large RIAs, typically corporations managing institutional assets, to register solely with the SEC. Smaller RIAs and individuals who are RIA representatives must register with state securities administrators. This legislation was designed to eliminate the old system of dual state and federal registration for firms. However, as you will see later in this chapter, it is possible to own a firm or be part of a firm that is registered with the SEC, but be an individual who is required to be registered with a state as an RIA representative.
Penalties for failing to register with the SEC as an investment adviser are horrifying. In addition to fines of up to $10,000, there is also the felony penalty of up to five years in jail. 20 These penalties apply per case. Simultaneously violating state investment adviser laws can increase the fines and jail time. Failing to register can also make all contracts advisers have with their clients void and unenforceable. This means clients do not have to pay the fees owed to the adviser, and the adviser may have to refund fees previously paid.
IN 1940, CONGRESS ENACTED the Investment Advisers Act and authorized the SEC to regulate a business that then consisted primarily of advising institutional investors. Since the Act has not kept up with the current business climate, one of the problems financial services providers have today is applying retail situations to definitions that were designed for institutional advisers and their clients.
Use the following brief summary and chart as your guideline. You, or your firm, must register with the SEC if you meet the definition of Investment Adviser, have more than $30 million of assets under management, and are neither excluded nor exempted from registration.
The term “investment adviser” is defined in Section 202(a)(11) of the Advisers Act to mean:
[A]ny person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities; but does not include:
a. A bank or any bank holding company as defined in the Bank Holding Company Act of 1956, which is not an investment company, b. Any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession, c. Any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore,
• You meet the definition of Investment Adviser21, and
• You have more than $30 million of assets under management, and
• You are not among the following who are excluded from the Definition:22
– banks
– broker/dealers, lawyers, accountants, teachers, and others whose advice about securities is incidental to their business
– certain publishers, or
• You are not among the following and others who are exempted from registration:23
– Your principal place of business is in one state, and you give no advice regarding securities on a listed national exchange
– Your clients are limited to insurance companies
– You had fewer than 15 clients in the preceding 12 months and do not hold yourself out as an investment adviser.
d. A publisher of any bona fide newspaper, news magazine, business or financial publication of general and regular circulation, e. Any person whose advice, analyses, or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States, or securities issued or guaranteed by Corporations in which the United States has a direct or indirect interest which shall have been designated by the Secretary of the Treasury, pursuant to Section 3(a)(12) of the Securities Exchange Act of 1934, as exempted securities for the purposes of that Act, or f. Such other persons not within the intent of this paragraph, as the commission may designate by rules and regulations or order.
The SEC, in Release No. IA-1092, has adopted a three-pronged test to determine whether a firm or individual person needs to be registered as an investment adviser. The release also looked at financial planning activities and how they apply to the Act. Although this Release applies to SEC RIAs, many states will use the same analysis. Persons need to be an RIA or affiliated with one if they:
• Provide advice, issue reports, or analyze securities • Are in the business of providing such services
• Provide such services for compensation.
As few people reading this book are excluded from the “in the business” element, it will simplify matters to focus on three words: compensation, advice, and securities. Each of these words is construed very broadly by the SEC. COMPENSATION Receiving any economic benefit from any source is, according to the SEC, compensation. Contrary to popular opinion, it is not necessary for the benefit to be a separate fee directly related to the investment advice or financial plan. Nor is it necessary for this to be a commission from the sale of securities. It has been determined that the receipt of commissions from a client’s insurance product or other investment is sufficient to satisfy the compensation test.24 In short, any fees for plans, commissions from product sales, or remuneration from any source is compensation.
GEORGE, A LIFE INSURANCE salesperson, holds himself out to be an estate planner. In performing his services, he reviews a client’s balance sheet and makes recommendations for specific insurance products. At a meeting with Mr. and Mrs. Client, he makes the following recommendation: “Since your ABC stock has been underperforming for the last five years, I recommend selling that stock and placing the proceeds in a whole life insurance policy.” George receives no fees for investment advice and no commission from the sale of the ABC stock. He will, however, receive commissions from the sale of the whole life insurance policy.
Question: Has George received compensation under the rule and is he required to be an RIA?
Answer: Yes. George gave advice regarding securities and he was compensated by an insurance commission. George has just committed a felony, could be facing five years in jail, and probably does not even know it. George could eliminate this problem completely either by registering as an investment adviser or by limiting all his recommendations to insurance and avoiding any advice about securities.
ADVICE is also interpreted broadly by the SEC. It is not unusual to find planners or consultants trying to avoid registering as an Investment Adviser by not giving specific investment advice. Instead of recommending the client buy the XYZ mutual fund, they will just recommend generic balanced mutual funds. The SEC, however, has found giving general advice about securities is sufficient to trigger the registration requirement; the advice need not be specific.25 The giving of advice need not constitute the primary or even major activity in order to satisfy that part of the test.26 The SEC envisioned that in order for most financial planners to do their jobs properly, they must discuss both the pros and cons of a particular investment with their clients.27 It is difficult to imagine
Investment Advisers Act of 1940 § 217.
Section 202(a)(11).
Section 202(a)(11)(A) through (F).
Section 203(b).
Investment Advisers Act Release No. IA-1092 (October 8, 1987).
Thomas P. Lemke and Gerald T. Lins,
Ibid., 1-4.
Investment Advisers Act Release No. IA-1092 (October 8, 1987).
