million immediately prior to entering into the advisory contract (net worth test)

as a reminder, the value of a natural person's primary residence must not be included in net worth:

remember, "value of primary residence" means the fair market value of a person's primary residence, minus the amount of debt secured by the property up to its fair market value (net equity)

note that "qualified" for NASAA is significantly less than "qualified" under federal law

neither the private fund adviser nor any of its advisory affiliates are subject to the "bad actor" provisions

those provisions disqualify anyone who has certain criminal convictions (generally felonies), certain SEC disciplinary orders, or suspension or expulsion from membership in a self-regulatory organization such as FINRA

a foreign private adviser is defined in the Dodd-Frank Act as any investment adviser that:

has no place of business in the United States

has, in total, fewer than 15 clients and investors in the United States in private funds advised by the adviser

has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the adviser of less than $25 million

does not hold itself out to the public in the United States as an investment adviser or act as an investment adviser to an investment company registered under the Investment Company Act of 1940

the rules define a venture capital fund as a private fund that:

has limited leverage

does not, except in certain limited circumstances, offer its investors redemption rights or other similar liquidity rights

represents itself as a venture capital fund to investors

is not registered under the Investment Company Act of 1940

Practice Question

Who of the following would not seek an exemption from registration under the Investment Advisers Act of 1940?

A. A person whose only advisory clients are insurance companies

B. A person whose only offices are in a single state, whose only clients are residents of that state, and who does not render advice on securities traded on a national exchange

C. A person who only gives advice to venture capital funds

D. An accountant whose advice is incidental to her accounting business and for which no separate fee is charged

Answer: D. This is tricky (as is the exam). The accountant is excluded from the definition. Therefore, there is no reason for her to look for an exemption. Anyone who is excluded is automatically exempt from registration. The other three choices meet the definition of investment advisers and qualify for one of the exemptions described above.

What makes someone a federal covered investment adviser? In most cases, they are the larger firms and are registered with the SEC, here are the three most tested categories:

those registered with the SEC because they are eligible ($100 million in assets under management) or required to register with the SEC because they meet the minimum threshold of assets under management (currently $110 million)

those under contract to manage an investment company registered under the Investment Company Act of 1940—e.g., a mutual fund, regardless of the amount of assets under management

those not registered with the SEC because they are excluded from the definition of an investment adviser by the Investment Advisers Act of 1940 (the most tested example of this case is the investment adviser whose advice is limited solely to securities issued by the U.S. government or one of its agencies)

large investment advisers

at least $100 million or more in assets under management, are eligible for SEC registration; once AUM reach $110 million, registration with the SEC is mandatory

unless covered by one of the exemptions mentioned previously, all large IAs must register with the SEC

state registration is not required because the federal law preempts state registration

small investment advisers

assets under management of less than $25 million

unless the investment adviser is an adviser to an investment company registered under the Investment Company Act of 1940, registration with the SEC is prohibited and, unless exempted under state rules, registration with the state is required

however, if the adviser would be required to register in 15 or more states, the prohibition is lifted and registration with the SEC would be permitted instead

mid-size advisers

AUM of at least $25 million but not $100 million

generally, these advisers are prohibited from SEC registration and must register with the state

however, there are more extensive exceptions than exist with the small advisers

just as with any other category, those who are advisers to investment companies registered under the Investment Company Act of 1940 register with the SEC

other exceptions under Dodd-Frank:

pension consultants providing advisory services to employee benefit plans having at least $200 million of assets may register with the SEC (even though the consultant does not itself have those assets under management)

the SEC picked that number to ensure that, in order to register with the SEC, if desired, the consultant's activities are "significant enough to have an effect on national markets"

those mid-size advisers with at least $100 million in AUM, but less than $110 million in AUM who elect to register with the SEC rather than the state(s) (this buffer will be described below)

investment advisers expecting to be eligible for SEC registration within 120 days of filing the application for registration on Form ADV

internet advisers

remember these three relevant times:

1. when a state-registered IA reports AUM at $110 million or more on the annual updating amendment, the IA must withdraw from the states and register with the SEC within 90 days

2. when a new investment adviser files for registration, if that IA believes that it will have at least $100 million in AUM within the first 120 days, it is eligible to register with the SEC, even if their AUM is way below that on "day 1", this is very common when a large BD decides to open an IA and knows that they'll have billions of dollars in a short time

3. when an SEC registered IA reports less than $90 million in AUM on the annual updating amendment, the IA must withdraw its registration with the SEC and register in the appropriate states within 180 days. Why is the time allowed in #3 twice as long as in #1? because it takes much less time to register with one agency, the SEC, than to register potentially with a number of states

to register with the state securities administrator, a person must:

submit an application

provide a consent to service of process; pay filing fees

post a bond (if required by the administrator)

take and pass an examination if required by the administrator

investment advisers use Form ADV to:

register with the Securities and Exchange Commission

register with one or more state securities authorities

amend those registrations

form ADV contains four parts:

1. Part 1A asks a number of questions about the investment adviser, its business practices, the persons who own and control the firm, and if the firm is involved in any other activities such as being a broker-dealer

2. Part 1B asks additional questions required by state securities authorities. Investment advisers applying for registration with or who are already registered with the SEC do not have to complete Part 1B

3. Part 2A requires advisers to create narrative brochures containing information about the advisory firm. The requirements in Part 2A apply to all investment advisers registered with or applying for registration with the SEC or the states

4. Part 2B requires advisers to create brochure supplements containing information about certain supervised persons. The requirements in Part 2B apply to all investment advisers registered with or applying for registration with the SEC or the states

Practice Question

If a prospective client wanted to know what type of investment strategies are employed by an investment adviser, the information would be found in the adviser's

1. Form ADV Part 1A.

2. Form ADV Part 1B.

3. Form ADV Part 2A.

4. Form ADV Part 2B.

Answer: C. Form ADV Part 2A contains information of most use to clients, such as the type of strategies employed by the adviser. Part 1A contains information needed by the regulators; Part 1B is only for state-registered IAs; Part 2B contains information dealing with those individuals in the firm who manage accounts.

in addition to the annual updating amendment, the IA must amend Form ADV by filing additional amendments if information relating to any of the following changes or becomes inaccurate in any way:

change of the registrant's name

change in the principal business location

change in the location of books and records, if they are kept somewhere other than at the principal location

change to the contact person preparing the form

change in organizational structure, such as from partnership to corporation and so on Information provided in the brochure becomes materially inaccurate

change to any of the questions regarding disciplinary actions

change in policy regarding custody of the customer funds and/or securities

notice filing

instead of registering with the state(s), covered advisers pay state filing fees and give notice to the administrator

as part of the notice filing, the administrator can require a federal covered adviser to file a copy of whatever has been filed with the SEC and, of course, pay a filing fee

consent to service of process

appoints the administrator as the applicant's attorney to receive and process noncriminal securities-related complaints against the applicant

under the consent to service of process, all legal documents (e.g., subpoenas or warrants) received by the administrator have the same legal effect as if they had been served personally on the applicant

form ADV-W

if an adviser no longer desires to engage in the business, application to withdraw registration is accomplished by filing

form ADV-W must be filed in order to withdraw the registration voluntarily

exempt reporting advisers (ERAs)

however, even though exempt from registration, if designated as exempt reporting advisers (ERAs), they are required to complete and electronically file reports using the Investment Adviser Registration Depository (IARD) system on certain amended items set forth in Form ADV Part 1, which will be made publicly available on the SEC's website

in the case of a federal covered adviser, it is considered substantial if

the IA collects prepayments of $1,200 per client, six months or more in advance

under the USA, it is more than $500, and again, six months or more in advance

in the case of a federal covered adviser, it is considered substantial if the IA collects prepayments of $1,200 per client, six months or more in advance

under the USA, it is more than $500, and again, six months or more in advance

Practice Question

Which of the following would NASAA consider to be a substantial prepayment of fees?

A. $500 covering the next six months

B. $800 covering the entire contract year

C. $800 covering the next calendar quarter

D. $5,000 covering the next month

Answer: B. NASAA (state law) defines a substantial prepayment of fees to be MORE than $500, six or more months in advance. While $800 and $5,000 are certainly more than $500, they cover a shorter period than six months.

if you have discretionary authority or custody of client funds or securities, or you require or solicit prepayment of more than $1,200 in fees per client, six months or more in advance:

you must disclose any financial condition that is reasonably likely to impair your ability to meet contractual commitments to clients

surety bond

usually issued by an insurance company (the surety) who guarantees payment of a specified sum to an injured party (either the client or the Administrator) when the securities professional causes damages by her actions or fails to perform

principal office

both state and federal law define this as "the executive office of the investment adviser from which the officers, partners, or managers of the investment adviser direct, control, and coordinate the activities of the investment adviser

Practice Question

Mammon Money Managers (MMM) has its principal office in State A and is also registered in States B, C, and D. MMM exercises discretion in client accounts. As a result, MMM would have to meet the net worth or bonding requirements of

A. the SEC.

B. State A.

C. the state with the highest requirement.

D. each state.

Answer: B. A state-registered investment adviser need only meet the financial requirements of the state in which its principal office is located. SEC requirements are meaningless here because this is a state-registered firm.

the SEC and the states require investment advisers to maintain the following books and records:

journals, ledgers, checkbooks, bank statements, and financial statements

records of all orders and instructions for securities transactions

copies of all written communications related to advice, transactions, and client interactions

all written agreements with clients and evidence of discretionary authority

copies of all distributed communications and reasons for specific security recommendations

scalping

the practice whereby an investment adviser, before the dissemination of a securities recommendation, trades on the anticipated short-run market activity that may result from the recommendation

the records required to be maintained and preserved may be maintained and preserved for the required time by an investment adviser on:

paper or hard copy form, as those records are kept in their original form

micrographic media, including microfilm, microfiche, or any similar medium

electronic storage media, including any digital (computer disk) storage medium or system as long as the investment adviser establishes and maintains procedures

Practice Question

Under the Investment Advisers Act of 1940, all of the following are true regarding adviser recordkeeping except

A. the IA must keep records of transactions made for its own account as well as the account of investment adviser representatives to lessen the likelihood of scalping.

B. computer-generated records may be stored in that format,

C. client account records must be maintained, including a list of recommendations made.

D. records must be maintained for a period of two years from the end of the fiscal year in which the last entry was made.

Answer: D. This is the exception, because the records must be kept for five years. Nothing in the question asked about the two-year requirement in the office. The five-year requirement is that records be easily accessible whether in the office or not.

chief compliance officer (CCO):

responsible for administering compliance policies and procedures

supervised person:

any officer, partner, director, employee, or person providing investment advice under the adviser's supervision