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Practising Law Institute1177 Avenue of the Americas
New York, New York 10036
Fundamentals of Investment Adviser
Regulation 2016
CORPORATE LAW AND PRACTICECourse Handbook Series
Number B-2259
ChairClifford E. Kirsch
Copyright © 2016 by Practising Law Institute. All rights reserved. Printed in the United States of America. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of Practising Law Institute. 978-1-4024-2713-8
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Prepared for distribution at the FUNDAMENTALS OF INVESTMENT ADVISER REGULATION 2016 Program July 13, 2016 CONTENTS: PROGRAM SCHEDULE ........................................................................... 9 FACULTY BIOS ...................................................................................... 17 1. Registration under the Investment Advisers Act of 1940:
Who is an Investment Adviser? (May 9, 2016) ............................... 35 Kenneth J. Berman Gregory T. Larkin Julie Baine Stem Debevoise & Plimpton LLP
2. Introduction to the Investment Advisers Act ................................... 61
Clifford E. Kirsch Sutherland Asbill & Brennan LLP
3. State Registration of Investment Advisers ...................................... 83
G. Philip Rutledge Bybel Rutledge LLP
4. An Investment Adviser’s Fiduciary Duty (May 2, 2016) ................ 139
Lorna A. Schnase Attorney at Law
5. Advisor Reliance on Compliance Consultants Hangs in
the Balance (October 29, 2015) .................................................... 205 Chris Stanley Loring Ward
6. SEC to RIAs: Beware the Ides of ‘May’ (April 9, 2015) ................ 211
Chris Stanley Loring Ward
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7. When and Why to Make Form ADV Updates (April 25, 2014) ............................................................................. 217
Chris Stanley Loring Ward
8. Advisor Conflicts of Interest: Finding and
Mitigating Them (December 24, 2013) ......................................... 223 Chris Stanley Loring Ward
9. Form ADV: Uniform Application for Investment
Adviser Registration and Report Form by Exempt Reporting Advisers ........................................................................ 229
Submitted by: Clifford E. Kirsch Sutherland Asbill & Brennan LLP
10. Investment Advisers and New Client Relationships
(May 9, 2016) ................................................................................ 347 Heather L. Traeger Teacher Retirement System of Texas Daniel Malooly Debra Groisser Prudential Insurance Company of America
11. Compliance and Exams for Investment Adviser
Lawyers (July 15, 2015) ................................................................ 419 Michael B. Koffler Sutherland Asbill & Brennan LLP Steven A. Yadegari Cramer Rosenthal McGlynn, LLC
12. Investment Advisers to Private Funds: A Short
Outline of Key Concepts (May 16, 2016) ...................................... 441 Peter M. Rosenblum Foley Hoag LLP
13. Registration by Investment Advisers to Private
Funds and Multiple Entities: SPVs and Relying Advisers (May 16, 2016) ............................................................... 455
Peter M. Rosenblum Foley Hoag LLP
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14. The National Society of Compliance Professionals: Currents—Doing More With Less: The New Compliance Paradigm (April 2016) ............................... 463
Alan K. Halfenger ACA Compliance Group Submitted by: Jeffrey C. Morton ACA Compliance Group
15. The Final Rule: DOL’s Expanded Definition of
Investment Advice Fiduciary Under ERISA and Revised Complex of Exemptions—Analysis and Critical Issues ................................................................................ 469
Submitted by: Vanessa A. Scott Sutherland Asbill & Brennan LLP
16. U.S. Securities and Exchange Commission, Office of
Compliance Inspections and Examinations, National Exam Program: Examination Priorities for 2016 ........................... 505
Submitted by: Clifford E. Kirsch Sutherland Asbill & Brennan LLP
17. An Investment Adviser’s Fiduciary Duty (July 13, 2016)
(PowerPoint slides) ....................................................................... 513 Lorna A. Schnase Attorney at Law
INDEX ................................................................................................... 523 Program Attorney: Lauren E. Nochta
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Program Schedule
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Fundamentals of Investment Adviser Regulation 2016 New York City, July 13, 2016 Live Webcast, www.pli.edu, July 13, 2016
Program Schedule: 9:00 a.m. - 5:00 p.m.
9:00Opening Remarks Clifford E. Kirsch
9:15Who is an Investment Adviser; Regulatory Jurisdiction
The Adviser definitionExceptions to the definition How does the SEC administer the Advisers Act? State regulation The interplay between the SEC and the States The role of the other regulators (DOL, FINRA, OCC, CFTC)
Kenneth J. Berman, Clifford E. Kirsch, G. Philip Rutledge
10:15How Do Investment Advisers Register; The Disclosure Regime; The Advisers’ Fiduciary Duty
The Form ADV The Adviser disclosure regime Advisers as fiduciaries
Lorna A. Schnase, Chris Stanley
11:15 Networking Break
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11:30Attracting Clients and Establishing the Investment Adviser-Client Relationship
Referral arrangements: solicitor programs Pay-to-PlayInvestment restrictions Advertising Custody
Maureen Baker Fialcowitz, Heather L. Traeger
12:30 Lunch
Afternoon Session: 1:30 p.m.-5:00 p.m.
1:30Brokerage and Trading Practices; Investment Adviser Compliance Programs
Selecting the broker Soft dollars and trading conflictsAffiliated brokerage Requirements regarding adviser compliance programs Role of the Adviser CCO
Steven W. Stone, Steven A. Yadegari
2:30Private Funds
Umbrella registration SEC’s exam focus Private fund reporting
Jeffrey C. Morton, Peter M. Rosenblum
3:30 Networking Break
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3:45The SEC’s 2016 Exam Program and “Hot” Topics in the Investment Adviser Industry
Robo advisers DOL’s Fiduciary Duty Rule Dual-registrants The SEC’s 2016-17 regulatory agendaCybersecurity
Michael Hershaft, Vanessa A. Scott
5:00 Adjourn
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Faculty
Clifford E. Kirsch Sutherland Asbill & Brennan LLP New York City Chair
Kenneth J. Berman Debevoise & Plimpton LLP Washington, D.C.
Maureen Baker Fialcowitz Chief Regulatory Counsel, Asset Management The Prudential Insurance Company of America Newark, New Jersey
Michael Hershaft Senior Special CounselOffice of Compliance Inspections and Examinations U.S. Securities and Exchange Commission Washington, D.C.
Jeffrey C. MortonACA Compliance Group Morristown, New Jersey
Peter M. Rosenblum Foley Hoag LLP Boston
G. Philip Rutledge Bybel Rutledge LLP Lemoyne, Pennsylvania
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Lorna A. Schnase Attorney at Law Houston
Vanessa A. Scott Sutherland Asbill & Brennan LLP Washington, D.C.
Chris Stanley General Counsel Loring Ward San Jose
Steven W. Stone Morgan, Lewis & Bockius LLP Washington, D.C.
Heather L. Traeger CCO & Compliance Counsel Teacher Retirement System of Texas Austin
Steven A. YadegariChief Operating Officer and General Counsel Cramer Rosenthal McGlynn, LLC New York City
Program Attorney: Lauren E. Nochta
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Faculty Bios
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ATLANTA AUSTIN HOUSTON LONDON NEW YORK SACRAMENTO WASHINGTON, DC
Cliff Kirsch began his career at the U.S. Securities and Exchange Commission (SEC), became chief legal officer for one of the country’s largest dually- registered broker-dealer/advisers and then joined Sutherland in 2006. He relies on his regulatory and in- house background and an up-to-date knowledge of regulatory developments to provide practical and innovative counsel to broker-dealers and investment advisers in the areas of securities regulation and compliance.
With more than 25 years of experience, Cliff regularly counsels clients on the design and distribution of investment products including wrap-fee programs and other advisory products, mutual funds, bank collective investment funds and insurance products. He also focuses on issues related to the design and implementation of compliance programs at financial services firms.
While at the SEC, Cliff received the Manuel F. Cohen Award, which recognizes younger lawyers who have displayed outstanding legal ability, integrity and judgment and he served as assistant director of the SEC's Division of Investment Management.
Cliff is a frequent speaker at industry conferences, and is the author and editor of two of the leading treatises in the broker-dealer and adviser arena: Broker-Dealer Regulation and Investment Adviser Regulation (published by the Practising Law Institute).
Cliff is also co-founder of the Julia Anne Kirsch Foundation, which seeks to serve the needs of disabled individuals and their families.
Experience Sutherland counsels a coalition of major life insurance companies on evolving state and federal regulations and other legal developments. Sutherland represents a coalition of major life insurance companies, which collectively account for more than 80% of the annuity business in the United States, in their efforts to affect the direction and details of various SEC, FINRA, CFTC, NAIC and state rule proposals and initiatives.
Related Practices / Industries
• Financial Services • Broker-Dealer • Insurance • Insurance Products • Investment Adviser • Mutual Funds • Capital Markets & Investments • Retirement Products & Services
Bar Admissions
• District of Columbia • New Jersey • New York
Clifford E. Kirsch, Partner
The Grace Building, 40th Floor 1114 Avenue of the Americas New York, NY 10036-7703 Office: 212.389.5052
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ATLANTA AUSTIN HOUSTON LONDON NEW YORK SACRAMENTO WASHINGTON, DC
Clifford E. Kirschcontinued
Sutherland serves as outside counsel on broker-dealer and adviser regulatory issues for one of the largest independent broker-dealer networks in the country. Sutherland serves as regular primary outside counsel on broker-dealer and adviser regulatory issues for one of the largest independent broker-dealer networks in the country.
Sutherland represents coalition of collective trust fund sponsors, advisers and other service providers. Sutherland serves as counsel to the Coalition of Collective Trust Funds. Among other things, Sutherland monitors and reports on legal and regulatory matters affecting collective trust funds.
Professional Activities Member, New York City Bar Association Faculty, FINRA Compliance Institute at The Wharton School of the University of Pennsylvania Former Chair, FINRA Variable Products Committee Former Board Member, National Society of Compliance Professionals
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Kenneth Berman
Kenneth Berman, a member of the Investment Management Group, focuses his practice on
providing regulatory and compliance advice to financial services firms, particularly investment
advisers and sponsors of mutual funds, private equity funds and other pooled investment
vehicles. Mr. Berman also counsels mutual fund independent directors and advises operating
companies concerning status issues they may face under the Investment Company Act of 1940. He
is recognized as a leading lawyer by Chambers USA (2009-2015), where clients note that he is an
“impressive” and “great” lawyer who offers “invaluable support throughout the decision-making
process.” Mr. Berman is also recommended by The Legal 500 US (2012-2015).
Prior to joining Debevoise, Mr. Berman was Associate Director of the Securities and Exchange
Commission’s Division of Investment Management, where he oversaw the division offices
responsible for processing applications for exemptive relief under the Investment Company Act and
administering the Public Utility Holding Company Act of 1935. He joined the SEC staff in 1988 after
several years of private practice. Before becoming Associate Director in 1997, Mr. Berman was
Assistant Director of the Division’s Office of Regulatory Policy.
Mr Berman is the co-author of numerous articles, including “What Will The “Eyes And Ears” Of The
SEC Choose To See And Hear This Year? OCIE Announces Examination Priorities For 2015,” Vol. 16
No.2, Journal of Investment Compliance, (July, 2015); “Expense Allocation: The SEC Brings Down
The Hammer,” Vol. 16 No. 1, Journal of Investment Compliance (May, 2015); “SEC Settles First
“Pay-To-Play” Enforcement Action,” Financial Fraud Law Report (October, 2014); “Debevoise &
Plimpton Discusses JOBS Act General Solicitations,” The CLS Blue Sky Blog (September, 2014);
“Debevoise & Plimpton Discusses Treatment of Special Purposes Vehicles under the Advisers Act,”
The CLS Blue Sky Blog (August, 2014); “Good News on ‘Bad Actors’,” PE Manager (March, 2014);
“A Touch of Solace for Broker-Dealer Compliance Personnel,” Law360 (November, 2013);
“Debevoise & Plimpton Discusses SEC’s Guidance on Supervisory Liability for a Broker-Dealer’s
Compliance and Legal Personnel,” The CLS Blue Sky Blog (November, 2013); “Time For Private
Equity To Focus On Form PF,” The Deal (June, 2012); “International Survey of Investment Adviser
Regulation,” Wolters Kluwer (June, 2012) and “SEC Risk Alert Discusses When Social Media
Interactions May Constitute Prohibited Hedge Fund Client Testimonials,” The Hedge Fund Law
Report (April, 2012).
Mr. Berman is a frequent speaker at conferences relating to investment company and investment
adviser issues. He is a member of the Committee on Investment Management Regulation of the
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Association of the Bar of the City of New York and served as Chair of that Committee from 2009 to
2012. Mr. Berman is also a member of the American Bar Association (Subcommittee on Investment
Companies and Investment Advisers, Subcommittee on Private Investment Entities) and the
District of Columbia Bar. Mr. Berman is also an adjunct professor of law in Georgetown University’s
LLM program.
Mr. Berman received his J.D. from the University of Chicago Law School, where he was a member of
the Law Review, and his B.A. from Dickinson College, where he was elected to Phi Beta Kappa.
Education
• University of Chicago Law School, 1979, J.D.
• Dickinson College, 1976, B.A.
Bar Admissions
• New York
• District of Columbia
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The Prudential Insurance Company of America Maureen Baker Fialcowitz Chief Regulatory Counsel, PGIM 655 Broad Street, 19th Floor Newark, NJ 07102 United States Tel: 973 802 5648 Fax: 973 802 3853 Email: [email protected] Maureen Baker Fialcowitz is Chief Regulatory Counsel of the PGIM Law Division of Prudential's law department. Maureen joined Prudential's law department in 1993 following four years of private practice with the New York law firm, Dewey Ballantine. Her practice areas include investment management, securities and general corporate law. Maureen received a B.A. from Georgetown University (cum laude) and a J.D. from Fordham University School of Law, where she also served on the Editorial Board of its Law Review. She is a member of the Association of the Bar of the City of New York (Investment Management Regulation Committee) and is an active member of the Investment Adviser Association. Maureen is also a member of the bars of the States of New York and New Jersey as well as the District of Columbia.
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Michael Hershaft Senior Special Counsel, Office of the Chief Counsel, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission Michael Hershaft is a Senior Special Counsel in the Office of Compliance Inspections and Examination's (OCIE) Office of Chief Counsel. In this role, he provides legal advice and guidance to the SEC's National Examination Program. In 2015, Michael served as a counsel to SEC Commissioner Daniel M. Gallagher and advised the Commissioner on enforcement matters, policy issues and rulemakings. Prior to joining OCIE in 2011, Michael was a special counsel in the Division of Trading and Markets (TM) Office of Chief Counsel. From 2008 to 2010, he served as a counsel to the TM Director. In this capacity, he advised the director on legal and policy issues, including the implementation of the Dodd-Frank Act. Prior to joining the SEC in 2005, Michael was an associate at WilmerHale where he advised financial institutions on regulatory and enforcement matters. He also served as a law clerk to Judge John M. Duhe, Jr. of the U.S. Court of Appeals for the Fifth Circuit. He received his BS and MS in journalism from Northwestern University and his JD from the University of Chicago Law School.
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JEFFREY C. MORTON 2016 BIOGRAPHY
Jeffrey C. Morton is a partner and co-founder of ACA. Among other things, Mr. Morton is responsible for conducting mock SEC inspections and compliance program reviews of investment advisers, hedge fund managers and private equity funds. Prior to forming ACA, Mr. Morton spent over five years as a Securities Compliance Examiner and Staff Accountant in the SEC’s Office of Compliance Inspections and Examinations in Washington, D.C. Mr. Morton speaks at numerous industry-sponsored conferences on a variety of topics, including: compliance benchmarking and testing and private equity and hedge fund compliance. Mr. Morton is also the co-founder of the New York City Chief Compliance Officer’s Roundtable, which meets semi-annually to discuss hot SEC and other regulatory compliance issues. Mr. Morton graduated from the University of Scranton and is a member of National Society of Compliance Professionals, Advisory Board of the Private Equity CFO Association (NY Chapter), Institutional Investor’s U.S. Institute Advisory Council, the Managed Funds Association, and the Alternative Investment Management Association (AIMA). Mr. Morton also serves on the board of directors of Elwyn Inc., a non-profit organization recognized nationally and internationally for the education and care of individuals with special needs.
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Driving Business Advantage
Peter M. Rosenblum Partner Boston 617 832 1151 direct 617 832 7000 fax Peter M. Rosenblum is a partner at Foley Hoag LLP and the co-head of its Investment Management Practice Group. He is actively involved in the firm’s corporate, corporate finance and international practices. His clients include private equity and venture capital funds, registered investment advisers, hedge funds, and other private funds, both onshore and offshore. He regularly represents investors in private equity, venture capital and other private funds. He has structured and organized numerous partnerships, limited partnerships, limited liability companies and offshore companies employed in the management and ownership of investments in public and private securities and alternative investments. He also counsels clients in a broad range of other industries on business and regulatory matters, financing strategies and structuring of corporate and international transactions.
Mr. Rosenblum is a member of Foley Hoag’s Executive Committee. He was Chairman of the firm’s Business Department from 2008 to 2011, and Co-Managing Partner from 2000 to 2005. He was Chairman of the Corporate Law Committee of the Boston Bar Association from 1995 to 1997 and Chairman of the Business Law Section of the Boston Bar Association from 1997 to 1999.
Mr. Rosenblum has been listed in The Best Lawyers in America since 1999. He is also listed in Chambers U.S.A.: America’s Leading Business Lawyers for private equity-buyouts and venture capital investment and corporate/mergers and acquisitions, in Chambers Global: The World’s Leading Lawyers for Business for private equity-buyouts and venture capital investment and in Legal Media Group’s Guide to the World’s Leading Lawyers for Banking, Finance and Transactional Law for investment funds and private equity.
Mr. Rosenblum graduated, summa cum laude, from Amherst College, received his M.A. in History from Yale University and his J.D., cum laude, from Harvard Law School. Prior to entering the private practice of law, he served as Law Clerk to Chief Justice G. Joseph Tauro of the Massachusetts Supreme Judicial Court. He is Chairman of the Boston Lawyers Group and a member of the Board of Directors of Ceres, Inc.
Mr. Rosenblum has written and lectured on a wide variety of subjects related to investment advisers and private funds. He is the author of “Offshore Investment Advisers” and “Overview of Institutional and Offshore Advisory Activity” in C. Kirsch, Investment Adviser Regulation (2006, 2008) and “Organization of a Private Investment Fund: Basic Structural and Legal Issues” in C. Kirsch, Financial Product Fundamentals (New York 2006, 2009, 2013).
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G. Philip Rutledge
Mr Rutledge is a partner of Bybel Rutledge LLP, Harrisburg, PA where his practice focuses on corporate and securities law, regulation of financial intermediaries and regulatory representation. He is a nationally recognized expert in securities regulation and was instrumental in shaping various provisions of the Securities Markets Improvement Act of 1996, the Gramm-Leach-Bliley Financial Modernization Act of 1999 and the Sarbanes-Oxley Act of 2002. He has served as an expert witness for the Pennsylvania Office of Attorney General and has prepared expert opinions and testified as a securities expert before the U.S. Senate Permanent Subcommittee on Investigations, in FINRA arbitrations and in civil litigation.
Mr. Rutledge has taught securities regulation at Widener University School of Law, The Dickinson School of Law of the Pennsylvania State University and the FINRA Compliance Certificate Program at The Wharton School, University of Pennsylvania. He currently holds an appointment as a Tutor, Centre for Financial and Management Studies, University of London. In 2015, he was appointed Visiting Professor in Securities Law and Regulation in the LLM Program at BPP University, London. He routinely is a guest lecturer at the Cambridge International Symposium on Economic Crime held at Jesus College, University of Cambridge, England.
He writes extensively in his area, most recently contributing chapters on State Regulation of Broker Dealers and State Regulation of Investment Advisers for the Practising Law Institute’s multi-volume Treatise on Broker-Dealer Regulation and Investment Adviser Regulation, respectively. He also is the author of books on Electronic Markets and Civil and Administrative Liability under Pennsylvania Securities Law and has written chapters for The Sarbanes-Oxley Handbook, The Fiduciary, the Insider and the Conflict, and International Tracing of Assets. His legal articles have appeared in the Banque de France Financial Stability Review, ABA Business Lawyer, Journal of European Financial Services Law, The Dickinson Journal of International Law, Journal of Financial Crime and The Company Lawyer.
Mr. Rutledge is a member of the Securities Regulation Advisory Committee for the American Law Institute and the Securities Advisory Committee of the Pennsylvania Department of Banking and Securities. He also served on the Board of Editors of the ABA Business Lawyer. For the past five years, he has been named in The Best Lawyers in America and, in 2015, was named “Lawyer of the Year” in Central Pennsylvania for his expertise in securities and securities regulatory matters.
He is a member of the Council of the Business Law Section of the Pennsylvania
Bar Association and is Chair of its Securities Regulation Committee. In 2009, he received the Freedom of the City of London in the Worshipful Company of Pattenmakers. In 2010, he was appointed to the Editorial Advisory Board of the Centre for Business Law, University of the Free State, in the Republic of South Africa.
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LORNA A. SCHNASE Attorney at Law Lorna Schnase has been practicing corporate and securities law for more than 25 years. Her practice emphasizes investment management matters, primarily for registered investment advisers and mutual funds. Ms. Schnase counsels clients regarding a wide range of matters such as compliance programs, fiduciary duty, disclosure, custody, organizational issues, registration of funds and advisers with the Securities and Exchange Commission, performance issues, adviser and fund advertising, changes of control, best execution, soft dollars, codes of ethics, director independence and other corporate governance issues, reporting obligations, electronic document delivery, privacy compliance and other issues. Ms. Schnase practices independently in Houston, Texas. Prior to establishing her independent practice, she was a partner of the law firm of Davis, Graham & Stubbs LLP. Prior to that, Ms. Schnase practiced with the law firm of Baker & McKenzie in Los Angeles and with the Dechert law firm in Denver. She is a member of the Advisory Board of the Mutual Fund Directors Forum and the Editorial Advisory Board of the journal “Practical Compliance & Risk Management for the Securities Industry.” Ms. Schnase graduated cum laude from Harvard Law School with a J.D. degree in 1982. In 1979, Ms. Schnase graduated summa cum laude from the University of Denver with a B.A. degree in mathematics. She was elected to Phi Beta Kappa and the Mortar Board honors society. She is a member of the bar in the States of Texas (1991), California (1989) (inactive) and Colorado (1982) (inactive).
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Vanessa Scott Vanessa Scott is a partner in Sutherland’s Washington DC tax practice, where she advises on employee benefits and matters related to the Employee Retirement Income Security Act (ERISA). Ms. Scott counsels domestic and international insurers on a wide range of regulatory and compliance matters relating to ERISA-governed benefits and retirement services products. She is nationally recognized for her insight on Patient Protection and Affordable Care Act (PPACA) issues, and is a sought-after speaker on the Department of Labor’s (DOL) re-proposal on the definition of investment advice fiduciary. Ms. Scott is focused on providing creative legal solutions for insurers operating in a quickly changing market. Her experience includes assisting one of the world’s largest international specialty reinsurers with ERISA issues associated with surplus and excess lines, stop-loss insurance, catastrophic coverage and specialty health risks. Ms. Scott also drafted several comment letters regarding the DOL’s fiduciary re-proposal on behalf of insurance groups and financial services firms. As a member of Sutherland’s Privacy and Data Security team, Ms. Scott also has experience advising on Health Insurance Portability and Accountability Act (HIPAA) issues, state health privacy laws, and claims-related cyber risk exposure. Ms. Scott’s unique practice combines her proficiency with the technical rules that govern ERISA-governed benefits and products with her policy experience as a former Congressional aide and federal government relations representative. She frequently represents her clients’ interests before federal and state agencies and the National Association of Insurance Commissioners, and she has testified before members of Congress on insurance matters relating to the PPACA and healthcare transparency.
Ms. Scott is frequently quoted in the trade press and national publications, and she was named a Washington, D.C. Super Lawyer for the third time in 2015. She serves as Sutherland’s national Chief Diversity Officer and is an adjunct professor at the Georgetown University Law Center. She attended Duke University and the Vanderbilt University School of Law, and she holds an LL.M. in Taxation from the Georgetown University Law Center.
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Chris Stanley General Counsel, Loring Ward Chris is the General Counsel for Loring Ward Holdings Inc. and its investment advisory and broker-dealer subsidiaries. In this role he provides legal advice and counseling related to federal and state securities laws, SEC and FINRA rules, investment management compliance, corporate governance, risk management, transition and succession planning, and general corporate legal matters. Chris worked for Loring Ward during law school as a part-time legal clerk, and eventually transitioned into a full-time role. His tenure at Loring Ward has included stints as Director of Compliance (from November 2009 to March 2011), Chief Compliance Officer (from April 2011 to October 2015), and General Counsel (from April 2011 to present). He also served as the Chief Legal Officer and Chief Compliance Officer for the SA Funds – Investment Trust, a mutual fund family advised by Loring Ward, from April 2011 to March 2016. Previously, he served as a Summer Associate for the law firm of Bell, Rosenberg and Hughes LLP (now Kilpatrick Townsend & Stockton, LLP). Chris' writings are regularly featured in ThinkAdvisor, and have also been published by the Journal of Financial Planning. In addition, he has been a speaker at conference panels hosted by the Investment Company Institute, State Street Bank & Trust Co., National Regulatory Services and K&L Gates LLP. He has been quoted in Investment News, On Wall Street, Financial Advisor IQ, NAPFA, IAWatch, Law360 and the Los Angeles Daily Journal. His writings can be found at his personal website, beachstreetlegal.com. Chris is an attorney admitted to the State Bar of California and the District of Columbia. He also has passed the FINRA Series 7 General Securities Representative and Series 24 General Securities Principal examinations, as well as the NASAA Series 66 examination. He received both a Juris Doctor and Masters of Business Administration from Santa Clara University, and a Bachelor of the Arts from Boston College.
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Steven W. Stone
1111 Pennsylvania Ave. NW \\ Washington, DC 20004 [email protected]
Steve advises major US broker-dealers in the private wealth and private client businesses that offer investment advice and brokerage services to high-net-worth clients as well as broker-dealers serving self-directing clients. He also works as counsel on various matters to the Securities Industry and Financial Markets Association’s (SIFMA) private client committee and represents most of the best-known US broker-dealers in this area. He also advises broker-dealers and investment advisers in the managed account or wrap fee area, and serves as counsel to the Money Management Institute, the principal trade association focused on managed accounts. Steve also counsels various institutional investment advisers and banks on investment management issues, including conflicts, trading, disclosure, advertising, distribution, and other ongoing regulatory compliance matters. Steve’s practice includes counseling clients on varied regulatory and transactional matters including the development of innovative products and services; regulation and operation of managed account (or wrap fee) programs and hedge funds; trading issues affecting broker-dealers and investment advisers; soft dollar arrangements; interpretive and no-action letter requests; insider trading issues; and related matters. He guides clients through SEC, Financial Industry Regulatory Authority (FINRA), and state investigations and enforcement actions. Additionally, he counsels clients on mergers, acquisitions, and joint ventures involving broker-dealers and investment advisers.
Steve serves on the firm’s Advisory Board, and was previously managing partner of the Washington, DC, office.
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Since 2005, Chambers USA: America’s Leading Lawyers for Business has recognized Steve as one of the leading US lawyers for investment management and broker-dealer law, calling him as “one of the best in the field.” Since 2009, The US Legal 500 has listed him for his work with mutual fund formation and management.
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Heather L. Traeger
Heather L. Traeger serves as the Chief Compliance Officer and Compliance Counsel for the Teacher Retirement System of Texas. TRS is one of the largest public pension plans in the country.
Ms. Traeger has significant experience advising a variety of financial institutions. Immediately prior to joining TRS, Ms. Traeger was a partner at O’Melveny & Myers LLP, in Washington, D.C., in the Financial Services Practice. Previously, she served as an Associate Counsel at the Investment Company Institute (ICI) and in several positions at the U.S. Securities and Exchange Commission, including as the Senior Counsel to Commissioner Roel Campos, Counsel to Commissioner Issac Hunt, and Senior Counsel in the Division of Market Regulation (now Trading and Markets). She also clerked for the Texas First Court of Appeals.
Ms. Traeger has written numerous articles and chapters on investment adviser and broker dealer regulatory and compliance issues. She also participates regularly in industry panels. Ms. Traeger is a faculty member for the Regulatory Compliance Association’s CCO University and is a member of the Board of Editors for the Investment Lawyer. While in Washington, D.C., she was a faculty member for Operation HOPE, Banking on Our Future, as well as a member of the Women’s White Collar Defense Association and Women in Housing and Finance. She now participates in Texas Wall Street Women and serves on the Boards of the Association of Securities and Exchange Commission Alumni and The Investment Lawyer.
Ms. Traeger is a member of the Texas and District of Columbia bars. She currently lives in Austin, Texas with her husband, Jeff Cohan, and her daughter, Elana.
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Steven A. Yadegari Steven A. Yadegari is Chief Operating Officer and General Counsel of Cramer Rosenthal
McGlynn, LLC, a registered investment adviser located in New York City. Mr. Yadegari
also serves as Chief Legal Officer and Chief Compliance Officer for the CRM Mutual
Fund Trust. Prior to joining CRM, Mr. Yadegari was a member of the Regulatory
Practice Group at K&L Gates and, before that, an associate at Proskauer. Mr. Yadegari
also has served as Senior Counsel in the Office of the Chief Counsel, Division of
Enforcement at U.S. Securities and Exchange Commission and as an Attorney-Adviser in
the Division of Market Regulation. He has spoken at a number of conferences and has
published articles on securities law topics. In 2007, Mr. Yadegari was recognized as a
top twenty “Rising Star of Compliance” by Institutional Investor. Mr. Yadegari is an
adjunct professor at Benjamin N. Cardozo School of Law and teaches in the areas of
dispute resolution and negotiation. Mr. Yadegari is Past President and current Chairman
of the Board of Old Westbury Hebrew Congregation and is a Past President of the
Association for Conflict Resolution of Greater New York, a not-for-profit organization.
Mr. Yadegari has received a BA from Brandeis University and earned his JD from the
Benjamin N. Cardozo School of Law. Mr. Yadegari has been awarded an honorary
Master’s Degree from the CCO University, a division of the Regulatory Compliance
Association for which he serves as an advisor and faculty member.
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Registration under the Investment Advisers Act of 1940: Who is an Investment Adviser? (May 9, 2016)
Kenneth J. Berman Gregory T. Larkin Julie Baine Stem
Debevoise & Plimpton LLP
Copyright © 2016 Debevoise & Plimpton LLP All Rights Reserved
Portions of these materials have appeared in other publications or forms. Debevoise & Plimpton reserves the right to use modified versions of these materials in other publications and forms. This outline is current as of May 9, 2016.
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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I. INTRODUCTION
Investment advisers are subject to federal regulation under the Investment Advisers Act of 1940 (the “Advisers Act”) and the rules and regulations thereunder. A significant number of investment advisers are not subject to regulation by the Securities and Exchange Commission (“SEC”), leaving them subject to state “blue sky” regulation. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), among other things, significantly changed the exemptions from registration under the Advisers Act and division of the regulation between the SEC and the states.
As discussed further below, the Advisers Act generally requires all investment advisers to register with the SEC or the states unless they are excluded from the definition of “investment adviser” (see Section II) or exempt from registration (see Section III). Even if an investment adviser is not required to register under the Advisers Act (e.g., because it qualifies under an exemption), it may still be required to register under state law and be subject to certain provisions of the Advisers Act.
This outline discusses: (1) who is an investment adviser, (2) who must register as an investment adviser, (3) the applicability of state regis-tration and regulation, (4) the registration of associated persons and affiliates and (5) the applicability to foreign advisers.
II. WHO IS AN “INVESTMENT ADVISER”?
The Advisers Act prohibits an investment adviser, including a non-U.S. investment adviser, from making use of the mails or any means or instrumentality of interstate commerce in connection with its business as an investment adviser, unless it is registered with the SEC or exempt from registration.1 The SEC and the U.S. courts have interpreted U.S. jurisdictional means broadly to include telephone calls, facsimile messages and letters into or out of the U.S.
“Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through pub-lications 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.2
1. Advisers Act, Section 203(a). 2. Advisers Act, Section 202(a)(11).
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A. Engaged in the Business
The key factor in determining whether a person is an investment adviser is the extent to which the person’s advisory activities constitute being “engaged in the business” of an investment adviser. The giving of investment advice need not constitute the principal business activity or any particular portion of the business activities of a person for that person to be an investment adviser. The SEC staff has stated that the giving of advice need only be done on such a basis that it “constitutes a business activity.” The frequency of the activity is a factor that, although not determinative, should be considered.
The SEC considers a person to be “engaged in the business” of providing investment advice if the person:
• holds himself or herself out as an investment adviser or as one who provides investment advice;
• receives any separate or additional compensation that represents a clearly definable charge for providing advice about securities, regardless of whether the compensation is separate from or included within any overall compensation, or receives transaction-based compensation if the client implements the investment advice; or
• on anything other than rare, isolated and non-periodic instances, provides specific investment advice. “Specific investment advice” is deemed to include a recom-
mendation, analysis or report about specific securities or specific categories of securities. It also includes a recommendation that a client allocate certain percentages of his or her assets to life insurance, bonds, and mutual funds or particular types of mutual funds such as growth stock funds or money-market funds. Specific investment advice would not, however, include advice limited to a general recommendation to allocate assets in securities, life insurance, and tangible assets.3
3. Applicability of the Investment Advisers Act to Financial Planners, Pension
Consultants, and Other Persons Who Provide Investment Advisory Services as a Component of Other Financial Services, SEC Release No. IA-1092 (Oct. 8, 1987).
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B. Advising Others
An investment adviser must also be in the business of providing investment advice for compensation to “others.” The SEC staff has provided no-action relief from registration for an investment adviser who only provides advice to (i) direct and indirect wholly owned subsidiaries of the adviser or its parent company, so long as the parent company and its subsidiaries are not Private Funds,4 (ii) funds with respect to which the parent of the investment adviser is the only investor (and there are no other holders of securities),5 and (iii) the adviser’s employee benefit plans subject to regulation under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), foreign employee benefit plans, and plans that consist solely of the company’s assets.6
C. Compensation
The definition of investment adviser applies to persons who give investment advice for “compensation.” The compensation element is satisfied by the receipt of any economic benefit, whether in the form of an advisory fee, some other fee relating to the total services rendered, commissions, expense reimbursement or some combination of the foregoing. It is not necessary for the person receiving the advice to pay the compensation; only that the adviser receive compensation from some source.7 The SEC staff has stated, however, that the receipt of “intangible” benefits may not constitute compensation. (For example, in the case of an employer that provides investment advice to employees, the employer would not be deemed to receive separate or additional compensation if the provision of investment information merely provides it with intangible benefits, such as the ability to attract and retain satisfied employees.)8
4. Allianz of America, Inc., SEC No-Action Letter (pub. avail. May 25, 2012);
MEAG MUNICH ERGO., SEC No-Action Letter (pub. avail. February 14, 2014). 5. Zenkoren Asset Management of America Inc., SEC No-Action Letter (pub. avail.
Jun. 30, 2011). 6. Lockheed Martin Investment Management Co., SEC No-Action Letter (pub. avail.
June 5, 2006). 7. Applicability of the Investment Advisers Act to Financial Planners, Pension
Consultants, and Other Persons Who Provide Investment Advisory Services as a Component of Other Financial Services, SEC Release No. IA-1092 (Oct. 8, 1987).
8. Department of Labor, SEC No-Action Letter (pub. avail. Dec. 5, 1995).
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D. Definition of Security
The definition of investment adviser also only applies to persons who give investment advice with respect to “securities.” The Advisers Act defines “security” broadly to mean: any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral trust certificate, preorganization certificate or subscription, transferable share, invest-ment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil or other mineral rights, any put, call, straddle, option or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option or privilege entered into a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guar-antee of, or warrant or right to subscribe to or purchase any of the foregoing.9
E. Application of Advisers Act to Financial Planners
The SEC staff has consistently taken the view that persons providing financial planning, pension consulting or other integrated advisory services (e.g., pension, sports, and entertainment consultants) are investment advisers if they (i) provide advice or issue reports or analyses regarding securities, (ii) are in the business of providing such services, and (iii) provide such services for compensation.10
The SEC staff believes that the first prong of this test is generally satisfied when a person provides advice, or issues or promulgates reports or analyses, that concern securities, even if the advice or reports do not relate to specific securities. In fact, such advice or reports would satisfy the test even if they only included the relative advantages and disadvantages of investing in securities in general as compared to other investments. Furthermore, advice to a client as to the selection or retention of an investment manager or managers could also be deemed to be advice regarding securities, particularly where the
9. Advisers Act, Section 202(a)(18). 10. Applicability of the Investment Advisers Act to Financial Planners, Pension
Consultants, and Other Persons Who Provide Investment Advisory Services as a Component of Other Financial Services, SEC Release No. IA-1092 (Oct. 8, 1987).
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advice includes a recommendation or an evaluation of the investment manager’s performance.
The “in the business” and “compensation” elements of the test are the same as laid out in Sections II.A and II.C above.
The Dodd-Frank Act mandated that the General Accounting Office (the “GAO”) study the oversight of financial planners. The GAO concluded that existing statutes and regulations appear to cover the great majority of financial planning services; that individual finan-cial planners nearly always fall under one or more regulatory regimes, depending on their activities; and that an additional layer of reg-ulation specific to financial planners is not warranted at this time. The GAO did recommend that “more robust enforcement of existing laws could strengthen oversight efforts.”11
F. Persons Excluded from Definition of Investment Adviser
The term “investment adviser” does not include: (1) banks, (2) certain professionals (such as lawyers and accountants), (3) broker-dealers, (4) publishers, (5) certain persons who only provide advice related to certain government securities, (6) nationally recognized statistical rating organizations that do not issue recommendations, hold securities or manage assets, (7) family offices, (8) such other persons as the SEC designates, and (9) government entities.
1. Banks
A company is excluded from the definition of investment adviser if it is a bank or any bank holding company as defined in the Bank Holding Company Act of 1956, as amended, that is not an investment company and that does not act as an investment adviser to a company registered under the Investment Company Act of 1940 (the “Investment Company Act”).12 The term “bank” does not include savings and loan institutions or a foreign bank.
If a separately identifiable department or division of a bank acts as an adviser to a registered investment company, the depart-ment or division, and not the bank itself, is deemed to be the investment adviser.
11. See Regulatory Coverage Generally Exists for Financial Planners, but Consumer
Protection Issues Remain, GAO-11-235 (Jan. 18, 2011). 12. Advisers Act, Section 202(a)(2) and 202(a)(11)(A).
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2. Certain Professionals
The definition of “investment adviser” excludes any lawyer, accountant, engineer, or teacher whose performance of investment advisory services is solely incidental to the practice of his or her profession.13
3. Broker-Dealers
A broker or dealer is not an “investment adviser” if its per-formance of advisory services is solely incidental to the conduct of its business as a broker or dealer and it receives no special compensation.14
Special compensation had generally been interpreted to mean compensation received by the broker other than traditional brokerage commissions or dealer compensation (i.e., mark-ups, mark-downs or similar fees). Changes in the manner in which certain brokers charged compensation for their traditional services raised issues con-cerning the interpretation of the term “special compensation.” In response to these and other changes, the SEC adopted Rule 202(a) (11)-1, which provided an exemption to certain broker-dealers registered under the Securities Exchange Act of 1934 (“Exchange Act”) from registration as investment advisers if, among other things, they charged asset-based fees. This Rule was overturned by the U.S. Court of Appeals for the D.C. Circuit in 2007.
In September 2007, the SEC adopted temporary Rule 206(3)-3T to allow registered broker-dealers offering fee-based brokerage accounts to comply with Section 206(3) of the Advisers Act when engaging in principal transactions. (The expiration date for this temporary rule has been extended until December 31, 2016). The temporary rule imposes a number of conditions related to disclosure and client consent.
The SEC also proposed an interpretative rule that would reinstate certain provisions of Rule 202(a)(11)-1, the rule vacated by the D.C. Circuit.15 The proposed interpretative rule would clarify that:
13. Advisers Act, Section 202(a)(11)(B). 14. Advisers Act, Section 202(a)(11)(C). 15. Interpretive Rule Under the Advisers Act Affecting Broker-Dealers, SEC Release
No. IA-2652 (Sep. 24, 2007).
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• a broker-dealer that exercises investment discretion with respect to an account or charges a separate fee, or separately contracts, for advisory services provides investment advice that is not solely incidental to its business as a broker-dealer;
• a broker-dealer does not receive special compensation within the meaning of the Advisers Act solely because it charges a commission for discount brokerage services that is less than it charges for full service brokerage; and
• a registered broker-dealer is an investment adviser solely with respect to those accounts for which it provides services or receives compensation that subjects it to the Advisers Act. As required by the Dodd-Frank Act, in 2011 the SEC issued
a study of the obligations of brokers, dealers and investment advisers.16 The study concluded that “retail customers should be protected uniformly when receiving personalized investment advice about securities regardless of whether they choose to work with an investment adviser or a broker-dealer” and recommended that the SEC “adopt and implement, with appropriate guidance, the uniform fiduciary standard of conduct for broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers.”
Based on this study, the SEC is expected to engage in rule-making with regard to the harmonization of the fiduciary duties of investment advisers and broker-dealers, but it has not determined whether to commence a rulemaking. On March 1, 2013, the SEC requested “data and other information, in particular quantitative data and economic analysis, relating to the benefits and costs that could result from various alternative approaches regarding the standards of conduct and other obligations of broker-dealers and investment advisers.”17 The SEC intends to address temporary Rule 206(3)-3T (and potentially the proposed interpretative Rule 202(a)(11)-1) as part of this “broader consideration of the regulatory requirements applicable to broker-dealers and investment
16. Study on Investment Advisers and Broker-Dealers As Required by Section 913 of
the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 21, 2011). 17. Duties of Brokers, Dealers, and Investment Advisers. SEC Release Nos. 34-69013;
IA-3558 (Mar. 1, 2013).
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advisers in connection with the Dodd-Frank Act.”18 In March, 2015 the Chair of the SEC, Mary Jo White, said that the SEC should act on a uniform fiduciary standard for brokers and invest-ment advisers that would be based on the fiduciary standard for investment advisers.
4. Publishers
The publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation is not an “investment adviser” under the Advisers Act.19 In Lowe v. SEC, 472 U.S. 181 (1985), the Supreme Court held that this exclusion is available for any publisher of a bona fide newsletter of general and regular circulation as long as the newsletter remains “entirely impersonal and do not develop into the kind of fiduciary, person-to-person relationships . . . that are characteristic of investment adviser-client relationships.” In SEC v. Park a/k/a Tokyo Joe et al., 99 F. Supp. 2d 889 (N.D. Ill. 2000), one court noted that, even where there is no personal relationship, Lowe requires that the publications must be (i) “bona fide” (i.e., containing disinterested commentary and analysis and not promotional material disseminated by a “tout”) and (ii) of “general and regular” circulation (i.e., not timing the advice to “specific market activity, or to events affecting or having the ability to affect the securities industry”).
The Tokyo Joe case involved a website and chat room. The SEC asserted that, under the circumstances of that case, the website did not satisfy the standards of the publisher exclusion. The SEC staff subsequently confirmed that a person who provides advice about securities through a website could fall with the publisher’s exclusion provided that the investment advice provided on the website is: (1) of a general and impersonal nature, in that the advice provided is not adapted to any specific portfolio or any client’s particular needs; (2) “bona fide” or genuine, in that it contains disinterested commentary and analysis as opposed to promotional material; and (3) of general and regular circulation, in that it is not timed to
18. Temporary Rule Regarding Principal Trades with Certain Advisory Clients, SEC
Release No. IA-3483 (Oct. 9, 2012) at fn. 13 and the accompanying text. 19. Advisers Act, Section 202(a)(11)(D).
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specific market activity or to events affecting, or having the ability to affect, the securities industry.20
5. Advisers on Certain Exempted Securities
The definition of “investment adviser” excludes any person whose advice, analyses, or reports relate only to securities which are direct obligations of or obligations guaranteed as to principal or interest by the U.S., or securities issued or guaranteed by corporations, in which the U.S. has a direct or indirect interest, which have been designated by the Secretary of the Treasury as exempted securities for purposes of the Exchange Act.21
6. Rating Agencies
A nationally recognized statistical rating organization (a “Ratings Agency”), as that term is defined in section 3(a)(62) of the Securities Exchange Act of 1934, is not an “investment adviser” unless such organization engages in issuing recommendations as to purchasing, selling, or holding securities or in managing assets, consisting in whole or in part of securities, on behalf of others.22
7. Family Offices
The Dodd-Frank Act has added a new exclusion from the definition of “investment adviser” for “family offices.”23
A “family office” is a company (including its directors, partners, trustees, and employees acting within the scope of their position or employment) that:
• has no clients other than family clients (with a one year grace period for a person who becomes a client due to death or other involuntary transfer);
20. Jonathon Hendricks, SEC No-Action Letter (pub. avail. Jan. 26, 2015) (noting that
“[t]he staff has generally declined to express an opinion as to whether a person qualifies for this exclusion, as interpreted by the United States Supreme Court, because this is a factual and not a legal determination.”).
21. Advisers Act, Section 202(a)(11)(E). 22. Advisers Act, Section 202(a)(11)(F). 23. Advisers Act, Section 202(a)(11)(G); Rule 202(a)(11)(G)-1.
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• is wholly owned and exclusively controlled (directly or indi-rectly) by family members and/or family entities; and
• does not hold itself out to the public as an investment adviser. A family client includes (i) any family member (lineal descend-
ants of a specified person and their spouses), (ii) any former family member, (iii) any key employee (executive officers, directors or similar persons who participate in the investment activities of the family office), (iv) any former key employee (subject to certain restrictions), and (v) certain trusts, estates, charitable organizations, or other company of family clients.
The rule contains a “grandfather provision” for family offices that were not registered or required to be registered with the SEC on January 1, 2010 and that provide advice solely to the following grandfathered clients: (A) natural persons who, at the time of their investment, (i) are officers, directors, or employees of the family office, and had invested with the family office before January 1, 2010; and (ii) are accredited investors under Regulation D of the Securities Act of 1933; (B) any company owned exclusively and controlled by one or more family members and (C) registered investment advisers that provide investment advice and identify investment opportunities to the family office and invest in such transactions on substantially the same terms as the family office and meet certain other conditions. In addition, the SEC continues to grant exemptions from Advisers Act registration to family offices that might not comply with all of the conditions of the rule.24
Any adviser that relies on the grandfather provision will be subject to the Advisers Act’s general anti-fraud provisions.
In adopting the family office rule, the SEC noted that the exclusion for family offices does not extend to family offices serving multiple families (“multi-family office”). The SEC staff has noted that a person who serves as a key employee of multiple family offices could be viewed as creating a multi-family office and thus would not be able to rely on the family office exclusion.25
24. See D-W Investments LLC, SEC Rel. No. IA-4066 (Apr. 20, 2015)(notice); SEC
Rel. No. IA-4090 (May 19, 2015)(order) (exemption granted to family office whose clients included the sister of the spouse of a lineal descendant of the specified person and an irrevocable trust of which she was the beneficiary, and thus not family members for purposes of the rule).
25. Peter Adamson III, SEC No-Action Letter (pub. avail. Apr. 3, 2012).
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8. Other Persons
The SEC may also designate by rules and regulations or order that other persons are not “investment advisers” if such persons are not within the intent of the Advisers Act.26
9. Governmental Entities
No provision of the Advisers Act applies to federal or state governments, governmental agencies, or their employees acting as such in the course of their official duties.27
III. WHO MUST REGISTER
A. Persons Exempted from Registration
In addition to the exclusions from the definition of “investment adviser” discussed above, the Advisers Act also provides exemptions from the registration requirements of the Advisers Act with regard to certain investment advisers. In general, these exemptions do not apply to investment advisers to investment companies registered under the Investment Company Act (“RICs”) and, in certain cases, investment advisers to entities who have elected under the Investment Company Act to become business development companies (“BDCs”), a special type of investment company that invests in small businesses and other companies unable to gain access to the public capital markets.
The Dodd-Frank Act substantially changed the exemptions that are available to investment advisers, particularly to investment advisers of Private Funds. A “Private Fund” is generally defined as a company that would be an investment company but for Sections 3(c)(1) or 3(c)(7) of the Investment Company Act.
1. Foreign Private Adviser Exemption
Any investment adviser that is a “foreign private adviser” is exempt from registration under the Advisers Act.28
A “foreign private adviser” is defined as an adviser that:
26. Advisers Act, Section 202(a)(11)(H). 27. Advisers Act, Section 202(b). 28. Advisers Act, Section 203(b)(3), Section 202(a)(30) and Rule 202(a)(30)-1.
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• has no place of business in the United States;
• has, in total, fewer than 15 clients in the United States and investors in the United States in Private Funds advised by the adviser;
• has aggregate “regulatory assets under management” attributable to U.S. clients and investors in the United States in Private Funds advised by the adviser of less than $25 million; and
• neither holds itself out generally to the U.S. public as an investment adviser, nor acts as an investment adviser to a RIC or a BDC. “Regulatory assets under management” should be calculated in
accordance with Item 5.F of Part 1A of Form ADV, which requires an investment adviser to determine the market value (or fair value) of any securities portfolio to which it provides continuous and regular supervisory or management services. For a Private Fund, this requires the calculation of the fair value of all of the assets of the Private Fund plus the value of any uncalled capital commitments.
An “investor” is:
• any person that would be included in determining the number of beneficial owners of the outstanding securities of a Private Fund under Section 3(c)(1) of the Investment Company Act or whether the outstanding securities of a Private Fund are owned exclusively by qualified purchasers under Section 3(c)(7) of the Investment Company Act; and
• any knowledgeable employee or the holder of short-term paper issued by a 3(c)(1) Fund. Whether a client or investor is “in the United States” generally
depends on whether that person is a “U.S. Person” under Regulation S, except that any discretionary account or similar account that is held for the benefit of a U.S. person by a non-U.S. dealer or other professional fiduciary would be deemed to be “in the United States” if the dealer or professional fiduciary is a related person of the investment adviser relying on the exemption. For example,
• a natural person would be a U.S. person (and therefore “in the United States”) if that person is a resident in the United States; and
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• a partnership or corporation would be a U.S. person if it is either (i) organized or incorporated under the laws of the United States; or (ii) organized or incorporated under the laws of any foreign jurisdiction and formed by a U.S. person principally for the purpose of investing in securities not reg-istered under the Securities Act of 1933 (e.g., interests in a Private Fund), unless it is organized or incorporated, and owned, by accredited investors who are not natural persons, estates or trusts. An adviser may treat as a single client:
• a natural person and: (A) that person’s minor children; (B) any relative, spouse, or relative of the spouse of the natural person who has the same principal residence; (C) all accounts of which the natural person and/or the person’s minor child or relative, spouse, or relative of the spouse who has the same principal residence are the only primary beneficiaries; and (D) all trusts of which the natural person and/or the person’s minor child or relative, spouse, or relative of the spouse who has the same principal residence are the only primary beneficiaries,
• a corporation, general partnership, limited partnership, limited liability company, trust, or other legal organization to which the adviser provides investment advice based on the organ-ization’s investment objectives, and
• two or more legal organizations that have identical shareholders, partners, limited partners, members, or beneficiaries. In addition, an adviser would have to count a shareholder,
partner, limited partner, member, or beneficiary (each, an “owner”) of a corporation, general partnership, limited partnership, limited liability company, trust, or other legal organization, as a client if the adviser provides investment advisory services to the owner separate and apart from the legal organization. The adviser is not required to count an owner as a client solely because the adviser, on behalf of the legal organization, offers, promotes, or sells interests in the legal organization to the owner, or reports peri-odically to the owners as a group solely with respect to the per-formance of or plans for the legal organization’s assets or similar matters.
An adviser is not be deemed to be holding itself out generally to the public in the United States as an investment adviser solely
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because it participates in a non-public offering in the United States of securities issued by a Private Fund.
An adviser exempt under Section 203(b)(3) is subject to certain Advisers Act anti-fraud rules including Rule 206(4)-5 (the “Pay-to-Play Rule”) and Rule 206(4)-8 (addressing fraud by advisers who defraud investors and potential investors in pooled investment vehicles).
2. Intrastate Adviser
An investment adviser does not need to register under the Advisers Act if all of its clients are residents of the state within which such investment adviser maintains a principal office and place of business, unless the adviser:
• furnishes advice or issues analyses or reports with respect to securities listed or admitted to unlisted trading privileges on any national securities exchange; or
• acts as an investment adviser to any Private Fund.29
3. Insurance Company Advisers
Any investment adviser whose only clients are insurance com-panies does not need to register under the Advisers Act.30 Because the definition of “insurance company” could be interpreted to include only domestic insurance companies, the SEC staff has provided no-action relief from registration under the Advisers Act to invest-ment advisers who also provide investment advice to foreign insurance companies that meet the requirements of Rule 3a-6 of the Investment Company Act.31
4. CFTC-Registered Adviser
An investment adviser does not need to register under the Advisers Act if it is registered with the Commodity Futures Trading Commission (the “CFTC”) as a commodity trading advisor whose business does not consist primarily of acting as an investment adviser unless
29. Advisers Act, Section 203(b)(1). 30. Advisers Act, Section 203(b)(2). 31. TACT Asset Management Inc., SEC No-Action Letter (pub. avail. Oct. 24, 2012).
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• the adviser acts as an investment adviser to any RIC or any BDC; or
• the adviser is an adviser to a Private Fund and the adviser’s business has become predominantly the provision of securities-related advice after July 21, 2010.32 The SEC staff has clarified that a CFTC-registered investment
adviser to a Private Fund may not rely on this exemption if either (i) it advises a RIC or BDC (in addition to a Private Fund) or (ii) its business was predominantly the provision of securities-related advice prior to July 21, 2010 and remains so after July 21, 2010.33
5. SBIC Advisers
An investment adviser, who is not a BDC, does not need to register under the Advisers Act if it solely advises:
• small business investment companies that are licensees under the Small Business Investment Act of 1958 (the “Small Business Investment Act”);
• entities that have received notice to proceed to qualify as a small business investment company under the Small Business Investment Act; and
• affiliates of the entities described in the first clause who have a pending application to be licensed under the Small Business Investment Act.34 A recent amendment to the Advisers Act (the “FAST Act”,
discussed below) preempts states from requiring advisers relying on the SBIC advisers exemption to register with the state. Although SBIC advisers may remain subject to SEC and state regulatory authority for anti-fraud purposes, they are not required to register or report at either the state or federal level.
32. Advisers Act, Section 203(b)(6). 33. Investment Advisers Registered with the Commodity Futures Trading Commission
(“CFTC”) that Advise Private Funds, Investment Management Staff Issues of Interest, http://www.sec.gov/divisions/investment/issues-of-interest.shtml#cftc (viewed on May 13, 2013).
34. Advisers Act, Section 203(b)(7).
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6. Venture Capital Fund Adviser Exemption
An investment adviser does not need to register under the Advisers Act if the adviser acts as an investment adviser solely to one or more “venture capital funds.”35
A “venture capital fund” is a Private Fund that satisfies the following requirements:
• The fund must be represented to investors as pursuing a venture capital strategy.
• Immediately after the acquisition of any asset (other than a qualifying investment or a short-term holding), the fund must hold no more than 20% of the fund’s aggregate capital con-tributions and uncalled capital in assets that are not qualifying investments or short-term holdings. A “qualifying investment” is generally an equity security issued by (and acquired directly from) a qualifying portfolio company (and certain equity securities issued in exchange for such equity securities). A “qualifying portfolio company” is generally a private company that (i) is not an investment company, securitization vehicle, Private Fund or commodity pool and (ii) has not borrowed or issued debt obligations in connection with the fund’s investment and distributed to the private fund the proceeds of such borrowing or issuance in exchange for the fund’s investment.36
• The fund’s borrowings must be (i) limited to less than or equal to 15 percent of the fund’s aggregate capital contributions and uncalled committed capital and (ii) for a non-renewable term of no longer than 120 calendar days (excluding any guarantee by the fund of a qualifying portfolio company’s obligations up to the value of the fund’s investment in the portfolio company).
• The investors in the fund may only withdraw from the fund or redeem their interests in extraordinary circumstances.
• The fund may not be RIC or BDC.
35. Advisers Act, Section 203(l); Rule 203(l)-1. 36. In a recent no-action letter, the SEC staff addressed a number of scenarios where
certain of the rule’s provisions did not appear to work as intended, particularly in the context of the application of the “qualifying portfolio company” definition. See Willkie Farr & Gallagher LLP, SEC No-Action Letter (pub. avail. Sept. 21, 2015) (addressing the operation of the rule in the context of companies under common control with portfolio companies that are public companies).
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In addition, as a result of a 2015 amendment to the Advisers Act contained in the Fixing America’s Surface Transportation Act (the “FAST Act”), a “venture capital fund” also includes a small business investment company and certain related entities described in Section 203(b)(7) of the Advisers Act (providing an exemption to SBIC advisers as described above).37 As a result of this amend-ment, an adviser whose only clients are rule 203(l)-1 venture capital funds and/or SBICs may rely on the venture capital fund adviser exemption.
7. Private Fund Adviser Exemption
Certain advisers to Private Funds are exempt from registration under the Advisers Act.38 The availability of this exemption is based on whether the adviser’s principal place of business is in the United States (a “U.S. Adviser”).
For a U.S. Adviser, (i) the adviser must act as investment adviser solely to Private Funds and (ii) the regulatory assets under management of the adviser (managed from any office wherever located) must be less than $150 million. An investment adviser relying on this exemption is required to calculate its regulatory assets under management annually.
For a Non-U.S. Adviser, (i) the adviser must have no client that is a U.S. person other than a Private Fund and (ii) the reg-ulatory assets under management of the Private Funds managed by the adviser from a place of business in the United States must be less than $150 million.
Note that a Non-U.S. Adviser with no place of business in the United States, that does not provide investment advice with regard to any U.S. person who is not a Private Fund, would be exempt from registration under this provision, regardless of the amount of money it manages that is attributable to U.S. investors in Private Funds.
For a Non-U.S. Adviser with a place of business in the United States, the key determination will be whether the adviser provides continuous and regular supervisory or management services from that place of business. The SEC has stated that “continuous and regular supervisory or management services” would not include
37. Fixing America’s Surface Transportation Act, Pub. L. No. 114-94, §§74001-
74003, 129 Stat. 1312, 1786-1787 (2015) (the “FAST Act”). 38. Advisers Act, Section 203(m); Rule 203(m)-1.
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situations where the adviser provides research or conducts due diligence at a U.S. place of business if a person outside of the United States makes independent investment decisions and imple-ments those decisions.39
“Regulatory assets under management” should be calculated in accordance with Item 5.F of Part 1A of Form ADV, which requires an investment adviser to determine the market value (or fair value) of any securities portfolio to which it provides continuous and regular supervisory or management services. For a Private Fund, this requires the calculation of the fair value of all of the assets of the Private Fund plus the value of any uncalled capital commitments.
The FAST Act revised this exemption by excluding SBIC assets from counting towards the $150 million threshold. As a result, an adviser that has assets under management in the United States of less than $150 million attributable to its non-SBIC private fund clients may rely on the private fund adviser exemption regard-less of the assets under management in the United States attribut-able to its SBIC client(s).40
Investment advisers that rely on either the Venture Capital Fund Adviser Exemption (described in III.A.6) or the Private Fund Adviser Exemption (described in III.A.7) are considered “exempt reporting advisers.” Exempt reporting advisers are subject to a certain amount of Advisers Act regulation and SEC oversight.
As a result of the FAST Act, it is the view of the SEC staff that an adviser currently relying on the SBIC adviser exemption and advising only SBICs may choose to instead: (1) rely on the venture capital fund adviser exemption and advise both SBICs and venture capital funds; or (2) rely on the private fund adviser exemption and advise both SBICs and non-SBIC private funds, provided those non-SBIC private funds account for less than $150 million in regulatory assets under manage-ment. However, unlike an adviser relying on the SBIC adviser
39. Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With
Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, SEC Release No. IA-3222 (Jun. 22, 2011) at 99.
40. Advisers Act, Section 203(m)(3). See also, FAST Act Changes Affecting Invest-ment Advisers to Small Business Investment Companies, IM Guidance 2016-3 (Mar. 2016) (“IM Guidance 2016-3”).
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exemption, the staff believes that an SBIC adviser that chooses to rely on either the venture capital fund adviser exemption or the private fund adviser exemption is required to submit reports to the Commission as an exempt reporting adviser. See IM Guid-ance 2016-3.
Exempt reporting advisers are required to file an abbrevi-ated Form ADV but are not required to file Form PF (the systemic risk-related Private Fund reporting form).
Exempt reporting advisers are subject to the anti-fraud provisions of the Advisers Act and certain Advisers Act anti-fraud rules including Rule 206(4)-5 (the Pay-to-Play Rule) and Rule 206(4)-8 (addressing fraud by advisers who defraud inves-tors and potential investors in pooled investment vehicles).
The SEC may examine exempt reporting advisers; although, it does not expect to subject exempt reporting advisers to routine examinations due to resource constraints. The SEC staff may conduct “for cause” examinations where it has some indi-cation that a violation of law may be occurring due to, for example, an investor complaint.
Exempt reporting advisers may also be subject to a rule relating to books and records; however, the SEC has not pro-posed any such rule.
B. Advisers to Pension Plans
As a practical matter, advisers to certain pension plans must be registered either with the SEC or with a state regulator. The addi-tional requirements that may be imposed by ERISA are beyond the scope of this outline.
C. Dual-Registration with CFTC
If an adviser provides advice to others on commodities or futures, registration with the Commodity Futures Trading Commission may also be required. The additional requirements that may be imposed by the Commodity Exchange Act, as amended, are beyond the scope of this outline.
IV. STATE REGISTRATION AND REGULATION
In a significant rebalancing of federal (SEC) and state responsibility for the regulation of investment advisers, the National Securities Markets
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Improvement Act of 1996 (“NSMIA”) generally preempted state regulation of investment advisers that have $25 million or more in assets under management or that advise registered investment companies.41 The Dodd-Frank Act raised this dividing line to $100 million or more assets under management if the adviser is subject to registration and examination as an investment adviser by the state’s relevant agency.
The remaining advisers are generally exempt from SEC registration and left principally subject to regulation by the states in which they maintain their principal office and place of business.
States may continue to investigate and bring enforcement actions against SEC-registered investment advisers for fraud or deceit, to require advisers to consent to service of process, to require certain filings and the payment of fees by investment advisers, and to license adviser repre-sentatives and solicitors.42
The interplay of the federal and state registration requirements is beyond the scope of this outline.
V. AFFILIATES AND ASSOCIATED PERSONS
A. Registration of Associated Persons Not Required
Persons associated with a registered investment adviser (i.e., the adviser’s officers, directors, and employees) are not themselves required to register, but their identity, business, and educational background generally must be disclosed in Form ADV (the federal registration form) and in most state registration documents.
B. Registration of Affiliates
1. Independent Subsidiaries
For many years, the SEC staff took the strict view that a parent company (whether or not based in the U.S.) that provided invest-ment advisory services through a subsidiary would be required to register as an investment adviser (unless exempt from registration) even if its subsidiary was a registered investment adviser—unless the registered subsidiary had a separate independent existence that functioned independently of its parent. The SEC staff set forth certain “safe harbor” guidelines to ensure that the subsidiary was
41. Advisers Act, Section 203A(a)(1)(A). 42. Advisers Act, Section 203A(b)(2).
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something more than a shell corporation serving as only a conduit for investment advice emanating from elsewhere. Under these guidelines, described in Richard Ellis, Inc., SEC No-Action Letter (pub. avail. Sept. 17, 1981), a subsidiary entity is regarded as having a separate independent existence and functioning independently of its parent if it:
• is adequately capitalized;
• has a buffer, such as a board of directors a majority of whose members are independent of the parent, between the subsidiary’s personnel and the parent;
• has employees, officers, and directors who, if engaged in providing investment advice in the day-to-day business of the subsidiary entity, are not otherwise engaged in the investment advisory business of the parent;
• itself makes the decision as to what investment advice is to be communicated to or is to be used on behalf of its clients and has and uses sources of investment information not limited to its parent; and
• keeps its investment advice confidential until communicated to its clients.
2. Subsidiaries Sharing Personnel with a Parent
In Unibanco-União de Bancos Brasileiros SA, SEC No-Action Letter (pub. avail. July 28, 1992), the SEC staff modified its position regarding the requirement for strict separation between a parent and a subsidiary. In addition, the SEC staff modified its views concerning the extraterritorial application of the Advisers Act. The SEC staff in Unibanco gave non-U.S. advisers greater flexibility to establish registered investment adviser subsidiaries without themselves being required to register. The SEC staff will not require a non-U.S. parent to register if its subsidiary registers as an investment adviser, provided that:
• the affiliated companies are separately organized (e.g., two distinct entities);
• the registered entity is staffed with personnel (whether phys-ically located in the U.S. or abroad) who are capable of providing investment advice;
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• all employees of the parent company who are involved in U.S. advisory activities are “associated persons” of the regis-trant; and
• the SEC has adequate access to trading and other records of each affiliate involved in U.S. advisory activities and its per-sonnel, to the extent necessary to monitor and police conduct that may harm U.S. persons or markets.43 The no-action relief in these letters is subject to a number of important conditions. Similarly, the SEC staff has confirmed that a foreign affiliate
of a U.S.-based registered investment adviser need not be registered if similar conditions are satisfied.44
3. Affiliates Other than Parent Companies
In Mercury Asset Management plc, SEC No-Action Letter (pub. avail. Apr. 16, 1993), the SEC staff first applied the sepa-rateness test in Unibanco (described above) to non-U.S. companies that are affiliated due to common ownership or control.
VI. EXTRATERRITORIAL APPLICATION
A. General
Historically, the SEC staff made broad claims as to the extra-territorial application of the Advisers Act and the SEC’s own jurisdiction with respect to SEC-registered advisers. For example, in Gim-Seong, SEC No-Action Letter (pub. avail. Nov. 30, 1987), the staff stated: “We . . . wish to point out that, generally speaking, all U.S. registered advisers (domestic and foreign) are subject to the relevant substantive provisions of the Advisers Act with respect to both U.S. and non-U.S. clients.” However, since 1992, the staff has
43. See also Mercury Asset Management plc, SEC No-Action Letter (pub. avail. Apr.
16, 1993); Kleinwort Benson Investment Management Limited, SEC No-Action Letter (pub. avail. Dec. 15, 1993); Murray Johnstone Holdings Limited, SEC No-Action Letter (pub. avail. Oct. 7, 1994); Thomson Advisory Group L.P., SEC No-Action Letter (pub. avail. Sept. 26, 1995); ABN-AMRO Bank N.V., SEC No-Action Letter (pub. avail. July 1, 1997); Royal Bank of Canada, SEC No-Action Letter (pub. avail. June 3, 1998).
44. ABA Subcommittee on Private Investment Entities, SEC No-Action Letter (pub. avail. Dec. 8, 2005).
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adopted a narrower approach regarding the application of the Advisers Act to foreign advisers and their non-U.S. clients.
In Unibanco (described above), the staff first applied the Advisers Act to foreign advisers on the basis of a “conduct and effects test,” i.e., only where an adviser’s activity involves conduct occurring in the U.S. or produces substantial and foreseeable effects in the U.S. will the Advisers Act apply.
B. Application of Registration Requirements to Non-U.S. Advisers
Unless excluded from the definition of investment adviser or exempted from registration as described above, a non-U.S. investment adviser that makes use of U.S. jurisdictional means to solicit, or provide advisory services to, persons resident in the U.S. must register under the Advisers Act. This is the case even if the adviser has less than $25 or $100 (as applicable) million in assets under management. However, a small non-U.S. investment adviser that maintains a place of business and office in a state would be subject to state regulation.
A non-U.S. adviser to non-U.S. clients may, however, use U.S. jurisdictional means to acquire information about the securities of U.S. issuers, and effect transactions in the securities of U.S. issuers through U.S. brokers or dealers, for the benefit of the adviser’s non-U.S. clients without registering under the Advisers Act. The SEC and its staff have stated that the substantive provisions of the Advisers Act will not apply to a registered non-U.S. adviser’s dealings with its non-U.S. clients.45 The non-U.S. adviser will, however, be required to keep certain books and records pertaining to its non-U.S. clients and make them available to the SEC upon request.
45. American Bar Ass’n, SEC No-Action Letter (pub. avail. Aug. 10, 2006). See also
Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, SEC Release No. IA-3222 (Jun. 22, 2011)(adopting release) at fn. 515 and the accompanying text.
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Introduction to the Investment Advisers Act
Clifford E. Kirsch
Sutherland Asbill & Brennan LLP
This outline is adapted from Chapter 1 of PLI’s Investment Adviser Regulation Treatise (Clifford E. Kirsch, Ed)
©2013 Sutherland Asbill & Brennan LLP
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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I. THE INVESTMENT ADVISORY PROFESSION
The investment advisory profession as we know it today dates back to the 1920s. Before then, investment advice was generally provided only through trust arrangements, and by lawyers, accountants, and brokers in the normal course of their business activities.
An investment adviser is a person or an entity that is in the business of providing investment advice. The adviser is the first cousin of the broker. Although both give investment advice, the broker is primarily in the business of executing securities transactions.
Investment advisers come in many shapes and sizes. On one end of the spectrum, a single person can be an adviser. At the other end of the spectrum, an adviser may be a large corporation that employs thousands of people, including money managers, marketing experts, financial analysts, lawyers, and accountants. The scope of investment adviser activity also varies. Some advisers limit their activity to producing a financial plan while other advisers manage client money (on either a discretionary or nondiscretionary basis).
While many advisers are affiliated with brokerage firms, banks, or insurance companies, many others are independent entities. Some advisers serve only individuals, while others serve only institutions, including mutual funds, pension plans, hedge funds, and offshore funds. Of course, many advisers serve both individuals and institutions.
II. SOURCES OF LAW
Typically, the investment adviser and the client have a contractual relationship. Less frequently, a trust instrument creates the relationship between them. Accordingly, the investment management lawyer may deal with common law principles of contract, agency, and trusts. However, because various statutes govern a wide range of advisory conduct, the investment management lawyer will deal primarily with statutory law.
Prior to 1997, advisers were directly regulated both by the Investment Advisers Act of 1940, a federal statute, as well as by state securities laws. Legislation that became effective on July 8, 1997, reallocated federal and state regulation of advisers. Generally, larger advisers fall under the Investment Advisers Act while smaller advisers are left to the states.
If an adviser manages investment company assets or private pension plan assets, the Investment Company Act of 1940 and the Employee Retirement Income Security Act of 1974 (ERISA), respectively, will govern important aspects of the adviser’s conduct.
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Advisers are not subject to regulation by any self-regulatory body, such as Financial Industry Regulatory Authority (FINRA). Although the Securities and Exchange Commission submitted a legislative proposal to Congress in 1989 calling for the self-regulation of investment advisers, it was not enacted. As discussed below in section 1:7, the Madoff scandal and the financial crisis has renewed calls by some for an adviser SRO.
In addition to being familiar with the statutory scheme, the investment management lawyer should be familiar with the operation of the various agencies that administer the statutes. The practicing lawyer will probably have frequent contact with the Securities and Exchange Commission (SEC), which administers the Investment Advisers Act of 1940 and the Investment Company Act of 1940, and the Department of Labor, which administers the provisions of ERISA relevant to advisers.
The SEC’s Division of Investment Management is the operating division primarily responsible for administering the Investment Advisers Act. The Division’s Chief Counsel Office is responsible for interpretations of legal and policy issues arising under the Advisers Act. The Division’s Office of Disclosure and Adviser Regulation is responsible for rulemaking under the Advisers Act. Other offices outside the Division of Investment Management also play a role in administering the Advisers Act. These include the Office of Compliance Inspections and Examinations, which, together with the SEC regional offices, inspects advisers. Also, the Office of Applications Report Services is responsible for processing adviser registration forms.
In addition to administering the Advisers Act, the Division of Invest-ment Management is responsible for administering the Investment Company Act of 1940.
An ongoing task for the investment management lawyer is to stay abreast of SEC pronouncements relevant to advisers. Generally, the most important of these emerge through rulemaking, enforcement actions, and requests for “no-action letters.” No-action letters include all letters to the SEC staff requesting advice, interpretation, opinions, or assurances that no enforcement action will be recommended by the staff to the Commis-sion under given circumstances. “No-action” refers to the staff’s written responses to such requests, responses that are generally public.
Another form of substantive law is generated by the SEC through exemptive orders. These orders relate to the authority given to the SEC by Congress in the Investment Company Act and the Investment
Advisers Act to grant exemptions from provisions of those acts. Exemptive orders are frequently requested under the Investment Company Act but less frequently requested under the Investment Advisers Act. The
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Division of Investment Management’s Office of Investment Company Regulation reviews most such requests.
The ERISA provisions relevant to investment advisers are admin-istered by the Department of Labor’s Employee Benefits Security Administration (EBSA). The EBSA offices most relevant to advisers are the Office of Regulations and Interpretations, the Office of Exemption Determinations, and the Office of Enforcement. An important procedure of which the investment management lawyer should be aware is the Depart-ment of Labor’s mechanism under which transactions may be exempted (on an individual or class basis) from particular ERISA prohibitions. To obtain an exemption, it is generally necessary to show that the arrangement will provide a fair, or better, deal for the plan.
III. THE INVESTMENT ADVISERS ACT OF 1940
The need for federal regulation of the investment management industry was recognized by Congress in 1935. In a provision of the Public Utility Holding Company Act of 1935, Congress directed the SEC to make a study of investment trusts. That study led to the enactment of the Investment Company Act of 1940 and the Investment Advisers Act of 1940.
The major focus of the SEC study was investment trusts and investment companies. In contrast, the subject of investment advisory services was given a limited review that resulted in a supplemental SEC report entitled “Investment Counsel, Investment Management, Investment Supervisory, and Investment Advisory Services.” The report found various abuses taking place in the investment advisory industry: the proliferation of “tipster services” in which unsubstantiated and unfounded claims were made to individuals; problems with respect to solvency and custody; issues relating to the assessment of performance fees, where advisers were compensated based on how well the client account performed; and problems with advisers assigning advisory contacts.
As originally enacted, the Investment Advisers Act provided little substantive regulation and was intended in large part merely to provide a census of the industry. David Schenker, the Chief Counsel of the SEC Investment Trust Study, described the purposes of the Act at a Con-gressional hearing in this way:
[The Act] does not attempt to say who can be an investment counselor. . . and does not even remotely presume to undertake to pass upon their qualifications. All we say is that in order to get some idea of who is in the business and what is his background, you cannot use the mails to perform your investment counsel business unless you are registered with us.
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The Act also set forth an antifraud provision and restricted certain practices such as the assessment of performance fees.
The Advisers Act has been amended on several occasions. Amend-ments in 1960 established, among other things, requirements for the maintenance of books and records by advisers. Those amendments also gave the SEC the right to routinely inspect those books and records. The 1960 amendments also extended the antifraud provisions to all advisers, whether or not they were registered, and gave the SEC the power to establish rules pursuant to the antifraud section. Amendments in 1970 increased the SEC’s disciplinary arsenal against advisers. Legislation that became effective in 1997 reallocated federal and state regulation of advisers. Most recently, in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act1 was enacted and, among other things, required many unregistered advisers to private funds to register.
The Advisers Act today stands as a formidable substantive body of regulation. As we will discuss in greater detail throughout the book, the Act attempts to check adviser misconduct in several ways.
First, unless subject to an exemption, advisers are required to register. As noted above, legislation effective in 1997 generally requires larger advisers to register with the SEC and smaller advisers to register with the states. Registration is accomplished by filing the Form ADV.
Second, advisers are required to disclose important information to clients. For instance, they must describe their services and fees and disclose potential conflicts of interest.
Third, certain conduct by an adviser is expressly restricted. This includes charging certain types of performance fees, entering into contracts that lack a nonassignment clause, and some types of trading transactions (for example, principal and agency cross-transactions).
Fourth, there is a specific antifraud provision, section 206. Signifi-cantly, in Securities and Exchange Commission v. Capital Gains Research Bureau, Inc., the Supreme Court noted that in applying the antifraud provision, an adviser is to be held to a fiduciary standard. This fiduciary standard will guide an adviser throughout its course of conduct. In addition, the SEC has established a series of rules pursuant to section 206 which set forth a specific framework applying to certain types of advisory activity, including advertising and maintaining custody of client assets.
Finally, there are provisions for SEC inspections and an enforcement mechanism. However, there is no provision in the Act that expressly sets
1. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-
203, H.R. 4173 (July 21, 2010).
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forth a private right of action for adviser misconduct. In TransAmerica Mortgage Advisors Inc. v. Lewis, the Supreme Court held that the Advisers Act provides only a limited private right of action for the voiding of an investment adviser contract.
A. A Glance at the Advisers Act Regulatory Framework
1. Registration Under the Investment Advisers Act
• Registration under the Advisers Act is effected by filing the Form ADV with the SEC and paying a fee.
• A distinction needs to be made between the adviser itself and individuals with the adviser.
• Registration is required of the adviser itself.
• Individuals associated with the adviser (which includes employees and those otherwise associated) are not separately registered as advisers.
• The form ADV consists of following parts:
• Part 1 is principally for use by regulators.
• Part 2A (the “Brochure”) serves as the basis for the disclosure document the adviser must provide to each of its advisory clients.
• Part 2B (the “Brochure Supplement”) is provided to clients with respect to certain advisory personnel.
2. Conduct Standards/Restrictions on Activities
An adviser’s conduct is shaped first and foremost by the fiduciary duty it owes clients.
Section 206 of the Advisers Act contains the antifraud provi-sions of the Advisers Act. That section provides that is unlawful for an adviser directly or indirectly to:
• employ any device, scheme, or artifice to defraud any client or prospective clients (section 206(1));
• engage in any transaction, practice, or course of business that operates as a fraud or deceit upon any client or prospective client (section 206(2)); and
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• engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative (section 206(4)). In Securities and Exchange Commission v. Capital Gains
Research Bureau, Inc.,2 the U.S. Supreme Court noted that in applying the antifraud provision, an adviser is to be held to a fiduciary standard. This fiduciary standard will guide an adviser throughout its course of conduct.
Among the most important requirements of section 206(1) and (2) is making full and adequate disclosure to clients regarding matters that may have an impact on the adviser’s independence and judgment.
The Advisers Act restricts certain specific activities that may be grouped into the following categories:
• Attracting Clients;
• Components of the Advisory Relationship;
• The Advisory Contract;
• Compensation;
• Suitability;
• Custody;
• Proxy Voting;
• Brokerage Transactions and Trading Practices; and
• Interactions with Municipalities: Pay to Play Practices
3. Attracting Clients
(a) Advertising
Rule 206(4)-1 is the primary rule covering advertising under the Advisers Act. The Rule includes four specific cate-gories of misleading advertising and one catchall provision. The most significant of the four specific categories are:
• No Testimonials; and
2. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963).
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• Past Specific Recommendations (cannot refer to successful securities recommendations without referring to unsuc-cessful recommendations).
The catchall category prohibits the use of any advertise-ment that “contain any untrue statement of a material fact, or which is otherwise false or misleading.” One particular kind of advertising—performance advertising—has been the source of many interpretative questions under the catchall category.
(b) Referral Fees
Many advisers rely on parties providing referrals—commonly known as “solicitors”—as sources of new business. Adviser cash payments to solicitors are governed by Rule 206(4)-3:
• Written agreement between solicitor and adviser is required; and
• Disclosure statement must be provided to the client and a signed acknowledgment received from the client when the solicitor is not affiliated with the adviser.
4. The Adviser-Client Relationship
(a) Advisory Agreements
Every advisory agreement with a client must provide, in substance, that the adviser may not assign the agreement without the client’s consent.
(b) Compensation
Generally, advisers are given wide latitude in structuring advisory fees, except for performance fees. The prohibition against the deduction of performance fees is contained in section 205(a)(1) of the Advisers Act. Exceptions to the performance-fee prohibition include:
• Asset-based fees;
• Fulcrum fees (popular arrangement with mutual funds that allows an adviser to adjust its base fee up or down
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depending on performance of the fund compared to an index);
• Wealthy client (Rule 205-3);
• Qualified Purchaser Fund; and
• Foreign Clients.
(c) Suitability
Advisers owe their clients a duty to provide only suitable investment advice. This duty generally requires an adviser to make a reasonable inquiry into the client’s financial situation, investment experience, and investment objectives, and to make a reasonable determination that the advice is suitable in light of the client’s situation, experience, and objectives.
(d) Custody
The Advisers Act imposes various requirements when an adviser maintains custody of client assets. A registered adviser that holds, directly or indirectly, client funds or securities, or has authority to obtain possession of clients’ funds or securi-ties, is deemed to have “custody” of those funds or securities. Rule 206(4)-2 establishes the following standards that apply when an adviser has or is deemed to have custody.
• Qualified custodian;
• Delivery of account statements;
• Surprise Audit;
• Internal Control Report (if custody by adviser or affiliate);
• Special rules for pooled investment vehicles.
(e) Proxy Voting
Rule 206(4)-6 provides that proxy voting policies and procedures must be adopted that are reasonably designed to ensure that the adviser votes proxies relating to clients’ securities in the best interest of clients.
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5. Brokerage and Trading Pictures
(a) Duty of Best Execution
As a fiduciary, an adviser is required to carry out its selection of brokers subject to the standard of “best execution.”
The advisory contract typically specifies whether the adviser or the client will be responsible for selecting the broker to execute orders on behalf of the client.
(b) Soft Dollars
As fiduciaries, advisers should negotiate with broker-dealers for lower commissions for its clients. In practice, brokers are reluctant to lower their usual commissions to clients, instead providing rebates that are paid in kind (by “soft” dollars) rather than in cash. An advisers’ receipt of soft dollars could constitute a breach of the adviser’s fiduciary duty.
Section 28(e) of the Securities Exchange Act of 1934 provides that advisers fall within the safe harbor when they pay more than the lowest available brokerage commissions if they receive research and benefits from the brokers.
The limits of section 28(e) have been addressed in various SEC releases and letters.
(c) Trading
Section 206(3) of the Advisers Act restricts advisers from acting in ways in which the advisers’ interest conflicts with clients’ interests. This includes principal transactions and agency cross-transactions.
In a principal transaction the adviser engages in transac-tions in which it buys securities for the adviser’s own inventory from a client or sells securities from the adviser’s own inventory to the client.
Agency cross-transactions involve the adviser operating on behalf of its advisory clients and those of the party on the other side of the brokerage transaction.
The Investment Advisers Act regulates principal transac-tions and agency cross-transactions by requiring that an
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adviser disclose the conflict and receive the consent of the client before effecting the transaction.3
Rule 206(3)-2 provides for safe harbor for agency cross-transactions and allows for blanket consent.
6. Interaction with Government Municipalities: Pay to Play Practices
On June 30, 2010, the SEC adopted Rule 206(4)-5 (the “Pay to Play Rule”) under the Investment Advisers Act. The Rule is designed to curtail “pay to play” practices by investment advisers.
There are three key aspects of the Pay to Play Rule: (1) Two-Year Compensation “Time Out”—a two-year “time out”
from receiving compensation for providing advisory services to certain government entities after certain political contributions are made;
(2) Solicitor Ban—a prohibition from paying third parties for soliciting government clients, except where such payments are made to “regulated persons” as defined in the rule; and
(3) Restriction on Coordinating Contributions—a prohibition on coordinating or soliciting contributions and payments.
7. Compliance
(a) Record-Keeping Obligations
Rule 204-2 under the Advisers Act requires that a broad range of books and records be maintained, including:
• the registered adviser’s accounting records;
• the registered adviser’s corporate records;
• records relating to the compliance policies and proce-dures records relating to clients, including transactions information, portfolio records and contracts;
• records relating to advertising and performance presentations;
3. Investment Advisers Act § 206(3).
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• records relating to clients’ assets that are, or are deemed to be, in the custody of the adviser; and
• records relating to personal securities transactions by principals and employees of the adviser.
Books and records must generally be maintained and preserved in an easily accessible place for five years from the end of the fiscal year during which the last entry was made on such record, and the first two years in an appropriate office of the adviser.
Books and records relating to the advertisements or performance information used in marketing materials must be maintained for a period of not less than five years from the end of the fiscal year during which the adviser last published or disseminated the materials.
Articles of incorporation, charters, minute books, and stock certificate books of the adviser and of any predecessor must be maintained in the principal office of the adviser and preserved until at least three years after termination of the enterprise.
(b) Compliance Program: Rule 206(4)-7
A registered adviser must adopt and implement written policies and procedures reasonably designed to prevent vio-lations of the Advisers Act by the registered adviser or any of its supervised persons.
These policies and procedures must be reviewed annually by the registered adviser to determine their adequacy and effectiveness.
Registered advisers are required to designate a chief com-pliance officer that has a position of sufficient seniority and authority within the organization to administer the compliance policies and procedures.
(c) Insider Trading and Code of Ethics
Under section 204A of the Advisers Act, an adviser must establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material, non-public information by the adviser or any person associated by the adviser.
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Each registered adviser must adopt a code of ethics that: • Sets out a standard of business conduct for the adviser
and its supervised persons;
• Prevents access to material non-public information of the adviser’s securities recommendations and client services, unless needed by personnel of the adviser for their duties; and
• Requires periodic reporting and review of the personal trading reports from “access persons” of the adviser and the implementation of personal trading procedures.
(d) Privacy
Under Regulation S-P, a registered adviser must adopt policies and procedures that address administrative, technical, and physical safeguards for the privacy protection of private customer records and information.
(e) Business Continuity Planning
The SEC has taken the position that a registered adviser’s fiduciary obligations to its clients include the obligation to take steps to protect the clients’ interests from being placed at risk as a result of significant business disruptions.
IV. STATE LAW
States generally have a regulatory framework similar to that of the Investment Advisers Act. Many states exclude from the definition of investment adviser many of the same categories excluded in the Invest-ment Advisers Act: banks, attorneys, accountants, teachers, and broker-dealers. Some states provide that these exclusions from the definition are unavailable to an entity that “holds itself out” to the public as an investment adviser.
Currently, forty-nine states and the District of Columbia require investment advisers to register. Wyoming has no such requirement. In addition to the adviser itself, many states require registration of the adviser’s employees. Many states also require that these individuals pass certain qualifying exams.
Some states have substantive regulation stricter than that of the federal Advisers Act. For example, some states prohibit an adviser from
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keeping custody of client assets, require the bonding of the investment adviser against larceny or embezzlement, and require an adviser to meet certain net capital requirements.
Finally, states generally have an enforcement mechanism to ensure compliance with the law. While some states routinely inspect advisers, others limit their activity to investigating those advisers that they suspect of wrongdoing.
V. THE INVESTMENT COMPANY ACT OF 1940
The Investment Company Act of 1940 imposes a very broad and detailed scheme of regulation upon investment companies and the advisers to investment companies. As already noted, the Investment
Company Act grew out of an SEC study mandated by Congress. Before the Investment Company Act, investment companies were generally subject only to disclosure regulation under the Securities Act of 1933, thereby escaping regulation of the type that was applied to other financial intermediaries such as banks and insurance companies. Congress believed that a specialized body of regulation was appropriate because the invest-ment company structure and the portable nature of its assets afforded the opportunity for self-dealing on the part of persons, such as the investment adviser, having a relationship with the company.
In approaching the Investment Company Act, it is important to determine first whether the entity in question falls under the definition of investment company in section 3. Once it has been concluded that an investment company is involved, it is then essential to determine the particular type of investment company involved. This is because certain provisions of the Act apply only to certain types of companies.
Section 4 of the Act divides investment companies into “face amount certificate companies,” “unit investment trusts,” and “management com-panies.” Face amount certificate companies, which today are almost extinct, issue certificates obligating them to pay a fixed sum on the maturity date. A unit investment trust issues redeemable securities representing an undivided interest in a fixed portfolio of specified securities. Because it has a fixed portfolio, this type of investment company does not employ an investment adviser. A management company is any investment company that is neither a face amount certificate company nor a unit investment trust.
Management companies are further subdivided into open-end com-panies and closed-end companies by section 5(a). An open-end company is one that offers shares that the company stands ready to redeem at net
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asset value upon tender by a shareholder. A closed-end company is any company that is not an open-end company. Both the open-end company and the closed-end company (together referred to as “mutual funds”) employ investment advisers.
The investment adviser is generally understood to be the most important service provider to the mutual fund. To understand their relationship properly, one should think of the investment adviser as the mother of the mutual fund. The adviser establishes the fund, registers it, seeds its initial minimum capital, and puts in place all of the necessary service arrangements (such as the distribution agreement, the shareholder servicing agreement, and the transfer service agreements).
The advisory relationship with a mutual fund can be either exter-nalized or internalized. The vast majority of funds have an externalized structure, under which the adviser’s relationship to the fund is a contrac-tual one. Under the arrangement, the adviser agrees to provide personnel and the means to manage the fund, such as office space. The fund is merely a shell with few employees. The adviser’s fee is determined contractually pursuant to some prescribed formula; it is not like a salary that an employer pays an employee.
In contrast, the internalized structure is similar to the structure of the typical corporation. In this structure, investment decisions are made by employees of the fund.
In both types of arrangements, the adviser is in a position to take advantage of the fund. As noted, the assets of the fund are liquid and portable. This fact, combined with the adviser’s influence over distribu-tion and portfolio brokerage, makes fund assets vulnerable to abuse by the adviser.
The Investment Company Act established various means to keep the adviser in check. There are provisions that (1) provide for prospectus disclosure of investment objectives and
investment policies; (2) place controls over the nature of the investment advisory contract; (3) impose a board of directors to serve as a watchdog over the adviser; (4) provide an express private right of actions for shareholders; and (5) restrict transactions between the fund and the adviser.
These provisions are discussed below. First, a fund is required to disclose its investment objective and
investment policies. The investment objective of the fund is, in effect, its major goal (for example, aggressive growth). The investment policies are
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the means by which the fund intends to achieve its objective. Disclosure is also required concerning those policies that are changeable only by shareholder vote. These provisions serve to limit the discretion that an adviser has to alter unilaterally a fund’s investment strategy.
Second, section 15 of the Investment Company Act places controls on the advisory contract. Specifically, the advisory contract must be written; must precisely describe all compensation; may continue for more than two years after execution only if continuance is approved annually by the majority of the board of directors or by a majority vote of shareholders; must provide that the fund may terminate it at any time without penalty on sixty days’ written notice; and must provide for the contract’s automatic termination if it is assigned.
Third, various provisions of the Investment Company Act establish a corporate structure to police conflicts between the fund and the adviser. Generally, section 15 imposes a duty on the board of directors to evaluate and review the advisory contract. In evaluating the terms of the advisory contract, directors are required to request and evaluate, and the adviser is required to furnish, certain information. This includes infor-mation about investment performance, compensation, brokerage and portfolio transactions, and overall fund expenses and expense ratios.
Fourth, the Investment Company Act imposes a fiduciary duty on the investment adviser with respect to the compensation the adviser receives from the company and its shareholders. The SEC and shareholders are authorized to bring an action against the adviser for breach of this duty.
Finally, various provisions of the Investment Company Act restrict transactions between a mutual fund and its affiliates, including the fund’s investment adviser. In relevant part, (1) section 17(a) prohibits transactions between a fund and adviser
where the adviser is acting as principal; (2) section 17(d), together with Rule 17d-1, restricts joint transactions
involving a fund and an adviser; (3) section 17(e) restricts the amount of compensation an adviser may
receive when acting as an agent to the fund; and (4) section 10(f) restricts a mutual fund’s acquisition of securities from
an underwriting syndicate if a member of the syndicate is affiliated with the fund in certain ways.
The SEC has established a variety of rules which serve to provide flexibility in the application of these provisions.
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VI. THE EMPLOYEE RETIREMENT INCOME SECURITY ACT OF 1974
Because a growing number of pension plans hire investment advisers to manage pension plan assets, the law governing pension plans is increas-ingly important to investment advisers. In approaching pension law, it is important to distinguish the laws that regulate public pension plans from those regulating private pension plans. The regulation of public pension plans is accomplished generally by common law and state or local statute. In contrast, the regulation of private pension plans, as relevant to investment advisers, is generally accomplished through the Employee Retirement Income Security Act of 1974 (ERISA).
ERISA, which is divided into four titles, establishes a comprehensive regulatory structure with significant liability attached to the operation of a pension plan. Title I, which establishes various protections from mis-management and misuse of plan assets, is the title relevant to registered investment advisers.
To understand the operation of Title I, one must be familiar with pension plan structure and the various parties playing a role in that structure. By way of background, before ERISA, plan structure was generally straightforward; an employer provided for the retirement needs of its employees either by paying directly from general assets or by setting aside assets. In contrast, ERISA requires that plan assets be held in trust and that persons responsible for plan assets be identified.
Every plan must be in writing and must designate at least one “named fiduciary.” Consistent with ERISA sections 402 and 405, the named fiduciary has the principal responsibility and authority to manage the plan’s operation and administration and to hire and fire other persons with investment discretion over plan assets. Typically, the plan sponsor (for example, the employer) selects itself as the named fiduciary.
ERISA also requires every plan to provide for one or more parties who have the authority to oversee the safekeeping of plan investments. This party is referred to as the trustee. A plan sponsor may choose to serve as its own trustee. However, because many plan sponsors are not financially sophisticated, an outside trustee, typically a bank, will often be selected.
Recognizing the possibility that named fiduciaries will seek to enter into arrangements with others to carry out the investment management function, ERISA creates a special category of fiduciaries called “investment managers.” If, pursuant to ERISA section 402(c)(3), a named fiduciary appoints an investment manager, limited relief from the fiduciary
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provisions is afforded the named fiduciary. However, the named fiduciary remains responsible for the initial appointment of the investment manager, for monitoring the actions of the investment manager, and for the con-tinuing appointment.
To be an investment manager, which is defined in section 3(38), two requirements must be satisfied. First, only banks, insurance companies, or advisers registered under the Investment Advisers Act or under state law are eligible to be investment managers. Second, the investment manager must acknowledge in writing that it is a fiduciary with respect to the plan.
Section 3(21)(A)(ii) creates another category of potential fiduciaries consisting of persons who provide investment advice, for compensation, with respect to plan or IRA assets.
The Department of Labor in Regulation 3-21 clarified the scope of the applicability of ERISA to such persons. This regulation provides that such a person becomes a fiduciary if for a fee or other compensation, a recommendation regarding plan or IRA investment activities is: made by an admitted fiduciary, is provided pursuant to a written or verbal under-standing that advice is based on the needs of the recipient, or is directed to the recipient about a particular management or investment decision. Persons unaware of these provisions may become inadvertent fiduciaries. This may be problematic, because if a person is not aware of being a fiduciary, he or she may not take precautions against engaging in prohib-ited transactions.
There are various duties that ERISA imposes on a fiduciary managing plan or IRA assets. First, it must discharge its duties solely in the interests of plan participants and beneficiaries and for the exclusive purpose of providing plan benefits to them and defraying the reasonable expenses of administering the plan. Second, it must act with care, skill, prudence, and diligence under the circumstances then prevailing and in a manner consistent with the actions of a prudent person acting in like capacity. Third, as a general matter, it must diversify plan investments in order to minimize the risk of large losses unless it is clearly prudent not to do so. Finally, its operations must be consistent with plan documents and other instruments.
Of special importance to those who are fiduciaries with respect to plans, including those managing pension plan assets, section 406 bars fiduciaries from engaging in certain transactions and activities, even if they are otherwise prudent. This is intended to expand the common law duties imposed on fiduciaries and the general duties imposed by ERISA, by prohibiting certain transactions that are potentially abusive.
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Significantly, ERISA prohibits a fiduciary from dealing with plan assets for his or her own account or in his or her own interest. Also, a fiduciary cannot cause a plan to engage in a transaction with a “party in interest” if the transaction involves, directly or indirectly, the sale, exchange, or lease of property; lending money or extending credit; furnishing goods, services, or facilities; or the transfer of assets to, or use of assets by or for the benefit of, a party in interest. A “party in interest” is generally someone who provides services to a plan (including a fiduciary) or sponsor of a plan or one who at least in part owns or is owned by such a person.
Moreover, the fiduciary may not deal in any capacity involving the plan on behalf of a party whose interests are adverse to the interests of the plan, its participants, or beneficiaries. Further, the fiduciary may not receive any consideration for his or her personal account from any party dealing with the plan in connection with a transaction involving plan assets. As a final example, the fiduciary cannot be paid for his or her services if he or she is already receiving full-time pay from the employer or union whose employees or members are participants.
Because of these prohibitions, persons providing services to plans, including investment managers or investment advisers, generally must avail themselves of the protection afforded by the statutory exemption of section 408(b)(2) of ERISA.
This section requires that such services must be provided on a reasonable basis (terminable on reasonably short notice by the plan) and the plan must not pay any more than reasonable compensation.
Under ERISA section 409, a fiduciary who causes a plan to engage in a prohibited transaction which the fiduciary knows or should know is prohibited is personally liable to compensate the plan for any resulting losses. Also, under the Internal Revenue Code, a party in interest (referred to as a “disqualified person” by the Internal Revenue Code) is liable for an excise tax for engaging in a prohibited transaction with a plan.
As discussed later in the book, the Department of Labor has granted various class exemptions relevant to money management activities. For example, an adviser that is itself a broker-dealer or affiliated with a broker-dealer is permitted to effect or execute securities transactions on behalf of a plan and/or to perform clearance, settlement, custodial, or other functions incidental to such transactions, provided that the conditions of Prohibited Transaction Class Exemption (PTE) 86-128 are satisfied. The principal condition is compliance with impartial conduct standards, including acting in the best interest of plans when exercising fiduciary activity. In addition, PTE 86-128 covers transactions in which an adviser
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to plan assets effects a sale or purchase of a security for the plan’s account while acting as a broker for a person other than the client.
VII. FINANCIAL INDUSTRY REGULATORY AUTHORITY (FINRA)
As noted above, there is no self-regulatory organization that regulates advisory conduct, however, in the aftermath of the Madoff scandal and the financial crisis, some have urged that advisers be subject to self-regulatory organization (SRO) oversight. Broker-dealers engaging in advisory activity are subject to FINRA requirements regarding supervisors. More specifically, FINRA requires that its member broker-dealers properly supervise the advisory activities of registered representatives that are independently engaged in advisory activity or associated as an invest-ment adviser representative with the firm itself or one of the firm’s affiliates. As discussed in chapter 2, the extent of the supervision required depends on the type of advisory activity that is being engaged in by the registered representatives.
VIII. PRIVATE ASSOCIATIONS
Various private associations help shape the regulation of investment advisers by setting forth standards of conduct with which their members are expected to comply. Among the more popular associations are:
• Investment Adviser Association;
• Association of Investment Management and Research;
• Investment Company Institute;
• GIPS; and
• CFP.
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State Registration of Investment Advisers
G. Philip Rutledge
Bybel Rutledge LLP
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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PREFACE
As this course focuses on an introduction to investment adviser regulation, the following information is designed to acquaint the reader with the scope of state jurisdiction over investment advisers and investment adviser representatives and various state registration and post-registration requirements.
A discussion of the various forms of administrative, civil and crim-inal liability to which investment advisers and investment adviser rep-resentatives may be subject under state securities laws is beyond the scope of an introductory program and this narrative. For those interested in that subject matter, an extensive examination of administrative and civil liability of investment advisers and investment adviser representatives is contained in Chapter 35 of PLI’s Treatise on Investment Adviser Regulation.
However, it is noteworthy that, in January 2016, state securities reg-ulators endorsed model state legislation to protect vulnerable adults (eg persons aged 65 or older and persons subject to adult protective services) from financial exploitation. This model legislation would allow investment advisers and investment adviser representatives to make disclosures con-cerning requested transactions by clients who are deemed to be vulnerable adults to state securities regulators and to delay requested disbursements from those client accounts without incurring administrative or civil lia-bility for their actions under the relevant state securities law.
INTRODUCTION TO STATE REGULATION
Although the National Securities Markets Improvement Act of 1996 (“NSMIA”)1 left state jurisdiction over broker-dealers and their registered representatives (denominated as “agents” at the state level) virtually undisturbed (except for rules relating to books and records and capital requirements), it significantly altered state and federal jurisdiction over investment advisers. Not only did NSMIA divide investment adviser registration into mutually exclusive universes of federal and state juris-diction, it also created a national de minimis provision, “home state” requirements relating to books and records, net capital and bonding and mandated establishment of an Investment Adviser Registration Depository
1. Public Law 104-296.
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(“IARD”).2 The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”)3 made further changes relating to state registration of investment advisers.
No discussion of state regulation of investment advisers is complete without addressing state regulation of investment adviser representatives. There is no requirement for investment adviser representatives to register with the U.S. Securities & Exchange Commission (“SEC”) and, unlike agents of broker-dealers who must register with the Financial Industry Regulatory Authority (“FINRA”), there is no self-regulatory organization for investment advisers or investment adviser representatives.4 Therefore, regulation of investment adviser representatives is solely a state function.
All states have a state agency charged with the administration of the state’s securities statute. However, the placement of the administering office within the structure of state government differs widely and usually has historical antecedents. Helpfully, the web site of the North American Securities Administrators Association (“NASAA”) maintains links to the web sites of every state securities regulator which provides easy navigation to determine what department of state government is charged with administering that state’s securities laws.5
Some states have viewed securities regulation akin to banking reg-ulation and have included securities regulation within its banking reg-ulatory structure. Connecticut, Nebraska and Idaho are examples of banking departments having jurisdiction over state securities regulation. Other states have combined financial regulation into one department. Washington, Vermont and Wisconsin are examples where securities regu-lation is part of a larger department of financial regulation. In other instances, state securities regulation is a function of a state’s department of commerce such as Ohio, Tennessee, Minnesota, Hawaii and Utah.
2. IARD is modeled after the highly successful Central Registration Depository used
by federal and state regulators and self-regulatory organizations to register broker-dealers and their agents.
3. Public Law 111-203. 4. In 2012, FINRA made a concerted effort to convince Congress to make it the self-
regulatory authority for investment advisers and obliging legislation was introduced. That legislation was fiercely opposed by, among others, the Financial Planning Association and the Investment Counsel Association, and the bill died at the end of the 112th Congress. On April 10, 2014, the Wall Street Journal reported that FINRA no longer would seek designation as a self-regulatory organization for investment advisers.
5. A complete list of state securities regulators with contact details can be found at www.nasaa.org.
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Some states, such as Virginia and Arizona, view securities regulation as adjunct to the duties of its corporation commission.
There exist a fair number of states where the responsibilities of securities regulation are vested in a statewide elected official, usually a secretary of state (eg North Carolina, Indiana, Illinois, Missouri, Massachusetts and Georgia), state auditor (eg Montana and West Virginia) or state attorney general (eg New York, Maryland, and Delaware). Lastly, some state securities regulators operate as independent agencies of state government. Oklahoma, Alabama and Arkansas are examples of states which follow that model.
NASAA is a non-profit organization whose membership consists of state securities regulators in the U.S., Puerto Rico, U.S. Virgin Islands, Guam and the District of Columbia as well as the securities regulators of the Canadian Provinces and Mexico. Although NASAA promotes uni-formity among its members by adopting uniform statutes, model statutory amendments, model rules and model policy statements, it cannot force its members to adopt these pronouncements and therefore, they have no binding legal effect on its member jurisdictions.
UNIFORM STATE SECURITIES ACTS
State securities regulation predates federal regulation of securities by several decades with the first state securities law having been enacted by Kansas in 1911. The first attempt to harmonize state securities laws into a uniform statutory scheme was undertaken by the National Conference of Commissioners on Uniform State Laws (“NCCUSL”) with its adoption of the Uniform Sales of Securities Act (1930) but this met with little success.6
Evolution of Uniform Securities Acts
The Uniform Securities Act (1956) (“USA 1956”) was the second and much more successful attempt by NCCUSL to provide for uniform state regulation of securities, broker-dealers, agents and invest-ment advisers as well as for civil liability and criminal penalties. The USA 1956 was enacted by 37 jurisdictions.7
In 1985, NCCUSL undertook an effort to update the USA 1956 to account for changes in the securities industry which had taken
6. Smith, Richard B., “A New Uniform Securities Act,” Wall Street Lawyer
(February 2003), p.8. Only a few states enacted the USA 1930. 7. Id.
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place in the intervening years. Although adopted by NCCUSL as a uniform act to be recommended for adoption by state legislatures, the Uniform Securities Act (1985) (“USA 1985”) never received the endorsement of key organizations such as NASAA and the American Bar Association and it consequently was adopted in only six states.8
In 1996, Congress enacted NSMIA which was the first major reallocation of securities regulatory authority between the SEC and state securities regulators since enactment of the Securities Act of 1933 (“1933 Act”), the Securities Exchange Act of 1934 (“1934 Act”) and the Investment Advisers Act of 1940 (“Advisers Act”).
In light of enactment of NSMIA and the failure of the USA 1985 to be widely adopted, NCCUSL tried again in 2002 to produce a new uniform securities act which would replace the USA 1956 and USA 1985 in their entirety. In the Prefatory Note to the Uniform Securities Act (2002) (“USA 2002”) by Professor Joel Seligman,9 he noted that the USA 2002 had three overarching themes: (1) emphasis on greater uniformity and cooperation among relevant state and federal govern-ments and self-regulatory organizations, (2) consistency with federal preemption provisions in NSMIA, and (3) the facilitation of electronic records, signatures and filing.
Unlike the USA 1985, the USA 2002 was endorsed by NASAA10 and the American Bar Association.11 Although enactment of the USA 2002 thus far by 20 jurisdictions12 is a much better record than the USA 1985, only two of the enacting states (Georgia and Michigan) are included in the ten most populous states in the United States.
Although there are many jurisdictions that still operate under the statutory framework of the USA 1956,13 an effective discussion of
8. The USA 1985 was the subject of amendments adopted by NCCUSL in 1988.
Although Maine enacted the USA 1985, it subsequently enacted the USA 2002, leaving only five jurisdictions with statutory roots in the USA 1985.
9. Professor Seligman served as NCCUSL’s Official Reporter for the USA 2002. 10. Endorsed by NASAA Members on January 6, 2003. 11. Endorsed by the American Bar Association on February 10, 2003. 12. Georgia, Hawaii, Idaho, Indiana, Iowa, Kansas, Maine, Michigan, Minnesota,
Mississippi, Missouri, New Hampshire, New Mexico, Oklahoma, South Carolina, South Dakota, U.S. Virgin Islands, Vermont, Wisconsin and Wyoming (effective July 1, 2017).
13. New York’s securities law, known as the Martin Act, is most unique. It is not based on the USA 1956 and is probably the only “dealer” statute left with respect to the issuance and distribution of securities. Although the securities laws of California, Florida, Ohio and Texas contain similarities to the USA 1956, they also contain significant differences. NCCUSL had hoped that its undertaking to produce the USA 2002 would induce these states in particular to adopt a uniform
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state regulation of investment advisers and investment adviser repre-sentatives should reference their treatment under both the USA 1956 and USA 2002.
It also is worth noting that many USA 1956 jurisdictions amended their securities statutes after enactment of NSMIA and adoption by NCCUSL of the USA 2002, particularly in regard to the preemptive features of NSMIA affecting investment advisers. That has resulted in some jurisdictions having a securities statute grounded in the USA 1956 but containing a number of provisions found in the USA 2002.
To aid practitioners, the State Securities Committee of the Business Law Section of the American Bar Association maintains a sub-committee on state liaisons to state securities administrators who periodically update the bar on statutory and interpretive develop-ments under various state securities laws.14
STATE REGULATORY JURISDICTION OVER INVESTMENT ADVISERS
NSMIA Establishes Mutually Exclusive Registration
NSMIA enacted Section 203A of the Advisers Act which states that no investment adviser that is regulated or required to be reg-ulated in the state in which it maintains its principal office and place of business shall register with the SEC under Section 203 of the Advisers Act unless the investment adviser (1) had assets under management of not less than $25 million (or such higher figure as the SEC may determine) or (2) is an investment adviser to an investment company registered under the Investment Company Act of 1940 (“1940 Act”).15
Rule 203A-3(c) under the Advisers Act defined, for purposes of Section 203A, the term “principal office and place of business” as the executive office of the investment adviser from which officers, partners or managers of the investment adviser direct, control and coordinate the activities of the investment adviser. Therefore, if a
securities act in the form of the USA 2002. To date, this aspiration has not been fulfilled.
14. See http://apps.americanbar.org/dch/committee.cfm?com=CL68002. Charles Schwab and U.S. Compliance Consultants have developed a helpful State Registration Fact Sheet available at http://www.uscomplianceconsultants.com/PDF/State% 20Registration%20Fact%20Sheets.pdf.
15. 15 U.S.C. §80b-3a(a)(1).
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state where the investment adviser maintains its principal office and place of business does not require registration of investment advisers, such adviser remains subject to SEC registration.16
Except for fraud and deceit,17 NSMIA created two exclusive registration universes for investment advisers based primarily upon the investment adviser’s amount of assets under management (“AUM”).18 The initial demarcation was $25 million AUM. Less than $25 million AUM placed the investment adviser exclusively under state registration while AUM of $25 million or more placed the investment adviser under exclusive SEC registration. Dodd-Frank revised the demarcation to $100 million AUM 19 but only with respect to those investment advisers required to be registered with a state in which it maintains its principal office and place of business and which would be subject to examination by that state.20
There are several categories of investment advisers which remain subject to exclusive SEC registration without regard to AUM. These include an investment adviser that (1) had its principal place of business in a state that did not regulate investment advisers,21 (2) is an investment adviser to an investment company registered with the SEC under the 1940 Act or a company which has elected to be a business development company under Section 54 of the 1940 Act,22 (3) is required to register in 15 more states,23 (4) is a pension
16. At the time NSMIA was enacted, there were several states which did not require
registration of investment advisers. Currently, only Wyoming does not require registration of investment advisers and investment advisers that maintain a prin-cipal office and place of business in Wyoming must register with the SEC.
17. 15 U.S.C. §80b-3a(b)(2). The SEC and states retain concurrent jurisdiction to investigate and bring enforcement actions against investment advisers and persons associated with investment advisers who engage in fraud or deceit.
18. 15 U.S.C. §80b-3(a)(3); 17 CFR 203A-3. Assets under management mean the securities portfolios with respect to which an investment adviser provides con-tinuous and regular supervisory or management services. See also Item 5.F. of Form ADV, 17 CFR 275.279.1.
19. The SEC may establish such higher amount as it deems appropriate. 20. 15 U.S.C. §80b-3a(a)(2)(B). Only New York indicated to the SEC that it did not
conduct investment adviser examinations and therefore investment advisers with a principal office and place of business in New York with an AUM of $25 million or more would be subject to exclusive SEC registration.
21. 15 U.S.C. §80b-3a(a)(1). The only state which currently does not regulate investment advisers is Wyoming. This will change on July 1, 2017 when the Wyoming Uniform Securities Act, which is based on the USA 2002, becomes effective.
22. 15 U.S.C. §80b-3a(a)(2)(A). 23. 15 U.S.C. §80b-3a(a)(2)(A); 17 CFR 275.203A-1(d).
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consultant with respect to assets of plans having an aggregate value of at least $200 million,24 (5) provides investment advice to all of its clients through the internet,25 (6) is eligible for SEC registration within 120 days after the registration becomes effective with the SEC,26 and (7) is controlling, controlled by or under common control with an investment adviser registered with the SEC.27
States Permitted to Require Notice Filings by SEC-Registered Investment Advisers
Even where investment advisers are subject only to registration with the SEC, NSMIA did permit states to require that SEC-registered investment advisers file any document filed with the SEC with each state in which it conducts business for notice purposes only accompanied by a consent to service of process and any required filing fee.28
Section 405(a) of the USA 2002 makes it unlawful for a federal covered investment adviser29 to transact business in the state as a federal covered investment adviser unless it complies with the notice filing requirements or is exempted from compliance.30 Section 405(b) of the USA 2002 exempts a federal covered investment adviser that does not have a place of business in the state from the notice filing requirement if (1) its only clients in the state are (a) federal covered investment advisers, investment advisers registered under the state’s securities laws and broker-dealers registered under the state’s securities
24. 17 CFR 275.203A-2(a). 25. 17 CFR 275.203A-2(e). Under Section 203A(c) of the Advisers Act, the SEC has
authority to designate, by rule or order, that certain persons be registered exclu-sively with the SEC. This exemption is an exercise of that authority.
26. 17 CFR 275.203A-2(c). 27. 17 CFR 275.203A-2(b). 28. Section 307(a) of NSMIA. Generally, this consists of an annual filing of Form
ADV and amendments thereto. Administratively, these filings are made through the IARD and are effective with the administrator upon filing. Section 407 of the USA 2002 permits a federal covered investment adviser succeeding to the notice filing of another federal covered investment adviser to file a notice under Section 405 for the unexpired portion of the current notice filing.
29. As used herein, federal covered investment adviser means an investment adviser subject to exclusive registration with the SEC. It is a term used in the USA 2002 to identify the same person.
30. Although the failure to make a notice filing may give rise to civil administrative enforcement under Sections 603 and 604 of the USA 2002, it would not give rise to any private civil cause of action under Section 509 of the USA 2002.
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laws, (b) institutional investors, (c) bona fide pre-existing clients whose principal places of residence are not in the state and (d) other clients specified by rule or order issued by the administrator, or (2) in the preceding 12 months, did not have more than five clients resident in that state, exclusive of the clients described in (1) above.
De Minimis Preemption and Enforcement of Home State Rules
NSMIA enacted Section 222(d) of the Advisers Act which preempts the application of state law to an investment adviser that otherwise would be subject to exclusive state registration based upon minimum contacts with residents of a particular state. Generally, an investment adviser will be subject to registration by at least the state in which it maintains its principal office and place of business (“Home State”).
This section prohibits a state from requiring registration if the investment adviser (1) does not have a place of business located within that state and (2) in the preceding 12-month period had fewer than six clients who are residents of that state (“National DeMinimis”).31 In contrast with the provisions of Section 222(b) and (c) governing imposition of books and records and capital and bonding requirements, there is no requirement that the investment adviser be registered in its Home State in order for the preemptive provisions of Section 222(d) of the Advisers Act to apply.
For purposes of application of the National DeMinimis, how to count clients becomes important and Rule 222-2 under the Advisers Act states that, for this purpose, the definition of “client” contained in Rule 202(a)(30)-1 shall govern without giving regard to paragraph (b)(4) of that section, including how to count legal organizations. Under SEC Rule 202(a)(30)-1 of the Advisers Act, a corporation, general partnership, limited partnership, limited liability company, certain trusts or other legal organization are counted as a single client provided that investment advice is based on the entity’s investment objectives rather than the individual investment objectives of the shareholders, partners, limited partners, members or beneficiaries. If two or more legal organizations have identical owners, they also would be counted as a single client.
31. A discussion of what constitutes legal residency is beyond the scope of these
materials but persons who maintain more than one residence in different states could be viewed as residents of more than one state.
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If an investment adviser is registered in its Home State and is in compliance with the Home State’s rules relating to books and records and net capital and bonding, the Advisers Act prohibits any other state in which the investment adviser must be registered from imposing any standards relating to books and records or net capital and bond-ing that exceed those under the Home State’s rules. Note that the investment adviser must be registered in its Home State for these federally imposed limitations to apply. If, for instance, an investment adviser is not required to be registered in its Home State in reliance on an exemption and has more than five clients in another state, the federally imposed limitations on books and records and net capital and bonding would not apply since the investment adviser is not registered in its Home State.
State Regulation of Exempt Reporting Advisers under Dodd-Frank
Under Section 203A(a)(1) of the Advisers Act, states are prohibited only from registering investment advisers registered with the SEC under Section 203 of the Advisers Act. Dodd-Frank enacted several exemptions from SEC registration under the Advisers Act. Without an exemption available under state law, these SEC-exempt investment advisers may be subject to state registration because states are not prohibited from regulating them as they are not registered with the SEC (even though they may be required to make notice filings with the SEC as “exempt reporting advisers”).32 Therefore, absent avail-ability of an exemption under state law, an investment adviser that is an “exempt reporting adviser” for SEC purposes simultaneously may be subject to (1) state registration and (2) an obligation to file certain reports with the SEC on Form ADV pursuant to federal law.
An example is the exemption from SEC registration under Section 203(m) of the Advisers Act for advisers to private funds with AUM in the United States of less than $150 million (“Private Fund Advisers”). Absent an exemption under state law, these advisers are subject to state registration. NASAA proposed a model exemption from registration under state law for Private Fund Advisers whereby advisers would be exempt from state registration if (1) neither the adviser nor any of its advisory affiliates were subject to a
32. See Item 15 of the General Instructions to Form ADV. Exempt reporting advisers
are those relying on the exemptions in Section 203(l) or 203(m) of the Advisers Act.
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disqualification described in Rule 262 under SEC Regulation A,33 (2) the adviser filed with the state each report and amendment thereto that it was required to file as an exempt reporting adviser with the SEC under Rule 204-4 of the Advisers Act and (3) the adviser paid any fee that may be specified under state law.
At first blush, this would appear to be an efficient corollary to the relevant SEC exemption. However, the NASAA model exemption imposes further conditions if the Private Fund Adviser advises at least one fund relying on the exemption in Section 3(c)(1) of the 1940 Act that is not a venture fund as defined in SEC Rule 203(1)-1 under the Advisers Act.34
Under these circumstances, the exemption is available only if (1) the outstanding securities of the issuer are owned by persons who, after deducting the value of their primary residence, meet the def-inition of qualified client under Rule 205-3 of the Advisers Act;35 (2) the issuer discloses the following in writing to each beneficial owner: (a) the fund is the adviser’s client, (b) a description of all services, if any, to be provided to individual beneficial owners, (c) all duties, if any, the investment adviser owes to the beneficial owners and (d) any other material information affecting the rights or responsibilities of the beneficial owners; and (3) the adviser obtains, on an annual basis, audited financial statements of each Section 3(c)(1) fund and delivers a copy of such financial statements to each owner of the fund.
Given the characteristics of Section 3(c)(1) funds, it is to be expected that most, if not all of the private funds advised by the adviser who is relying upon the Section 203(m) exemption, will qualify as Section 3(c)(1) funds and therefore, the additional conditions on the availability of the NASAA model exemption will apply. The utility of the exemption could be diminished if one Section 3(c)(1) fund advised by the adviser does not prepare audited financial statements which might be the case with respect to a fund consisting of a small number of beneficial owners. Although some states have
33. 17 CFR 230.262. 34. This exemption applies to pooled private funds of an issuer whose outstanding
securities are not owned by more than 100 persons and which is not making and does not presently propose to make a public offering of its securities.
35. Generally, a person who has $1 million of AUM with the adviser, has a net worth (exclusive of his primary residence) of $2 million or is a qualified purchaser under the 1940 Act. The AUM and net worth standards are subject to periodic revision by the SEC in accordance with 17 CFR 275.205-3(e).
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adopted the NASAA model exemption for Private Fund Advisers, it does not appear to have gained universal acceptance.36
No Self-Regulatory Organization
Although FINRA is the primary self-regulatory organization for broker-dealers, there is no federal or state requirement that investment advisers be members of a self-regulatory organization. During the 112th Congress, FINRA lobbied Congress to pass legislation which would allow it to become the self-regulatory organization for investment advisers and House Financial Services Committee Chair Spencer Bachus introduced draft legislation that would have author-ized establishment of a self-regulatory organization for investment advisers.37 There was much disagreement within the investment adviser and regulatory community as to the need or desirability of a self-regulatory organization for investment advisers and the legislation did not move beyond the committee stage. On April 10, 2014, the Wall Street Journal reported that FINRA no longer would seek designation as a self-regulatory organization for investment advisers.38
Fiduciary Standard
Although there is no specific statutory language in the Advisers Act, the USA 1956 or the USA 2002 which explicitly states that investment advisers and federal covered investment advisers are deemed to be fiduciaries, federal and state securities regulators, the courts and the industry agree that, based on the U.S. Supreme Court decision in SEC v. Capital Gains Research Bureau, Inc., investment advisers and investment adviser representatives are held to a fiduciary standard as stated in the Congressional report which accompanied introduction of federal legislation that became the Advisers Act.39
NASAA has adopted a model rule relating to unethical business practices of investment advisers, investment adviser representatives and federal covered investment advisers which states unequivocally that a person who is an investment adviser, investment adviser
36. For example, Maryland, Washington and Virginia have indicated their adoption
of the NASAA model exemption. See http://www.nasaa.org/category/regulatory-activity/state-rule-proposals.
37. H.R. 4624, “The Investment Adviser Oversight Act of 2012.” 38. Rieker, Matthew, “Finra Backs Off Expanding Oversight,” Wall Street Journal,
April 10, 2014. 39. 375 U.S. 180 (1963).
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representative or a federal covered investment adviser is a fiduciary and has a duty to act primarily for the benefit of its clients.40
Anti-Fraud Provisions Specifically Relating to Investment Advisory Activities
Section 102 of the USA 1956 and Section 502 of the USA 2002 contain specific anti-fraud provisions applicable to persons who engage in investment advisory activities for compensation whether or not they are registered as investment advisers. Under Section 102(a) of the USA 1956, it is unlawful for any person who receives any consideration from another person primarily for advising the other person as to the value of securities or their purchase or sale, whether through the issuance of analyses or reports or otherwise to (1) engage in any device, scheme or artifice to defraud the other person or (2) engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon the other person.
Section 102(b) of the USA 1956 makes it unlawful for an investment adviser to enter into, extend or renew any investment advisory agreement unless it provides in writing that (1) the invest-ment adviser shall not be compensated on the basis of a share of capital gains upon, or capital appreciation of the funds or any portion of the funds of the client;41 (2) no assignment of the contract may be made by the investment adviser without the consent of the other party to the contract;42 and (3) the investment adviser, if a partnership, shall notify the other party to the contract of any change in the membership of the partnership within a reasonable time after the change. Section 102(c) of the USA 1956 makes it unlawful for any investment adviser to take or have custody of any securities or funds of any client if the
40. NASAA Model Rule 102(a)(4)-1 under the USA 1956. 41. This does not prohibit a contract which provides for compensation based upon the
total value of a fund averaged over a definite period or as of definite dates or taken as of a definite date. NASAA Model Rule 102(f)-3 under the USA 1956 permits certain performance based compensation.
42. Assignment includes any direct or indirect transfer or hypothecation of an investment advisory contract by the assignor or of a controlling block of the assignor’s outstanding voting securities by a security holder of the assignor but, if the investment adviser is a partnership, no assignment of an investment advisory contract is considered to result from the death or withdrawal of a minority of the members of the investment adviser having only a minority interest in the business of the investment adviser, or from the admission to the investment adviser of one or more members who, after admission, only will be a minority of the members and will have only a minority interest in the business.
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administrator by rule prohibits custody or, in the absence of a rule, the investment adviser fails to notify the administrator that he has or may have custody.
Section 502(a) of the USA 2002 parallels the provisions contained in Section 102(a)(1) of the USA 1956. With respect to Section 102 (a)(2) of the USA 1956, Section 502(b) of the USA 2002 vests in the administrator the authority to adopt rules defining an act, practice or course of business of an investment adviser or an investment adviser representative, other than a supervised person of a federal covered investment adviser, as fraudulent, deceptive, or manipulative, and prescribe means reasonably designed to prevent investment advisers and investment adviser representatives, other than supervised persons of a federal covered investment adviser, from engaging in acts, practices, and courses of business defined as fraudulent, deceptive or manipulative.43 The USA 2002 does not have a parallel provision to Section 102(b) of the USA 1956 concerning investment advisory contracts but Section 502(c) of the USA 2002 grants the administrator broad authority to adopt rules specifying the contents of an invest-ment advisory contract.44
The USA 2002 addresses the issue of custody by investment advisers and investment adviser representatives in Section 411(f). Subject to any applicable preemption provisions in Section 222(d) of the Advisers Act, an investment adviser representative may not have custody of funds or securities of a client except under the supervision of an investment adviser or a federal covered investment adviser. The administrator is authorized by this section to adopt a rule or order that may prohibit, limit or impose conditions on an investment adviser regarding custody of securities or funds of a client.45
Transitioning Between Regulatory Regimes
The SEC has adopted specific rules governing investment advisers that must switch from state to SEC registration and vice versa.46 Generally, if an investment adviser is registered under state law and becomes eligible for registration with the SEC, the investment adviser must apply for registration with the SEC within 90 days of
43. See NASAA Model Rule 502(b) under the USA 2002. 44. See NASAA Model Rule 502(c) under the USA 2002. 45. NASAA Model Rule 411(f)-1 under the USA 2002. 46. 17 CFR 275.203A-1(b).
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filing of its annual updating amendment to Form ADV wherein the investment adviser reports that it is eligible for SEC registration.47
A SEC-registered investment adviser is not required to switch to state registration unless its AUM is less than $90 million.48 If it reports AUM of less than $90 million on its annual updating amend-ment, the SEC-registered adviser has 180 days from its fiscal year end to withdraw from registration with the SEC by filing Form ADV-W with IARD unless the adviser again becomes eligible for SEC registration within that time period.49 Once the investment adviser no longer qualifies for registration with the SEC, it must become registered with the applicable states in which it conducts business unless it can rely on an exemption, exclusion or the National De Minimis.
It is important to note that previous registration with the SEC does not guaranty automatic registration at the state level and require-ments applicable to state-registered investment advisers are different from federal requirements. For instance, depending on the nature of its business plan, a state-registered investment adviser may be required to demonstrate that it maintains a minimum level of net worth. Compliance with state registration requirements may take some time and a SEC-registered investment adviser that has reason to believe it will need to switch from SEC registration should file for state registration well before it must file Form ADV-W to withdraw from SEC registration. During this time, it is quite possible that the invest-ment adviser will be registered simultaneously with the SEC and state securities regulators.
Specific Anti-Fraud Rules under Advisers Act
Federal covered investment advisers are subject to specific SEC rules requiring them to disclose policies relating to proxy voting,50 appointing a chief compliance officer,51 adopting a code of ethics52 or complying with guidelines relating to political contributions.53 All of these rules were adopted by the SEC pursuant to the general
47. 17 CFR 275.203A-1(b)(1). 48. 17 CFR 275.203A-1(a)(1). 49. 17 CFR 275.203A-1(b)(2). 50. 17 CFR 275.206(4)-6. 51. 17 CFR 275.206(4)-7. 52. 17 CFR 275.204A-1. 53. 17 CFR 275.206(4)-5.
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anti-fraud provision contained in Section 206 of the Advisers Act. Although Section 502 of the USA 2002 contains language similar to Section 206 of the Advisers Act and permits the administrator to adopt rules implementing this anti-fraud provision, NASAA has not adopted Model Rules under that section similar to the foregoing rules adopted by the SEC under the Advisers Act.54
One might think that these specific SEC anti-fraud rules may not apply to state-registered investment advisers who would be subject to the anti-fraud provisions of their respective state securities laws, particularly as registration and primary regulatory oversight rests with the states and there has been no adoption of analogous rules at the state level.
However, the SEC has stated that, although investment advisers may be required to register with the states, the antifraud provisions of the Advisers Act continue to apply.55 Since the aforementioned SEC rules were adopted under the general anti-fraud provisions of the Advisers Act and the SEC has stated that state-registered investment advisers are subject to the anti-fraud provisions of the Adviser Act, the question is whether state-registered investment advisers need to comply with the aforementioned SEC rules.
Even if the SEC would respond to this question in the affirmative, it is the states and not the SEC that conduct compliance examinations on state-registered investment advisers and theoretically would be responsible for checking for compliance with these SEC rules. So, even if the SEC took the view that state-registered investment advis-ers must comply with its rules on political contributions, appointing a chief compliance officer, establishing a code of ethics and adopting a policy on proxy voting, it does not appear to possess a meaningful method to enforce these rules on state-registered investment advisers since it does not carry out routine compliance examinations on them.
54. The only Model Rules adopted by NASAA under Section 502 of the USA 2002
address (1) Prohibited Conduct in Providing Investment Advice (Rule 502(b)) and (2) Contents of an Investment Advisory Contract (Rule 502(c)).
55. See Footnote 126, SEC Release on “Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings,” Release No. 33-9415, 34-69959 and IA-3624 (July 10, 2013).
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STATE REGULATORY JURISDICTION OVER INVESTMENT ADVISER REPRESENTATIVES
Generally, investment adviser representatives of both SEC-registered investment advisers and state-registered investment advisers must be registered with at least one state securities regulator. However, the deter-mination of who must register differs slightly depending on whether the investment adviser representative is employed by, or associated with, a SEC-registered investment adviser or a state-registered investment adviser and whether the client base is institutional or retail.
Investment Adviser Representatives of Federal Covered Investment Advisers
Section 203A(b)(1) of the Advisers Act governs state registration of investment adviser representatives employed by, or associated with, a SEC-registered investment adviser. This section provides that no state may require registration, licensing or qualification as a super-vised person of an investment adviser that is registered with the SEC under Section 203 or that is a supervised person for such registrant except that a state may license, register or otherwise qualify any investment adviser representative who has a place of business located in that state or that is not registered under Section 203 because the person is excepted from the definition of an investment adviser under Section 202(a)(11) of the Advisers Act.
The initial determination must be whether the individual is an investment adviser representative upon whom states can impose a registration requirement. For purposes of Section 203A(b)(1) of the Advisers Act, an “investment adviser representative” means a super-vised person of the investment adviser who (1) has more than five clients56 who are natural persons (other than excepted clients) and (2) more than 10% of whose clients are natural persons (other than excepted clients).57
However, a supervised person is not an investment adviser rep-resentative if the supervised person does not, on a regular basis, solicit, meet with, or otherwise communicate with clients of the
56. A supervised person may rely on 17 CFR 202(a)(30)-1(a)(1) to identify natural
persons as clients. 57. An excepted person is a natural person who is a qualified client under 17 CFR
275.205-3(d)(1) which is a natural person with $1 million of AUM or a net worth of more than $2 million (exclusive of primary residence).
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investment adviser or provides only impersonal investment advice.58 Therefore, an individual whose clients are exclusively or primarily institutional clients or who provides impersonal investment advice most likely would not be deemed an investment adviser repre-sentative for purposes of Section 203A(b)(1) and therefore the state where the individual had a place of business could not require reg-istration of such individual as an investment adviser representative.
For purposes of Section 203A, the SEC has defined “place of business” as (1) an office at which the investment adviser representative regularly provides investment advisory services, solicits, meets with, or otherwise communicates with clients and (2) any other location that is held out to the general public as a location at which the investment adviser representative provides investment advisory ser-vices, solicits, meets with, or otherwise communicates with clients.59 For example, if an investment adviser representative of a SEC-registered investment adviser maintains an office in Pennsylvania but it is known to the general public (eg by means of business cards, advertisements, web site content) that the individual is at a specific place across the Delaware River in New Jersey the first Monday of each month in which he engages in any of the aforementioned activities, the individual most likely would be required to be registered as an investment adviser representative in both Pennsylvania and New Jersey.60
Investment Adviser Representatives of State Registered Investment Advisers
Individuals employed by or associated with an investment adviser subject exclusively to state registration must register as an investment
58. Impersonal investment advice consists of written materials or oral statements that
do not purport to meet the objectives or needs of specific individuals or accounts. 59. 17 CFR 275.203A(b). Although out of step with the rest of the states, Texas has
taken the position that even if an investment adviser representative does not have a place of business in Texas but has Texas clients, he must “notice file” in Texas by filing Form U-4 with IARD and paying the same fee ($285 for an original filing and $275 each year for a renewal filing) as if the individual was registering as an investment adviser representative. See generally http://www.ssb.state.tx.us/ Dealer_And_Investment_Adviser_Registration/Frequently_Asked_Questions.php#twoB.
60. It should be noted that Section 203A(b)(1) and SEC Rule 203A(b) require a physical presence. Use of fax, email or correspondence from one state into another state does not create the necessary nexus to impose registration as an investment adviser representative, Texas’ position to the contrary notwithstanding.
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adviser representative in each state in which they conduct business unless exempt from registration (including application of the National DeMinimis). In these instances, the definition of investment adviser representative set forth in Section 102(16) of the USA 2002 is used to determine if an individual is subject to state registration as an invest-ment adviser representative. Although there is no analogous definition in the USA 1956, most states that have enacted investment adviser regulation also have amended their statutes to include a definition of investment adviser representative.
DEFINITION OF INVESTMENT ADVISER UNDER STATE SECURITIES LAWS
USA 1956
An “investment adviser” is defined in the USA 1956 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 a part of a regular business, issues or promulgates analyses or reports concerning securities.” This definition is identical to the federal definition of investment adviser in Section 202(a)(11) of the Advisers Act.
USA 2002
The definition of “investment adviser” in the USA 2002 is identical to the USA 1956 but the USA 2002 added a separate state-ment emphasizing that “the term includes a financial planner or other person that, as an integral component of other financially related ser-vices, provides investment advice to others for compensation as part of a business or that holds itself out as providing investment advice to others for compensation.” Official Comment 17 to Section 102 of the USA 2002 indicates that the second sentence was added to the definition “to achieve functional regulation of financial planners who satisfy the definition of investment adviser” and cites SEC Investment Advisers Act Release 1092.61 The Official Comment further states that use by a person of a title, designation or certification as a financial
61. 39 SEC Docket 494 (1987); http://www.sec.gov/rules/interp/1987/ia-1092.pdf.
For example, see Section 25009(b) of the California Corporations Code and Section 101(h)(1) of the Maryland Securities Act.
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planner or other similar title alone does not require registration as an investment adviser.62
SEC/NASAA Joint Investment Adviser Release 1092 (“IA 1092”)
IA 1092 was issued jointly by the SEC Division of Investment Management and NASAA in 1987 to provide uniform interpretation of federal and state investment adviser laws to financial planners and other persons. Given the states’ ownership of IA 1092, it is instruc-tive to review its contents in context of the definition of “investment adviser” under state securities laws and under what circumstances state securities regulators would deem a person to come within the definition of investment adviser. IA 1092 focused on three main elements of the definition of investment adviser: (1) in the business of (2) giving advice concerning securities (3) for compensation.
IA 1092 indicates that one can be “in the business” of giving investment advice even if the giving of such investment advice does not constitute the principal business activity or a particular portion of a person’s business activities. A person will be deemed to be “in the business” if the person (1) holds himself out to the public as an investment adviser or a person who provides investment advice, (2) receives any separate or additional compensation that represents a clearly definable charge for providing advice about securities, regard-less of whether the compensation is separate from, or included within, any overall compensation or receives transaction-based compensation if the client implements the investment advice, and (3) except in rare, isolated and non-periodic instances, provides specific investment advice.
IA 1092 states that a person who provides advice or issues or promulgates reports or analyses which concern securities generally would come within the definition of investment adviser even if such advice does not relate to specific securities. Therefore, persons who provide advice for compensation concerning the advantages or dis-advantages of investing in securities in general as compared to other investments would come within the definition of investment adviser. In the context of discussing what constitutes being in the business of an investment adviser, IA 1092 notes that the provision of “specific investment advice” includes a recommendation, analysis or report
62. Infra note 66.
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about specific securities or specific categories of securities and also includes a recommendation about allocation of assets even if the allocation recommendation includes assets that are not securities.
Receipt of compensation for giving investment advice is a key element of the definition but what constitutes compensation? IA 1092 states that the compensation element is satisfied by the receipt of any economic benefit, whether in the form of an advisory fee or some other fee relating to the total services rendered, commissions, or some combination of the foregoing. It is not necessary that the person who provides the investment advice charge a separate fee for the investment advisory portion of his total services. The compensation element is satisfied if a single fee is charged for a number of different services, including investment advice or issuing of reports concerning securities. Nor is it necessary that the adviser’s compensation be paid directly by the person receiving the investment advice. The relevant issue is that the adviser received compensation from some source for the services rendered.
IA 1092 reflects state regulatory concerns over financial planners which may have resulted in the addition of a cautionary alert in the form of the additional sentence to the definition of investment adviser in Section 102(15) of the USA 2002. State regulators want to empha-size that persons who hold themselves out to the public as financial planners and offer clients non-securities products such as life insurance or fixed annuities nonetheless would come within the definition of investment adviser if they received compensation from any source related to the provision of investment advice concerning securities whether it be advice as to a specific security, categories of securities, the advantages or disadvantages of investing in securities or allocation of assets involving, in whole or in part, securities.
Dodd-Frank Study on Financial Planners
In Dodd-Frank, Congress expressed concern over individuals who hold themselves out as financial planners and engage in misleading titles, designations and marketing materials and directed the General Accounting Office to conduct a study of current state and federal oversight structures and regulations for financial planners and identify any gaps in the regulation of financial planners and other individuals who provide or offer financial planning services to consumers.63 The
63. Section 919C of Dodd-Frank.
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GAO report, issued in January 2011, noted that, although there is no definition of financial planner, financial planning generally includes preparing financial plans for clients based on their financial circum-stances and objectives and making recommendations for specific actions clients may take, including recommending insurance products, securities and other investments.64
State Regulatory Perspective on Financial Planners
The primary state regulatory concern is that a financial planner will seek to avoid registration as an investment adviser in reliance on the use of titles or engaging in a primary line of business not involving securities, such as insurance. The state regulatory perspec-tive is that any person whose business includes the provision of investment advice for which the person receives compensation, as set forth broadly in IA 1092, will be deemed to come within the def-inition of investment adviser unless an exemption or exclusion oth-erwise is available.65 Therefore, every financial planner should read IA 1092 carefully to determine whether registration as an investment adviser is required.
Despite the content of IA 1092 and the fact that it was a joint SEC/NASAA release, some states have prohibited the use of terms like financial planner, investment counselor, financial consultant, money manager, investment manager, investment planner, Chartered Financial Consultant or the abbreviation of “CFP” unless the person is registered as an investment adviser or investment adviser repre-sentative, is exempt from registration or is excluded from the def-inition of investment adviser.66
64. “Regulatory Coverage Generally Exists for Financial Planners but Consumer
Protection Issues Remain,” GAO Report 11-235 (January 2011). 65. Pennsylvania issued a release two years after IA 1092 on Registration of Financial
Planners that was similar in content and scope to IA 1092, PSC Bulletin (July 1989); Compendium of Pennsylvania Securities Laws, 2d ed., Positions, p. 101.
66. Revised Code of Washington, 21.20.040(3); Washington Administrative Code 460-24A-040(2). Pennsylvania makes it unlawful to represent that a person is an “investment counsel” or to use that name as descriptive of his business unless a substantial part of his business consists of rendering investment advisory services on the basis of the individual needs of clients. 70 P.S. §1-404(a)(6).
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DEFINITION OF INVESTMENT ADVISER REPRESENTATIVE UNDER STATE SECURITIES LAWS
Investment adviser representatives were not subject to state registration under the USA 1956 and therefore, the USA 1956 contained no definition of the term.
The USA 2002 defines “investment adviser representative” as an individual employed by, or associated with, an investment adviser or a federal covered investment adviser and who makes any recommendations or otherwise gives investment advice regarding securities, manages accounts or portfolios of clients, determines which recommendation or advice regarding securities should be given, provides investment advice or holds herself or himself out as providing investment advice, receives compensation to solicit, offer or negotiate for the sale of or for selling investment advice or supervises employees who perform any of the foregoing.
EXCLUSIONS FROM THE DEFINITION OF INVESTMENT ADVISER
USA 1956
Under the USA 1956, the term “investment adviser” does not include (1) a bank, savings institution or trust company,67 (2) a lawyer, accountant, engineer or teacher whose performance of investment advisory services is incidental to the practice of their profession, (3) a broker-dealer whose performance of investment advisory services is solely incidental to the conduct of the business as a broker-dealer and who receives no special compensation for those services,68 (4) a
67. The USA 1956 contained no definitions for “bank,” “savings institution” or “trust
company.” 68. Official Comment to Section 102 of the USA 2002 states that the Official
Comment to the USA 1956 on this provision quoted an opinion of the SEC General Counsel in Investment Advisers Act Release 2 on the meaning of special compensation, to wit: “[This clause] amounts to a recognition that brokers and dealers commonly give a certain amount of advice to their customers in the course of their regular business, and that it would be inappropriate to bring them within the scope of the Investment Advisers Act merely because of this aspect of their business. On the other hand, that portion of clause [(C)] which refers to ‘special compensation’ amounts to an equally clear recognition that a broker or dealer who is specially compensated for the rendition of advice should be considered an investment adviser and not be excluded from the purview of the Act merely because he is also engaged in effecting market transactions in securities…The essential distinctions to be borne in mind in considering borderline cases… is the
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publisher of any bona fide newspaper, news magazine or business or financial publication of general, regular and paid circulation, (5) a person whose advice, analyses or reports relate only to government securities, (6) a person who has no place of business in the state if (a) his only clients in the state are other investment advisers, broker-dealers, banks, savings institutions, trust companies, insurance com-panies, investment companies as defined in the 1940 Act, pension or profit sharing trusts or other financial institutions or institutional buyers69 or (b) during any period of 12 consecutive months, he does not direct business communications into the state in any manner to more than five clients other than those described in (a) whether or not any of the persons to whom communications are directed is then present in the state and (7) any person not within the intent of the definition as the administrator may designate by rule or order.
USA 2002
The USA 2002 retained the exclusions from the definition of investment adviser in the USA 1956 with respect to (1) lawyers, accountants, engineers and teachers, (2) broker-dealers whose per-formance of investment advisory services are solely incidental to the conduct of the business as a broker-dealer and who receive no special compensation for those services,70 (3) publishers of newspapers, magazines or newsletters of general and regular circulation, (4) banks and savings institutions,71 and (5) other persons designated by rule or order of the administrator.
Due to the expansion of state regulation of investment adviser representatives and passage of NSMIA, the USA 2002 included exclusions for a federal covered investment adviser, an investment adviser representative and any person excluded from the definition of investment adviser under the Advisers Act. However, the more important change in the USA 2002 over the USA 1956 is the treat-ment of investment advisers with no place of business in the state
distinction between compensation for advice itself and compensation for services of another character to which advice is merely incidental.”
69. The USA 1956 contained no definitions for “pension or profit sharing trusts,” “financial institutions” or “institutional buyers.”
70. Supra note 68. 71. Section 102((3) of the USA 2002 contains a definition of “bank.” Savings insti-
tution is not separately defined but comes within the definition of “depository institution” under Section 102(5) of the USA 2002 which is deemed to be an “institutional investor” under Section 102(11) of the USA 2002.
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who deal exclusively with other investment advisers, broker-dealers, investment companies, insurance companies and other financial insti-tutions or only with a de minimis number of clients. These exclusions from the definition of investment adviser in the USA 1956 became exemptions from the registration requirement in the USA 2002.
Whether treated as an exclusion or an exemption, the de minimis provision contained in the USA 1956 and USA 2002 for investment advisers with no place of business in the state rests upon not having more than a specified number of clients. As indicated previously, determining the number of clients for purposes of the National DeMinimis is governed by Rule 202(a)(30)-1 of the Advisers Act. However, the provisions of that rule would not apply in an exam-ination of whether an exemption or exclusion is available based on state law. Therefore, it is possible that states may count clients differ-ently for state law purposes than set forth in SEC Rule 202(a)(30)-1, particularly with respect to legal organizations, and care should be taken to research the position of the relevant state in this regard.
IA 1092
IA 1092 also discussed the availability of exclusions from the definition of investment adviser and, since IA 1092 was a joint release by SEC staff and state securities regulators (through NASAA), its advices in this regard merit some discussion. With respect to the exclusion for a lawyer or an accountant, IA 1092 states that the exclusion would not be available where a lawyer or accountant holds himself out to the public as providing financial planning, pension consulting or other advisory services as it would not appear that the rendering of investment advisory services was incidental to the practice of law or accounting. Similarly, the exclusion for the broker-dealer or associated person of a broker-dealer would not be available if the person receives special compensation for providing investment advisory services or if the advice was provided by an associated person outside of his scope of employment with the broker-dealer.
EXCLUSIONS FROM THE DEFINITION OF INVESTMENT ADVISER REPRESENTATIVE
Investment adviser representative was not a defined term in the USA 1956 so it contained no exclusions from the definition.
Under the USA 2002, investment adviser representative does not include an individual who (1) performs only clerical or ministerial acts,
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(2) is an agent whose performance of investment advice is solely inci-dental to the individual acting as an agent and who does not receive special compensation for investment advisory services,72 (3) is employed by, or associated with, a federal covered investment adviser unless the individual has a place of business in the state as that term is defined in the Advisers Act and is (a) an investment adviser representative as that term is defined in the Advisers Act or (b) is not a “supervised person” as that term is defined in Section 202(a)(25) of the Advisers Act, or (4) is excluded by rule or order adopted by the administrator.
STATE INVESTMENT ADVISER REGISTRATION REQUIREMENTS
The USA 1956 makes it unlawful for a person to transact business in a state as an investment adviser unless the person (1) is registered under the state securities act, (2) is registered as a broker-dealer without the imposition of a condition under Section 204(b)(5) thereof73 or (3) his only clients in the state are investment companies as defined in the 1940 Act or insurance companies. The USA 2002 simply makes it unlawful for a person to transact business in a state as an investment adviser unless the person is registered as an investment adviser or is exempt from registration. The USA 2002 also makes it unlawful for an investment adviser to employ or associate with an individual required to be reg-istered as an investment adviser representative who transacts business in the state on behalf of the investment adviser unless the individual is registered or is exempt from registration.
Successor Registration
Section 407 of the USA 2002 permits an investment adviser succeeding to the current registration of another investment adviser to file an application for registration under Section 401 (initial appli-cation) for the unexpired portion of the current registration. An investment adviser that changes its form of organization or juris-diction of organization may continue its registration by filing an amendment to Form ADV if the change does not involve a material change in its financial condition or management. The amendment becomes effective when filed or on a date designated by the registrant in the amendment filing. The new organization will be deemed the
72. Supra note 68. 73. Section 204(b)(5) authorizes the administrator to condition the registration of a
broker-dealer upon not transacting business in the state as an investment adviser.
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successor to the original registrant. Any predecessor registered under the state securities act must stop conducting its business other than winding down transactions and must file Form ADV-W with IARD within 45 days of filing of the amendment effecting the succession.
Limitation on Association
Section 404(e) of the USA 2002 introduced a new provision making it unlawful for an investment adviser, directly or indirectly, to employ or associate with an individual to engage in an activity related to providing investment advice in the state if the registration of the individual is suspended or revoked or the individual is barred from employment or association with an investment adviser, federal covered investment adviser or broker-dealer by an order issued under the state’s securities laws,74 the SEC, or a self-regulatory organization (eg FINRA). The USA 2002, however, provides an investment adviser with an affirmative defense that it does not violate this pro-vision if it did not know and in the exercise of reasonable care could not have known of the suspension, revocation or bar.75 In addition, where such circumstances exist and are known to the investment adviser, the investment adviser may petition the administrator to modify or waive, in whole or in part, the application of the pro-hibitions contained in this provision.
EXEMPTIONS FROM INVESTMENT ADVISER REGISTRATION
The USA 1956 did not have any exemptions from investment adviser registration.
Under Section 403(b)(1) of the USA 2002, a person without a place of business in the state that is registered under the securities laws of the state in which the person has its principal place of business is exempt from registration as an investment adviser in that state if its only clients in that state are (1) federal covered investment advisers, broker-dealers registered with that state, or investment advisers registered with that
74. This section does not appear to include a similar order issued by another state
securities regulator. 75. Since such actions must be reported by such individuals on Form U-4 and by
the regulatory and self-regulatory organizations on Form U-6 and filed with CRD/IARD, it is unlikely that an investment adviser conducting appropriate due diligence on an investment adviser representative could sustain the burden of proof necessary to be able to rely upon this affirmative defense.
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state; (2) institutional investors;76 (3) bona fide preexisting clients whose principal residence is not in the state if the investment adviser is reg-istered under the securities laws of the state in which the client maintains his principal place of residence and (4) any other client exempted by rule or order of the administrator.
Section 403(b)(2) of the USA 2002 also converted the de minimis client exclusion in the USA 1956 to an exemption as well as made it conform to the National DeMinimis as imposed by Section 222(d) of the Advisers Act. Therefore, a person without a place of business in the state is exempt from registration as an investment adviser in that state if the person had, during the preceding 12 months, not more than five clients that are resident in the state excluding the clients described in the immediately preceding paragraph.
STATE INVESTMENT ADVISER REPRESENTATIVE REGISTRATION REQUIREMENTS
The USA 1956 did not require registration of investment adviser rep-resentatives. The USA 2002 makes it unlawful for an individual to transact business in a state as an investment adviser representative unless the individual is registered under the state securities act or is exempt from registration. The USA 2002 further provides that the registration of an investment adviser representative is effective only while the indi-vidual is employed by, or associated with, an investment adviser reg-istered under the state securities laws or a federal covered investment adviser that has made, or is required to make, a notice filing under Section 405 of the USA 2002.
EXEMPTIONS FROM INVESTMENT ADVISER REPRESENTATIVE REGISTRATION
The USA 1956 did not require registration of investment adviser rep-resentatives and consequently, it did not include any exemptive pro-visions. Under Section 404(b) of the USA 2002, an individual who is employed by or associated with an investment adviser that is exempt from registration under Section 403(b) or a federal covered investment adviser exempt from making a notice filing under Section 405 is exempt from registration as an investment adviser representative. The USA 2002 also
76. “Institutional investor” is defined in Section 102(11) of the USA 2002.
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authorized the administrator to exempt other investment adviser rep-resentatives from registration by rule or order.
DUAL REGISTRATION OF INVESTMENT ADVISER REPRESENTATIVES UNDER STATE SECURITIES LAWS
The USA 1956 did not require registration of investment adviser rep-resentatives and consequently contained no provision relating to dual registration. Although the USA 2002 prohibits dual registration of agents of broker-dealers unless otherwise permitted by rule or order of the administrator, it is opposite with respect to investment adviser repre-sentatives. Section 404(d) of the USA 2002 permits such individuals to be registered simultaneously with one or more investment advisers or federal covered investment advisers unless otherwise prohibited by rule or order of the administrator.
STATE REGISTRATION PROCESS
NASAA, the Securities Industry Association (now the Securities Industry and Financial Markets Association (SIFMA)) and state securities admin-istrators were pioneers in establishing a national electronic licensing system for state-based securities licenses.77 The genesis of this effort, which began in the early 1980s, was to harmonize and make uniform the broker-dealer and agent registration application process. Previously, states used various sized forms, had different font requirements, and mandated use of certain color ink in their applications. This was in addition to the great disparity in the amount and type of information requested by each state application.
Central Registration Depository (“CRD”)
CRD was conceived as a one-stop electronic licensing function which could be accessed and used by all persons involved in the broker-dealer licensing function. It would process uniform data col-lected in a uniform manner pursuant to uniform rules in an electronic environment. After determining that CRD was working properly for broker-dealers, its functions were expanded to include agents. This uniformity and electronic processing produced millions of dollars of
77. CRD became the model for similar electronic licensing systems for state licensing
of insurance producers and mortgage originators.
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savings in compliance costs for the securities industry and improved the regulatory function of state securities administrators.
Investment Adviser Registration Depository
Building on the success of the CRD in reducing regulatory costs, Section 303 of NSMIA permitted the SEC to require an investment adviser to make filings with the SEC through a filing depository designated by the SEC.78 As a result, the SEC created the Investment Adviser Registration Depository (“IARD”) which, like CRD, is run by FINRA. The architecture of the IARD is similar to CRD which is intentional since many brokerage firms have investment adviser affil-iates and many associated persons of broker-dealers also are regis-tered as investment adviser representatives.
Similar to CRD, all filings required to be made with the states by SEC-registered investment advisers, state-registered investment advisers and investment adviser representatives are made through IARD. These include filings relating to initial and renewal registration, amendments to Form ADV and Form U-4, registration transfers and withdrawals from registration. Also, the IARD collects all state filing fees and effects electronic fund transfers to various financial insti-tutions designated by the state administrator as the depository for such fees.
Uniform Forms
Following the blueprint of CRD, states and the SEC use Form ADV as the common registration form for investment advisers. All investment advisers must complete Part 1A and state-registered advisers also must complete Part 1B. Part 2A is the narrative, known in the industry as a “brochure,” which each investment adviser must give to clients or prospective clients and which provides specific information about the firm. Part 2B is the individual supplement to the brochure which provides specific information about each invest-ment adviser representative. Form ADV-W is used to withdraw from investment adviser registration.
Registration as an investment adviser representative with the states is effected through Form U-4. Form U-4 cannot be filed without the signature and authority of the investment adviser with whom the investment adviser representative is associated. Form U-4
78. 15 U.S.C. §80b-4(c).
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also is used for state registration of agents of broker-dealers, many of whom also are registered as investment adviser representatives. Form U-5 is used for withdrawals from registration as an investment adviser representative.
Form U-6 is used exclusively by securities regulators and self-regulatory organizations to report actions taken by such regulators against registrants or former registrants.79 This information becomes part of the person’s CRD or IARD record and is in addition to any affirmative duties such person may have to report the same action as an amendment to Form ADV or Form U-4.
These uniform forms are quite detailed in the information required to be provided and therefore, a discussion of each informational item is beyond the scope of this summary presentation.
Consent to Service of Process
The execution pages for Form ADV contain a separate consent to service of process for investment advisers subject to state registration and federal covered investment advisers subject to state notice filing requirements. By signing Form ADV, the investment adviser and federal covered investment adviser irrevocably appoint the legally designated officers and their successors, of the state in which the adviser maintains its principal office and place of business and any other state in which the adviser may be applying for registration or amending its registration or making a notice filing, as its agents to receive service, and agree that such persons may accept service on its behalf of any notice, subpoena, summons, order instituting proceed-ings, demand for arbitration or other process or papers and it further agrees that such service may be made by registered or certified mail, in any federal or state action, administrative proceeding or arbitration brought against it in any place subject to the jurisdiction of the United States if the action, proceeding or arbitration:
• Arises out of any activity in connection with an investment advisory business that is subject to the jurisdiction of the United States; and
79. Under Article 4, Section 6 of the FINRA Bylaws, a withdrawing broker-dealer
and associated person remain subject to FINRA jurisdiction relating to inves-tigations, fines and sanctions for two years from the date of withdrawal as a broker-dealer or associated person.
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• Is founded, directly or indirectly, upon the provisions of: ○ The Securities Act of 1933, the Securities Exchange Act of
1934, the Trust Indenture Act of 1939, the Investment Company Act of 1940 or the Investment Advisers Act of 1940 or any rule or regulation under any of these acts; or
○ The laws of the state in which it maintains its principal office and place of business or any state in which it is applying for registration or amending its registration or making a notice filing.
Form U-4 also contains a consent to service of process similar to the consent found in Form ADV but with the request that a copy of any notice, process, pleading or subpoena or other document served be mailed to the current residential address as reflected in Form U-4 or any amendment thereto. Form U-4, however, contains a separate consent concerning the service of any process, pleading, subpoena or other document in any investigation or administrative proceeding conducted by the SEC, the Commodity Futures Trading Commission (“CFTC”) or a jurisdiction in any civil action in which the SEC, CFTC or the jurisdiction is a plaintiff or the notice of any investigation or proceeding by any self-regulatory organization against the applicant. In this regard, the applicant consents to personal service being made by regular, registered or certified mail or confirming telegram at the applicant’s residential address as reflected in Form U-4 or any amendment thereto.
Examination Requirements
The USA 1956 permits the administrator to adopt a rule to provide for a licensing examination which may be written or oral or both to be taken by any class or all applicants. Section 412(e) of the USA 2002 specifically authorizes that an examination specified by the administrator must be completed successfully by a class of indi-viduals or all individuals. It further enables the administrator to waive by order, in whole or in part, any examination as to any individual and to waive by rule, in whole or in part, an examination as to a class of individuals, in both cases if the administrator determines that the examination is not necessary or appropriate in the public interest or for the protection of investors.
Although the USA 2002 retains the USA 1956 provision per-mitting the administrator to take action against an applicant or registrant
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if such person is not qualified on the basis of factors such as training, experience and knowledge of the securities business, it expressly prohibits the administrator from taking such action where the person has taken and passed any licensing examination required by rule or order of the administrator adopted under Section 412(e) of the USA 2002. This reflects the trend of all states requiring and accepting the Series 65 examination in lieu of an independent examination or qual-ification process administered by each state on an individual basis.
Absent waiver of the licensing examination requirement, most states will not register an individual as an investment adviser or as an investment adviser representative unless he or she has taken and passed the Uniform Investment Adviser Law Examination (Series 65).80 If an individual applicant has taken and passed the General Securities Representative Examination (Series 7), then the applicant, in lieu of the Series 65 examination, may take and pass the Uniform Combined State Law Examination (Series 66).
The Series 65 and Series 66 examinations are administered by FINRA on behalf of the states. Qualification by examination remains in effect for purposes of compliance with state securities laws provided that the individual has not experienced a lapse in registration as an investment adviser or investment adviser representative for a period exceeding two years from the date of filing an application for reg-istration. Should this occur, the individual will have to retake the relevant examination or seek a waiver from the administrator.
Unlike agents of broker-dealers, NASAA has endorsed and most states have adopted a uniform examination waiver for individuals holding certain designations and IARD is able to accommodate these examination waivers automatically. The examination requirement is waived for individuals who have been awarded the following des-ignations and, at the time of filing of the registration application, currently are in good standing:81
80. NASAA Model Rule 412(e)-1((g) makes an examination optional for an invest-
ment adviser representative who acts only as a solicitor. 81. See NASAA Model Rule 412(e)-1 under the USA 2002. Some states, such as
Pennsylvania, require that, in addition, the individual cannot have made an affirm-ative response on Form U-4 indicating certain disciplinary history. Also, Penn-sylvania has waived the examination requirement for certified public accountants and attorneys who are licensed and in good standing. Since these are not uniform waivers, they cannot be accommodated by IARD and a waiver request must be filed directly with the Pennsylvania Department of Banking and Securities. See 10 Pa. Code §303.032(c).
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• Certified Financial Planner (CFP) awarded by the Certified Financial Planners Board of Standards;
• Chartered Financial Consultant (ChFC) or Masters of Science and Financial Services (MSFS) awarded by the American College, Bryn Mawr, Pennsylvania;
• Chartered Financial Analyst (CFA) awarded by the Institute of Chartered Financial Analysts;
• Personal Financial Specialist (PFS) awarded by the American Institute of Certified Public Accountants; and
• Chartered Investment Counselor (CIC) awarded by the Investment Adviser Association.
Use of Senior-Specific Certifications and Professional Designations
State regulators have been concerned about the proliferation in the use of certifications or designations by persons who may be regis-tered investment advisers or investment adviser representatives that are designed to appeal to seniors who may become clients.82 NASAA adopted a Model Rule on the Use of Senior-Specific Certifications and Professional Designations which makes it a dishonest or unethical practice in the securities business to use:
• A certification or professional designation by a person who has not actually earned it or is otherwise ineligible to use such cer-tification or designation;
• A non-existent or self-conferred certification or professional designation;
82. As an example, Maryland enacted Section 11-305 of its state securities statute
which makes it unlawful for any person to use a senior or retiree credential or designation in a way that is or would be misleading in connection with the offer, sale or purchase of securities, acting as a broker-dealer, agent, investment adviser or investment adviser representative or receiving, directly or indirectly, any con-sideration from another person for advising the other person as to the value of securities or their purchase or sale. The Commissioner is authorized by rule or order to define what constitutes a misleading use of a senior or retiree credential or designation. Other states with similar provisions include California, Florida, New Jersey and Texas.
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• A certification or professional designation that indicates or implies a level of occupational qualification obtained through education, training or experience that the person using the certification or professional designation does not have; and
• A certification or professional designation that was obtained from a designating or certifying organization that: ○ Is primarily engaged in the business of instruction in sales or
marketing; ○ Does not have reasonable standards or procedures for assuring
the competency of its designees or certificate holders; ○ Does not have reasonable standards or procedures for mon-
itoring and disciplining its designees or certificate holders; or
○ Does not have reasonable continuing education requirements for its designees or certificate holders in order to maintain the designation or certification.83
If an applicant for registration as an investment adviser or invest-ment adviser representative uses a designation which the administrator believes is a senior-specific designation or professional certification, the applicant most likely will be required to comply with the terms of the NASAA Model Rule or agree not to use such certification or professional designation in that state.
Time Period for Action on an Application
Under the USA 1956, an application for registration as an invest-ment adviser became effective at noon of the 30th day after the appli-cation was filed unless the administrator specified an earlier date. The effective date, however, could be prolonged by order of the admin-istrator to noon of the 30th day after the filing of any amendment. Section 406(c) of the USA 2002 reiterates this position but extends the time period from 30 to 45 days.
83. The rule contains a rebuttable presumption that a designating or certifying organ-
ization is not disqualified when the organization has been accredited by the American National Standards Institute, the National Commission for Certifying Agencies or an organization that is on the U.S. Department of Education list entitled “Accrediting Agencies Recognized for Title IV Purposes” and the designation or credential issued therefrom does not apply primarily to sales or marketing.
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Where staff of a state securities regulator requests additional information, such as whether the investment adviser previously con-ducted business in the state or with residents of the state, this request often is used by state regulatory staff to delay effectiveness of reg-istration citing that the responses would be deemed to be an amend-ment necessary to complete the application and therefore, the 30 or 45 day time period does not run until the amendment is received. Of course, the response filed with the administrator could generate additional requests for information which will re-trigger the 30 or 45 day time period. In other words, an investment adviser registration generally will not be effective absent an affirmative act of the administrator.
SUBSTANTIVE REQUIREMENTS RELATING TO INVESTMENT ADVISER APPLICATIONS
Applications for registration as an investment adviser with a state secu-rities regulator are reviewed for compliance with a number of substantive provisions contained in state securities laws. Although NASAA has adopted model rules implementing all of these substantive requirements, it cannot legally impose these standards on its member jurisdictions.84 Therefore, it is important to review the securities laws and regulations of each relevant jurisdiction when contemplating filing an application for registration as an investment adviser.
An investment adviser applicant should anticipate that state securities regulatory staff may request that, along with an initial application for registration filed on Form ADV, the applicant also will be expected to demonstrate compliance with the substantive requirements set forth below.
Net Worth and Bonding
Unlike the SEC, the states impose net worth requirements on investment advisers depending on the adviser’s plan of business. Net worth means the excess of assets over liabilities as determined by
84. Available at http://www.nasaa.org/wp-content/uploads/2011/07/IA-Model-Rule-
Definition-Under-2002-Act.pdf. Although NASAA had adopted similar model rules under the USA 1956, all of the model rules were updated after NCCUSL’s adoption and NASAA’s endorsement of the USA 2002. Therefore, only refer-ences to the NASAA model rules reflecting the provisions of the USA 2002 are included as they provide the most recent guidance from NASAA on these issues.
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generally accepted accounting principles (“GAAP”), but excludes as assets: prepaid expenses (except as to items properly classified as assets under GAAP), deferred charges, goodwill, franchise rights, organizational expenses, patents, copyrights, marketing rights, unamor-tized debt discount and expense, all other assets of an intangible nature, home, home furnishings and automobiles, and any other personal items not readily marketable in the case of an individual; advances or loans to stockholders and officers in the case of a cor-poration; and advances or loans to partners in the case of a partnership.
An investment adviser registered or required to be registered under state law that has custody of client funds or securities must maintain at all times a minimum net worth of $35,000. An investment adviser that may be deemed to have custody solely due to direct fee deduction or advising a pooled investment vehicle need not comply with the $35,000 net worth requirement if it meets the terms and conditions of certain rules relating to such activities.85
Custody is defined as holding, directly or indirectly, client funds or securities or having any authority to obtain possession of them. An investment adviser also will be deemed to have custody if a related person holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them in connection with advi-sory services the investment adviser provides to clients. Custody also includes any arrangement under which the investment adviser is authorized or permitted to withdraw client funds or securities main-tained with a custodian upon the investment adviser’s instruction to the custodian.
Furthermore, custody includes any capacity (such as a general partner of a limited partnership or managing member of a limited liability company) that gives the investment adviser or a supervised person legal ownership of, or access to, client funds or securities. Custody will not be imposed if an investment adviser inadvertently receives checks drawn by clients and made payable to third parties if it forwards the check within three business days of receipt and keeps appropriate records.86
85. NASAA Model Rule 411(f)-(1)(b) under the USA 2002. 86. NASAA Model Rule 411(f)-(1) under the USA 2002 is the general rule imposing
certain obligations on investment advisers to their clients when they have custody of client funds or securities. It provides two alternatives with respect to certain client reporting obligations where an investment adviser serves as a general partner of a limited partner or a managing member of a limited liability company.
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An investment adviser registered or required to be registered under state law that has discretionary authority over client funds or securities but does not have custody of client funds or securities, must maintain at all times a minimum net worth of $10,000.87 An invest-ment adviser will not be deemed to exercise discretion when it places trade orders with a broker-dealer pursuant to a third party trading agreement if:
• The investment adviser has executed a separate investment advi-sory contract exclusively with its client which acknowledges that a third party trading agreement will be executed to allow the investment adviser to effect securities transactions in the client’s brokerage account;
• The investment advisory contract specifically states that the client does not grant discretionary authority to the investment adviser and the investment adviser in fact does not exercise discretion with respect to the account; and
• A third party trading agreement is executed between the client and a broker-dealer which specifically limits the investment adviser’s authority in the client’s brokerage account to the place-ment of trade orders and deduction of investment advisory fees.88 An investment adviser who has custody of, or discretion over,
client funds or securities and does not meet the minimum net worth requirements may seek a bond in the amount of the net worth defi-ciency rounded up to the nearest $5,000, provided the bond is issued by a company qualified to do business in the state in a form deter-mined by the administrator and is subject to the claims of all clients of the investment adviser without regard to the client’s state of residence.89
An investment adviser registered or required to be registered under state law that accepts prepayment of advisory fees of more than six months in advance and more than $500 per client must maintain at all times a positive net worth.90 Investment advisers registered or required to be registered under state law that do not fall within one of the aforementioned categories have no net worth requirement.
87. NASAA Model Rule 411(a)-1(b) under the USA 2002. 88. NASAA Model Rule 411(a)-(1)(g) under the USA 2002. 89. NASAA Model Rule 411(c)-1 under the USA 2002. 90. NASAA Model Rule 411(a)-1 under the USA 2002.
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An investment adviser that has its principal place of business in another state shall maintain such minimum net worth as required by the state in which the investment adviser maintains its principal place of business, provided that the investment adviser is registered or licensed in such state and is in compliance with the state’s minimum capital requirements. This is a restatement of the Home State rules imposed on the states under Section 222(c) of the Advisers Act.
An investment adviser must notify the administrator within the close of the next business day after it is determined that the investment adviser is not maintaining the required net worth. After transmitting the notice, the investment adviser shall file with the administrator by the close of business on the next business day a report of its financial condition, including a trial balance of all ledger accounts, a statement of all client funds or securities which are not segregated, a computation of the aggregate amount of client ledger debit balances and a state-ment as to the number of client accounts.91
Brochure
The basis for requiring the preparation, use and delivery of a bro-chure is grounded in the specific antifraud provisions of Section 102(a) of the USA 1956. In addition to retaining the same specific antifraud provisions in the USA 1956, Section 411(g) of the USA 2002 permits the administrator to adopt a rule or order to require investment advis-ers to furnish and disseminate to clients or prospective clients in the state such information or other record as it deems necessary or appropriate in the public interest and for the protection of investors and advisory clients.92
Part 2A of Form ADV fulfills requirements under federal93 and state law for investment advisers to deliver to clients and prospective clients a brochure disclosing certain information about the firm. Part 2A is known in the industry as the “brochure rule” because the required narrative is intended to read like an informative brochure about the firm.94 Part 2B of Form ADV is much shorter and is intended as a brief biography of each investment adviser representative associated with or employed by the investment adviser. Parts 2A and 2B to Form ADV are filed by the investment adviser through IARD. If a
91. NASAA Model Rule 411(a)-1(d) under the USA 2002. 92. NASAA Model Rule 411(g) under the USA 2002. 93. 17 CFR 275.204-3. 94. Supra note 92.
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firm offers several substantially different types of advisory services, it is permitted to create a separate brochure for each advisory service.
The development of the brochure is highly structured and invest-ment advisers must follow the format set forth in Parts 2A and 2B precisely. Due to the structured nature of Parts 2A and 2B and the fact that this will be the document given to clients and prospective clients by the investment adviser, some state securities regulators will review the proposed brochure and request that the applicant amend the brochure to address any staff comments, including a failure to follow the required presentation format.
An investment adviser must deliver Part 2A and any applicable Part 2B brochure supplement to a prospective advisory client (1) within 48 hours prior to entering into an investment advisory contract or (2) at the time of entering into an investment advisory contract if the advisory contract provides the client with the right to terminate the contract without penalty within five business days after entering into the advisory contract.
Solicitor’s Disclosure
Although the NASAA Model Rule under the USA 2002 relating to brochures95 does not require a separate disclosure for cash payments to solicitors similar to SEC Rule 206(4)-3 under the Advisers Act, some states have imposed this requirement.96 In such instances, a person who directly or indirectly solicits a client for, or refers any client to, an investment adviser who receives a cash payment from an investment adviser for solicitation activities related to the provision of impersonal advisory services must provide written disclosure con-taining (1) the name of the solicitor, (2) the name of the investment adviser, (3) the nature of the relationship, including any affiliation, between the solicitor and investment adviser, (4) a statement that the solicitor will be compensated for his solicitation services by the investment adviser, (5) the terms of the compensation arrangement, including a description of the compensation to be paid to the solicitor and (6) the amount, if any, for the cost of obtaining the account which the client will be charged in addition to the advisory fee.
95. NASAA Model Rule 411(g) under the USA 2002. 96. See Pennsylvania Department of Banking and Securities Regulation 404.012, 10 Pa.
Code §404.012.
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Investment Advisory Contracts
All requirements relating to investment advisory contracts in the USA 1956 were contained in the specific anti-fraud provisions of Section 102(b). Section 502(c) of the USA 2002 authorizes the administrator to adopt rules specifying the contents of an investment advisory contract. The relevant NASAA Model Rule establishes a set of prohibitions about what cannot be in a contract and a set of disclosures which must be given to a client before entering into an investment advisory contract.97 State securities regulators may request that an applicant for registration as an investment adviser file a form of investment advisory contract which it plans to utilize to ensure compliance with these requirements.
BASIS FOR DENIAL OF APPLICATION
Section 204 of the USA 1956 and Section 412 of the USA 2002 enumerate the statutory bases upon which an administrator may deny an application for registration as an investment adviser or an investment adviser representative. This introduction to investment adviser regulation does not permit an extensive discussion of these provisions and interested readers should refer to Chapter 35 of PLI’s Treatise on Investment Adviser Regulation.
Although an investment adviser or investment adviser representative applicant may meet one of the criteria set forth in either the USA 1956 or USA 2002 upon which its application may be denied, whether or not to exercise this authority is within the total discretion of the administrator subject only to such action being in public interest. The USA 2002 rec-ognized that an administrator may be persuaded that the relevant circum-stances do not justify a denial of registration but may justify granting limited registration. Granting a conditional license is a status permitted under the USA 2002.
Sections 204 of the USA 1956 and 412 of the USA 2002 particularly may be subject to non-uniform treatment as individual states may have expanded the criteria contained therein, often in response to specific sit-uations that occurred in their jurisdiction. Therefore, special care should be taken in reviewing the corresponding provision of a state’s securities law where the registration application will be filed.
97. NASAA Model Rule 502(c) under the USA 2002.
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If an investment adviser or investment adviser representative would meet one of the criteria enumerated in the relevant provision of the state’s securities law upon which the registration application could be denied, it is good practice to contact the licensing section of that state’s administering office prior to filing a registration application to discuss whether or not the state likely would exercise its discretion and deny the application or whether it would entertain registration based upon certain representations (eg heightened supervision) or limitations imposed on the registration. Doing so could avoid issuance of a denial of registration order which not only is reportable on Form ADV and Form U-4 but also may serve as a basis for regulatory action in other jurisdictions.
ISSUES RELATING TO RENEWAL, TERMINATION, WITHDRAWAL AND TRANSFER OF REGISTRATION
Renewal of Investment Adviser and Investment Adviser Representative Registration
Under the USA 1956, each investment adviser registration was effective for one year from its effective date unless renewed. With the advent of CRD and the move toward greater uniformity, states revised their securities laws to have registrations of all licensed persons effec-tive until 31 December of each year unless renewed.98 Section 406(c) of the USA 2002 has codified this practice with respect to investment advisers and investment adviser representatives.
It should be noted that it is possible that, if an application was approved on December 1 of a given year, the registration would be effective for only one month before it needs to be renewed which renewal will incur all applicable renewal fees. Renewal requires the payment of fees imposed by each state’s securities statute.99 Renewals are accomplished wholly within IARD and an opportunity is given to each registrant not to renew its registration in any given jurisdiction. Under the USA 2002, a registration automatically is renewed and effective upon filing such records as may be required for renewal with IARD and paying any applicable fees.100
98. However, a registration of an investment adviser representative only can be
effective while such individual is employed by, or associated with, a registered investment adviser or federal covered investment adviser.
99. Section 406(a) of the USA 2002. 100. Section 406(d) of the USA 2002.
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Termination of Registration
The USA 1956 permits the administrator to cancel the registration of a registrant or application of an applicant if the administrator finds that the registrant or applicant (1) is no longer in existence, (2) has ceased to act as an investment adviser, (3) is subject to an adjudication of incapacity or is subject to the control of a committee, conservator, or guardian or (4) cannot be reasonably located.
The USA 2002 has a provision similar to the USA 1956 but extends it to investment adviser representatives and requires the admin-istrator to adopt a rule with respect to taking such actions. It further provides that any administrator may reinstate a terminated registra-tion, with or without hearing, and make the registration retroactive.
Withdrawal of Registration
Whereas termination may reflect an affirmative action by the administrator, a withdrawal generally is a voluntary request filed with the administrator by the registrant. An application for withdrawal from registration is accomplished by means of filing Form ADV-W for investment advisers and Form U-5 for investment adviser rep-resentatives, both of which are filed through IARD.
Under the USA 1956, withdrawal from registration as an invest-ment adviser becomes effective 30 days after receipt of an application to withdraw or within such shorter period of time as the administrator may determine unless a revocation or suspension proceeding is pend-ing when the application is filed or a proceeding to revoke or suspend or to impose conditions upon the withdrawal is instituted within 30 days after the withdrawal application is filed. If a proceeding is pending or instituted, withdrawal becomes effective at such time and upon such conditions as the administrator by order may determine. The provisions in the USA 2002 mirror those in the USA 1956 except that the USA 2002 extends the provision to investment adviser rep-resentatives and the period prior to effectiveness of the withdrawal from 30 to 60 days.
Even if an application to withdraw becomes effective, both the USA 1956 (with respect to investment advisers) and USA 2002 permit the administrator to institute a revocation or suspension proceeding within one year after the automatic effectiveness of the withdrawal and issue a revocation or suspension order as of the last date on which the registration was effective if a proceeding is not pending. Official Comment No. 1 to Section 409 of the USA 2002 states that
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this provision is designed to prevent withdrawal of an effective reg-istration “under fire” and preserves the regulator’s ability to initiate a suspension or revocation proceeding under circumstances where the administrator did not know the reasons which formed the basis of the proceeding until after the withdrawal application became effective by operation of law.
In such circumstances, the administrator is authorized to issue a revocation or suspension order as of the last day on which the reg-istration was effective and no proceeding was pending. This has the effect of ensuring that such regulatory order is reportable to, and captured by, IARD and thereby could form the basis for denial of an application for registration in another state. In other words, if a registrant believes he might be the subject of a state investigation and files an application to withdraw which automatically becomes effec-tive and the administrator, within one year of the effective date of the withdrawal, institutes a proceeding which results in a revocation or suspension order, such order will be deemed issued and entered while the person was a registrant and will become part of that person’s permanent IARD record.
Transfer of Investment Adviser Representative Registration
A transfer of registration of an investment adviser representative from one investment adviser or federal covered adviser to another is effected on Form U-4 and filed through IARD. Since many agents of broker-dealers simultaneously are registered as investment adviser representatives and use Form U-4 as the principal agent registration application, it made eminent sense to use Form U-4 as the principal registration application for investment adviser representatives.
Due to antecedent history relating to the registration of agents under the USA 1956101 and the use of Form U-4 to effect transfers, states treat a transfer as a de novo application for registration. If an individual has been registered in a jurisdiction 30 days prior to the date the application for registration (transfer) is filed with IARD, such person is eligible, by signing the acknowledgement in Item 15C of Form U-4 for a temporary registration while the transfer appli-cation is under review by the relevant state securities regulator.
The “temporary registration” status is a recognition that, on the one hand, the investment adviser representative has been in the
101. See Regulation of Broker-Dealers (Practising Law Institute), Chapter 5A.
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investment advisory business in a registered status and business con-siderations favor a seamless transfer from one employer to another but, on the other hand, the state’s insistence that the transfer, in effect, is a new registration application for association with a different investment adviser or federal covered investment adviser and subject to state regulatory review. This “temporary registration” status has been recognized by Section 408(b) of the USA 2002, is administered through IARD and is the subject of Item 15C to Form U-4.
Under Section 408(b) of the USA 2002, if an investment adviser representative registered under the state securities act terminates employment or association with an investment adviser registered under such act or a federal covered investment adviser that has filed a notice under such act and applies for registration within 30 days after termination which complies with Section 406(a)(initial application for registration), the registration becomes (1) immediately effective upon filing and payment of any filing fee if the investment adviser representative’s IARD record does not contain new or amended disciplinary disclosure within the previous 12 months; or (2) is tem-porarily effective if the investment adviser representative’s IARD record contains new or amended disciplinary disclosure within the preceding 12 months. Even where an investment adviser repre-sentative meets these requirements, the USA 2002 authorizes the administrator to prevent the effectiveness of the new or temporary registration based on the public interest and the protection of investors.102
The administrator may withdraw a temporary registration if there are grounds for discipline under Section 412 of the USA 2002 and the administrator effects the withdrawal within 30 days after filing of the transfer registration application. If the administrator fails to with-draw the temporary registration within the 30 day period, the temporary registration automatically becomes permanent on the 31st day after filing.
102. Official Comment No. 2 to Section 408 of the USA 2002 states that this
authorization is intended to ensure that the administrator has the authority to prevent immediate effectiveness in appropriate cases.
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Form U-5 and Defamation Actions
Form U-5 is used for withdrawal of investment adviser repre-sentative registration and requires the investment adviser to provide a reason for the withdrawal. This requirement has proved somewhat problematic for investment advisers where an investment adviser representative has been terminated for cause. In such circumstances, the investment adviser is concerned that the reasons for termination stated on Form U-5 would become the basis of a complaint for defamation filed against the investment adviser and its principals by the terminated investment adviser representative.103
Libel and defamation actions generally are governed by the applicable law of each particular state. In 2007, the New York Court of Appeals, in answering a question certified to it by the United States Court of Appeals for the Second Circuit, opined that state-ments made by a broker-dealer on Form U-5 are protected by absolute privilege.104 It would seem that the same would apply in context of an investment adviser and investment adviser repre-sentative. It should be noted that an investment adviser representative who has been the subject of a Form U-5 filing may respond to specific adverse disclosures and have those responses included in publicly available IARD information.
In recognition of this defamation issue, the USA 2002 provides that an investment adviser, federal covered investment adviser or investment adviser representative is not liable to another broker-dealer, agent, investment adviser, federal covered investment adviser or investment adviser representative for defamation relating to a statement contained in a record required by the administrator or designee of the administrator (ie IARD), the SEC or a self-regulatory organization unless the person knew or should have known at the time that the statement was made, that the statement was false in any material respect or that the person acted in reckless disregard of the truth or falsity of the statement.105
103. Note waiver of liability provisions in Form U-4. 104. Rosenberg v. Metlife, Inc., 8 N.Y.3d 389, 866 N.E.2d 439 (Ny.App. 2007);
Rosenberg v. Metlife, Inc., Metropolitan Life Insurance Company and Metlife Securities, Inc., 453 F.3d 122 (2nd Cir. 2006).
105. Section 507 of the USA 2002. Official Comment No. 7 to this section advises that several states have adopted qualified immunity by judicial decision.
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POST-REGISTRATION REQUIREMENTS
Recordkeeping
With respect to broker-dealers, states cannot impose recordkeep-ing requirements that are in excess of, or different from, those imposed by the SEC. However, with respect to state-registered invest-ment advisers, states may impose their own recordkeeping rules. In this regard, NASAA has adopted a model rule with two alternatives.106 The first alternative provides detailed rules on recordkeeping require-ments to be imposed directly under state regulatory authority. The second alternative is incorporation by reference into state law of the books and records requirements for federal covered investment advisers adopted by the SEC in Rule 204-2 under the Advisers Act.107
Annual Updating Amendments
Investment advisers are required to file an annual updating amendment through IARD to Form ADV within 90 days after the end of the registrant’s fiscal year. This includes updating responses to all items on Form ADV as well as updating corresponding sections of Schedules A, B, C and D. Registrants also must submit a summary of material changes required by Item 2 of Part 2A either in the brochure (on the cover page or the page immediately thereafter) or as an exhibit to the brochure.
Material Amendments to Form ADV and Form U-4
Investment advisers are required to amend Form ADV promptly if any information (1) provided in response to Items 1, 3, 9 (except 9.A.(2), 9.B.(2), 9.E. and 9.F.) or 11 of Part 1A or Items 1, 2.A. through 2.F., or 2I of Part 1B becomes inaccurate in any way;108 (2) provided in response to Items 4, 8 or 10 of Part 1A or Item 2.G. of Part 1B becomes materially inaccurate;109 or (3) provided in the
106. NASAA Model Rule 411(c)-1 under the USA 2002. 107. 17 CFR 275.204-2. 108. This includes Identifying Information, Form of Organization, Custody, and Dis-
closure Information with respect to Part 2A and State Registration, Person Responsible for Supervision and Compliance, Net Capital, Disclosures relating to denial or revocation of bonds, unsatisfied judgments or liens, arbitrations, and other civil administrative actions, and Custody under Part 1B.
109. This includes Successions, Participation or Interest in Client Transactions, and Control Persons under Part 1A and Other Business Activities under Part 1B.
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firm’s brochure or a brochure supplement for an investment adviser representative becomes materially inaccurate.
Annual Financial Reporting
Investment advisers that have custody of client funds or securities and investment advisers who have discretion over client funds and securities must file an annual financial report with the administrator.110 Unlike most other filings with state securities regulators, financial reports generally are filed directly with the administrator and not through IARD. An investment adviser that has custody of client funds or securities or requires payment of advisory fees six months or more in advance and in excess of $500 per client must file an audited balance sheet as of the end of the investment adviser’s most recent fiscal year which must be:
• Examined in accordance with GAAP;
• Audited by an independent certified public accountant; and
• Accompanied by an unqualified opinion of the accountant as to the report of the financial position and a note stating the prin-ciples used to prepare it, the basis of included securities and any other explanations required for clarity.111 An investment adviser that has discretionary authority over client
funds or securities, but not custody, must file a balance sheet which need not be audited but must be prepared in accordance with GAAP or such other basis of accounting acceptable to the administrator and represented by the investment adviser or the person who prepared the statement to be true and accurate, as of the end of the investment adviser’s most recent fiscal year.112
110. NASAA Model Rule 411(b)-1. Generally, a financial report in the form required
annually must be submitted with an application for registration by an investment adviser that will have custody of, or discretionary authority over, client funds and securities.
111. Some states require that, in addition to the audited balance sheet, a supplemen-tary opinion must be submitted by the accountant with respect to any material inadequacies found to exist in the accounting system, the internal accounting controls and procedures for safeguarding securities and funds and indicate any corrective action taken or proposed. See 10 Pa. Code §304.022(a)(1).
112. NASAA Model Rule 411(b)-1 under the USA 2002.
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Annual Custody Audits
Investment advisers that have custody of client funds or securities will need to arrange for an annual custody audit by an independent certified public accountant to verify, by actual examination, the client funds and securities over which the investment adviser has custody. The audit must be unannounced and the accountant is responsible for filing the custody report with the state securities regulator by filing Form ADV-E through the IARD.113
Annual Offer to Deliver a Brochure
Part of the rule governing the obligation of the investment adviser to create a brochure is the requirement of annual delivery.114 Annually, an investment adviser must, within 120 days of the end of its fiscal year, deliver (1) a free, updated brochure and related brochure supplements which include or are accompanied by a summary of material changes or (2) a summary of material changes115 that includes an offer to provide a copy of the updated brochure and supplements and information on how the client may obtain a copy of the brochure and supplements but no summary of material changes or brochure need be delivered to clients if no material changes have taken place since the last summary and brochure delivery. Delivery of the brochure and related brochure supplements need not be made to (1) clients who have received only impersonal advice and who pay less than $500 annually in fees and (2) an investment company reg-istered under the 1940 Act or a business development company as defined in the 1940 Act and whose advisory contract meets the requirements of Section 15c of the 1940 Act.
Advertising
Advertising is addressed under the specific investment adviser anti-fraud provisions of Section 502(b) of the USA 2002. The relevant NASAA Model Rule provides for two alternatives. The first alternative is incorporation by reference into state law of the advertising
113. NASAA Model Rule 411(f-(1) under the USA 2002 contains detailed rules
relating to custody and the annual custody audit as well as exemptions from application of the custody rule.
114. NASAA Model Rule 411(g)(b) under the USA 2002. 115. Some states only require delivery of a written offer to provide a free copy of the
brochure and brochure supplement. See 10 Pa. Code §404(e).
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rules adopted by the SEC in Rule 206(4)-1 under the Advisers Act applicable to federal covered investment advisers. The second alter-native is a rule which prohibits the use of certain types of advertising and use of certain representations.116
Continuing Education
Section 411(h) of the USA 2002 authorizes the administrator to adopt a rule or order requiring continued education for a registered investment adviser representative. Often, a registered investment adviser representative also is a registered representative of a registered broker-dealer and, as such, is subject to FINRA rules on continuing education.117 Where this is the case, Section 411(h) of the USA 2002 permits the administrator to require such individual to participate in a continuing education program approved by the SEC and administered by FINRA.
By its terms, Section 411(h) of the USA 2002 authorizes an administrator to establish a state law continuing education requirement for investment adviser representatives and failure to comply with such requirement could constitute a violation of state law (as opposed to a FINRA requirement with respect to individuals dually registered as agents and investment adviser representatives) which failure could be the subject of administrative enforcement as provided in Section 604 of the USA 2002, including imposition of a civil penalty.
REGULATORY AUDITS AND INSPECTIONS
The USA 1956 authorizes the administrator to conduct at any time and from time to time reasonable periodic, special or other audits or inspections within or without the state as the administrator deems necessary or appropriate in the public interest or for the protection of investors.
The USA 2002 mirrors the language of the USA 1956 but adds that the inspection may be made without prior notice. Further, the administrator is authorized to copy, and remove for audit or inspection, copies of all records the administrator reasonably considers necessary or appropriate to conduct the audit or inspection. The USA 2002 also permits the administrator to assess the registrant a reasonable charge for conducting an audit or inspection.
116. NASAA Model Rule 502(b)(o) under the USA 2002. 117. FINRA Rule 1250.
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Official Comment No. 6 to Section 411 of the USA 2002 observes that, although the administrator’s power to copy and examine records is subject to all applicable privileges, no subpoena is required as the powers granted by this section for inspection are separate and distinct from the administrator’s enforcement powers in Section 602. The Official Comment further states that failure to allow or engaging in actions which impede the administrator from conducting an audit or inspection or refusal of access to a registrant’s office to conduct an audit or inspection may result in an action against the registrant’s license, a criminal prose-cution or an injunction.118
Under Section 203A(c) of the Advisers Act, states retain authority to bring enforcement actions with respect to fraud or deceit against any federal covered investment adviser or any person associated with a federal covered investment adviser. Use of the terms “fraud and deceit” suggest that states would have to utilize their investigatory and subpoena powers vested in Section 407 of the USA 1956 and Section 602 of the USA 2002 with respect to federal covered investment advisers and not their regulatory audit and inspection authority.
INVESTMENT ADVISOR PUBLIC DISCLOSURE
The Investment Adviser Public Disclosure (“IAPD”) is a web page on the SEC web site that provides public access to information appearing on Form ADV filed by SEC-registered investment advisers and state-registered investment advisers.119 The web site also will search FINRA’s BrokerCheck® system and indicate whether an investment adviser is affiliated with a brokerage firm. Since the IAPD captures all Form ADV filings with IARD, it also will contain information on “exempt reporting advisers” with the SEC even if such entities have an exemption from registration at the state level. IAPD will disclose any customer complaints, arbitrations, bankruptcies, regulatory actions, civil suits and criminal prosecutions that are subject to disclosure on Form ADV.
118. See Section 412(d)(8) of the USA 2002 which provides a basis for action by the
administrator against a registrant’s license for refusing or otherwise impeding the administrator from conducting an audit or inspection or refusing access to a registrant’s office to conduct an audit or inspection. However, Official Comment No. 11 to Section 412 of the USA 2002 notes that a request by a person subject to an audit or inspection for a reasonable delay to obtain the assistance of counsel does not constitute conduct justifying the administrator taking disciplinary action under this provision.
119. See http://www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.aspx.
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IAPD also is available to search for information concerning indi-vidual investment adviser representatives. IAPD will provide information concerning the individual’s professional background and conduct, including current registrations, employment history, and any disciplinary events. Information about investment adviser representatives who are or were associated persons of broker-dealers also will be made available through an interface with FINRA’s BrokerCheck® system.
STATE ACTIONS PROVIDING A BASIS FOR FEDERAL REGULATORY ACTION
Section 203(e)(9) of the Advisers Act permits the SEC to censure, deny or suspend the registration of an investment adviser subject to SEC registration if the investment adviser or any person associated with such investment adviser (whether prior to or subsequent to becoming so associated) is subject to any final order of a state securities commission that (1) bars such person from association with any entity regulated by such commission or from engaging in the business of securities, or (2) constitutes a final order based on violations of any laws or regulations that prohibit fraudulent, manipulative or deceptive conduct.
Unless there is a stay in effect, a final order of an administrator meeting the criteria of Section 203(e)(9) of the Advisers Act will be sufficient to provide a basis for regulatory action by the SEC even where the respond-ent has petitioned for judicial review of the final order.
Therefore, when an investment adviser or investment adviser repre-sentative is negotiating a regulatory consent order with a state securities administrator, it is important to consider whether or not the proposed language of the order would provide a basis for disciplinary action under Section 203(e)(9) of the Advisers Act.
USA 2002 CONCEPT OF CONTROL PERSON DISCIPLINE
The USA 2002 introduced a new concept of control person liability with respect to discipline (ie suspension or revocation) that could be imposed on a registrant under Section 412. Under Section 412(h) of the USA 2002, a person that controls, directly or indirectly, a person not in com-pliance with Section 412 may be disciplined by order of the administrator under this section to the same extent as the non-complying person, unless the controlling person did not know, and in the exercise of reasonable care could not have known, of the existence of conduct that is grounds for discipline under this section.
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Although this provision is new to the USA 2002 and did not exist in the USA 1956, there is no official comment in the USA 2002 as to the basis for inclusion. However, there does appear to have been a com-promise perhaps related to its inclusion in that the USA 2002 contains a statute of limitations with respect to each basis under Section 412 (except a felony conviction) upon which a registration may be suspended, revoked or conditioned whereas the USA 1956 generally did not. In particular, the USA 2002 imposes a ten year statute of limitations with respect to willful violations of the state’s securities law, failing to supervise an agent, investment adviser representative or other individual or engaging in dishonest or unethical practices in the securities, commodities, invest-ment, franchise, banking, finance or insurance business.
Under Section 412(h) of the USA 2002, an investment adviser could face the possibility of a suspension of its license solely because an investment adviser representative entered into a consent order with the administrator in which he agreed to have his license suspended for thirty days. Even though the investment adviser did not participate in negotiation of the consent order, it may be required to invest time and money in establishing an affirmative defense if the administrator seeks to impose similar discipline on the investment adviser or a control person of the investment adviser similar to that imposed on the investment adviser representative.
Except for Pennsylvania and Washington State, only jurisdictions that have adopted the USA 2002 in its entirety have enacted this provision. A recent amendment to Pennsylvania’s securities law added this section,120 and Washington State adopted a modified version of Section 412(h) of the USA 2002 that substitutes a “good faith” standard121 in lieu of the affirmative defense contained in Section 412(h). It provides that a person who, directly or indirectly, controls a person not in compli-ance with any part of this section may also be sanctioned to the same extent as the non-complying person, unless the controlling person acted in good faith and did not directly or indirectly induce the conduct constituting the violation or cause of the sanction122
120. 70 P.S. §1-305(h). 121. This is the same standard used in both the civil and administrative context for
control person liability under Section 20(a) of the 1934 Act. 122. Revised Washington Code 21.26.110(6).
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An Investment Adviser’s Fiduciary Duty (May 2, 2016)
Lorna A. Schnase
Attorney at Law
© 2010–2016 Lorna A. Schnase
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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Fiduciary duty remains a contentious issue as regulators try to decide which financial service providers should be subject to a fiduciary duty and under what circumstances. This paper explains an investment adviser’s fiduciary duties, focusing on advisers regulated by the U.S. Securities and Exchange Commission (“SEC”) under the Investment Advisers Act of 1940 (“Advisers Act”).
WHAT IS THE FUNDAMENTAL NATURE OF THE RELATIONSHIP BETWEEN AN ADVISER AND ITS CLIENTS?
An adviser’s relationship with its clients is fundamentally one of “trust and confidence.”1 This flows from the fact that clients seek assistance from advisers on sensitive matters, such as their financial well-being, where clients may have little to no expertise. Some advisers even have discretionary authority to act on behalf of their clients, opening accounts, trading securities, moving assets and the like. As such, advisory clients are vulnerable2 to the adviser and, in some cases, highly vulnerable. To afford some measure of protection in light of that vulnerability, advisers are held to have fiduciary duties to their clients, which help avoid adviser
1. See For Investors>What Is An Investment Adviser?> Fiduciary Duty, on the
website of the Investment Adviser Association at https://www.investmentadviser.org/ (IAA): “Investment advisers owe a fiduciary duty to their clients. As such, an investment adviser stands in a special relationship of trust and confidence with its clients.” See also In the Matter of Arleen W. Hughes doing business as E.W. Hughes & Company, Securities Exchange Act of 1934, Release No. 4048 (February 18, 1948), aff’d Hughes v. SEC, 174 F.2d 969 (D.C. Cir. 1949) (Hughes): “This reliance and repose of trust and confidence, of course, stem from the relationship created by registrant’s position as an investment adviser.”; SEC v. Capital Gains Research Bureau, 375 U.S. 180 (1963) (Capital Gains): “In describing their profession, leading investment advisers emphasized their relationship of ‘trust and confidence’ with their clients….” (citing Senate hearings held at the time the Advisers Act was originally enacted); and In the Matter of James C. Dawson, Advisers Act Release No. 3057 (July 23, 2010) (Dawson): “Dawson’s misconduct undercuts the trust that is the foundation of the investment advisory relationship, and demonstrates a lack of fitness to serve as a fiduciary….” (footnotes omitted).
2. There are various theories for why or when fiduciary duties are imposed under the law. Some theories require that the relationship contain an element of vul-nerability, such as the vulnerability of a beneficiary to the fiduciary’s abuse of power. Other theories require that the fiduciary have discretion to act on behalf of the beneficiary or that the fiduciary be acting with respect to a critical resource of the beneficiary. For a more complete discussion of the theory grounding fiduciary duty, see D. Gordon Smith, The Critical Resource Theory of Fiduciary Duty, 55 Vand. L. Rev. 1399 (20002) (Theory of Fiduciary Duty).
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overreaching or abuse of position and support the relationship as one of trust and confidence.
WHAT IS THE LEGAL BASIS FOR AN ADVISER’S FIDUCIARY DUTIES?
There are two main legal bases for an investment adviser’s fiduciary duties: common law and federal statutory law. These are outlined below.
COMMON LAW
An investment adviser, as agent, owes fiduciary duties to its client, as principal, under common law principles of agency.3 Certain other aspects of an adviser’s fiduciary duties are grounded in the law of trusts.4 Under either of those frameworks, an adviser’s duties under common law will depend on judge-made case law emanating from the state level, including application of conflicts of law principles to determine which state’s law applies, and will be enforceable by anyone with standing to sue.
FEDERAL STATUTORY LAW
Section 206. An adviser’s fiduciary duty also emanates from certain federal statutes, most notably Section 2065 of the Advisers Act, an anti-fraud section which generally prohibits an adviser6 from engaging
3. Agency is the fiduciary relationship that arises when one person (a “principal”)
manifests assent to another person (an “agent”) that the agent will act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consents to so act. Restatement (Third) of Agency § 1.01 (2006).
4. “We then saw [the fiduciary] concept develop over hundreds of years in the common law. As it did, we saw two streams of analysis emerge: one couched in the law of trusts, the other in the laws of agency.” Remarks of Andrew J. Donohue, Director of the SEC Division of Investment Management at IAA/ACA Insight’s Investment Adviser Compliance Forum 2010 (February 25, 2010).
5. Section 206 applies by its terms to all persons within the scope of the definition of “investment adviser” under the Advisers Act, including SEC-registered, state-registered and unregistered advisers, even though some of the rules adopted by the SEC under Section 206 are limited only to SEC-registered advisers. The SEC has also noted that an adviser’s fiduciary duties do not turn on whether the advice given is discretionary or non-discretionary. See Amendments to Form ADV, Release No. IA-3060 (July 28, 2010) (ADV Release) at footnote 256.
6. An adviser can be held liable for its own breaches of fiduciary duty, as well as those of associated persons acting on its behalf, under theories of control or supervisory responsibility. See, for example, In the Matter of Fidelity Management &
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in any practice that is fraudulent, deceptive or manipulative.7 In the seminal case of SEC v. Capital Gains Research Bureau,8 the U.S. Supreme Court said (in dicta) that the Advisers Act reflects a con-gressional recognition “of the delicate fiduciary nature of an investment advisory relationship.”9
It is not clear whether the Court in Capital Gains was merely explaining common law, interpreting Section 206 or both. Either way, the case has long been cited for the proposition that advisers owe a fiduciary duty to their clients under the Advisers Act,10 including an
Research Company and FMR Co., Inc., Release No. IA-2713 (March 5, 2008) (settled) (FMR) (Fidelity found to have breached its fiduciary duty to its advisory clients by, among other things, allowing certain executives’ and traders’ receipt of travel, entertainment and gifts from brokers and certain traders’ family or romantic relationships with brokers to influence its selection of brokers for client transactions, resulting in the substantial possibility of higher execution costs to Fidelity’s advisory clients); and the Outline written by Staff of the Investment Adviser Regulation Office of the SEC’s Division of Investment Management (March 2013) at http://www.sec.gov/about/offices/oia/oia_investman/rplaze-042012.pdf (SEC Staff Outline) at footnote 199: “The SEC has stated that the ‘delicate fiduciary relationship’ between an investment adviser and a client imposes an obligation on an adviser to review and to monitor its activities and the activities of its employees.” (citation omitted). Associated persons of an adviser can themselves be held liable for breaches of fiduciary duty, either directly or through allegations of aiding and abetting or “causing” another person’s violation. See, for example, In the Matter of Mohammed Riad and Kevin Timothy Swanson, SEC Administrative Proceeding File No. 3-15141. Initial Decision Release No. 590 (April 21, 2014) (Riad/Swanson) (stating that “[i]nvestment advisers and their associated persons are fiduciaries” (citations omitted)); and In the Matter of Ambassador Capital Management, LLC and Derek H. Oglesby, Advisers Act Release No. 3725 (November 26, 2013) (Ambassador Capital) (adviser and portfolio manager alleged to have caused money market fund’s failure to comply).
7. Note that an adviser’s fiduciary duties under Sections 206(1) and (2) of the Advisers Act extend not only to “clients” but “prospective clients” as well.
8. Capital Gains, supra note 1. 9. In the Capital Gains case, the adviser had a practice of purchasing shares for its
own account shortly before recommending them for long-term investment to its clients, and then immediately selling its own shares at a profit upon the rise in the market price following the recommendation, a practice sometimes referred to as “scalping.” The case held that the adviser’s practice operated as a fraud or deceit upon clients within the meaning of Section 206 of the Advisers Act.
10. At least under Section 206(2) of the Advisers Act, which had been enacted at the time of the events at issue in the Capital Gains case and was the principal focus of the Court’s opinion. The fiduciary relationship embedded in the Advisers Act is also referenced in Lowe v SEC, 472 U.S. 181 (1985), CCH Fed. Sec. L. Rep. ¶92,062, where the Court recognized the adviser-client relationship as a kind of fiduciary, person-to-person relationship intended to be covered by the Act. See also Hughes, supra note 1, where the SEC discussed an adviser’s fiduciary
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affirmative duty to act with utmost good faith, to make full and fair disclosure of all material facts, and to employ all reasonable care to avoid misleading clients.11
As a result, Section 206 is viewed as setting a “federal” fiduciary standard12 for advisers. Because there is generally no private right of action under the Advisers Act,13 the contours of that duty will be shaped largely by federal courts interpreting the Act, as well as by SEC interpretations of Section 206 and rules promulgated under that section.
Although there is likely substantial overlap between an adviser’s common law fiduciary duty and its federal fiduciary duty under the Advisers Act, the two are unlikely to be identical. Some commentators believe the federal fiduciary duty as a subset of the adviser’s general fiduciary duty.14 That could be the case if the federal fiduciary duty under Section 206 is interpreted to be, in short, a duty not to defraud clients. However, that also implies every violation of Section 206 would also ground a claim for breach of fiduciary duty under common law. It is unclear whether that would be the case, given the far-reaching scope of Section 206 and its related rules.15 Moreover,
duties under common law while finding the registrant in that case in violation of anti-fraud provisions in the Securities Act of 1933 and the Securities Exchange Act of 1934; and In the Matter of SignalPoint Asset Management, et al., Release No. IA-3868 (July 2, 2014) (settled) (adviser’s alleged breaches of fiduciary duty were found to constitute violations of Section 206(2)).
11. Capital Gains, supra note 1, in the text surrounding footnote 44. 12. This was confirmed in the U.S. Supreme Court case of Transamerica Mortgage
Advisors, Inc. v. Lewis, 444 U.S. 11 (1979) (Transamerica): “As we have previously recognized, [Section] 206 establishes ‘federal fiduciary standards’ to govern the conduct of investment advisers…,” citing Capital Gains and other cases. “Indeed, the Act’s legislative history leaves no doubt that Congress intended to impose enforceable fiduciary obligations.” Id. (citations omitted).
13. Transamerica, supra note 12. 14. See Memorandum to the SEC Investor Advisory Committee from the Investor as
Purchaser Subcommittee, dated February 15, 2010, regarding Fiduciary Duty Issue, at 3: “The federal fiduciary duty comprises a subset of the general fiduciary duty that an investment adviser owes to his clients.”.
15. Section 206 is, after all, an anti-fraud provision and the SEC has on occasion defined as “fraudulent” in rules under Section 206 conduct that would not seem to be recognized as “fraud” at common law. For example, advisers who are deemed to have custody under Advisers Act Rule 206(4)-2 must maintain client assets with a “qualified custodian” or risk committing fraud under that rule. Similarly, advisers who exercise proxy voting discretion without adopting proxy voting pro-cedures risk committing fraud under Advisers Act Rule 206(4)-6. Without more, neither of those scenarios seems likely to constitute “fraud” – or breach of fiduciary duty for that matter – at common law. Moreover, in Capital Gains, the Supreme
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common law breaches of fiduciary duty, such as simple breaches of due care, would not ground a claim under Advisers Act Section 206 unless the breach was found to have operated as a fraud, deceit or similar conduct within the scope of that section.16
Dodd-Frank Act – Advisers
Importantly, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) of 2010 has further shaped an adviser’s federal fiduciary duty under the Advisers Act. The Dodd-Frank Act calls for the SEC to study existing legal and regulatory standards of care for advisers17 when providing personalized investment advice to retail customers.18 That study was completed in January 201119 and, based on that, the SEC is authorized – but not required – to promulgate rules requiring advisers to “act in the best interest of the customer without regard to the financial or other interest of the adviser providing the advice,” under a standard of conduct which is no less stringent than the standard applicable to advisers under Advisers Act Section 206.20 The rules must also require disclosure of any material conflicts of interest.
The Dodd-Frank Act does not actually hold advisers to a “fiduciary duty” using those words, but the “best interest” standard, the reference to Section 206 and the disclosure requirements seem to all point
Court quite explicitly rejected the idea that the Advisers Act prohibitions on fraud and deceit are constrained by principles of common law fraud. Capital Gains, supra note 1, in footnote 6 and the text surrounding footnotes 39-47.
16. For example, a careless trading error might ground a common law claim for breach of fiduciary duty of care brought by harmed clients, but unless the careless conduct was also fraudulent, deceitful, manipulative or misleading in some manner (for example, inconsistent with the adviser’s disclosures), it would not seem to violate Section 206 as well.
17. The Dodd-Frank Act calls for the SEC to look at others in addition to advisers, such as brokers, dealers and their associated persons.
18. See Dodd-Frank Act Section 913 generally. 19. See the SEC staff’s Study on Investment Advisers and Broker-Dealers As Required
by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011) , at www.sec.gov/news/studies/2011/913studyfinal.pdf; and the SEC’s subsequent public request for data in Duties of Brokers, Dealers, and Investment Advisers, Release No. IA-3558 (March 1, 2013) at http://www. sec.gov/rules/other/2013/34-69013.pdf.
20. Oddly, the Act required the SEC to study the issue but seems to have pre-determined the result by giving the SEC a specific standard of conduct to require from advisers if it opts to engage in rulemaking in this area (to act in the best interest of clients, etc.).
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in that direction. Although the relevant study was completed quite some time ago, the SEC has still not decided whether to engage in rulemaking in this area.
Dodd-Frank Act – Municipal Advisors
The Dodd-Frank Act also added to the Securities Exchange Act of 1934 a new class of financial service providers called municipal advisors.21 The definition of “municipal advisor” specifically excludes investment advisers registered with the SEC under the Advisers Act. Significantly, and in contrast to advisers registered under the Advisers Act, the Dodd-Frank Act imposes on municipal advisors an express fiduciary duty:
“A municipal advisor and any person associated with such municipal advi-sor shall be deemed to have a fiduciary duty to any municipal entity for whom such municipal advisor acts as a municipal advisor, and no municipal advisor may engage in any act, practice, or course of business which is not consistent with a municipal advisor’s fiduciary duty or that is in con-travention of any rule of the [MSRB (the Municipal Securities Rulemak-ing Board)].”22 (emphasis added)
To implement this provision, the MSRB adopted Rule G-42 Duties of Non-Solicitor Municipal Advisors,23 effective June 23, 2016, which imposes on municipal advisors various standards of conduct, including a “fiduciary duty” owed to municipal entity clients. Rule G-42 also spells out specific requirements applicable to the municipal advisor-client relationship, such as those for:
disclosure of conflicts of interest and disciplinary information;
21. “Municipal advisor” is generally defined as anyone who provides advice to or on
behalf of a municipal entity with respect to municipal financial products or who solicits a municipal entity on behalf of another person (like an investment adviser seeking an advisory engagement). See Dodd-Frank Act Section 975. Among other things, municipal advisors must register with the SEC. See Registration of Municipal Advisors, Release No. 34-70462 (Sept. 20, 2013). The Act also grants the SEC authority to regulate and sanction municipal advisors for fraudulent conduct and other violations of the federal securities laws.
22. Dodd-Frank Act Section 975. The MSRB is a self-regulatory organization whose mission is to protect investors, municipal entities and the public interest by promoting a fair and efficient municipal market, regulating firms that engage in municipal securities and advisory activities, and promoting market transparency.
23. MSRB Rule G-42 can be accessed here: http://www.msrb.org/Rules-and-Interpretations/MSRB-Rules/General/~/link.aspx?_id=883FE79BCE8645739286 DB9B675A8C6B&_z=z.
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written documentation of the advisory relationship, covering key items such as compensation, scope of engagement and termination of or withdrawal from the relationship; and
the advisor’s recommendations to be based on a reasonable belief that they are suitable for the client (based on information obtained through reasonable diligence).24 Rule G-42 also contains express prohibitions relative to the
municipal advisor-client relationship, such as prohibitions against:
excessive compensation;
making false or misleading representations or omissions in the process of seeking an engagement;
certain fee-splitting arrangements;
certain payments made for the purpose of obtaining business; and
except in limited circumstances, engaging in certain principal transactions with a municipal entity client.25 Rule G-42 is accompanied by extensive Supplementary Material
providing guidance as to what the specific provisions are intended to mean and how they are intended to apply.
On its surface, Rule G-42 does not appear to impose obligations on municipal advisors that are very far afield of those familiar to all advisers. However, time will tell how the new MSRB fiduciary duty will be interpreted and applied in practice. Except for aspects that may be unique to municipal securities, one could envision that a municipal advisor’s fiduciary duty and the fiduciary duty imposed on other advisers will be interpreted similarly.26
24. MSRB Rule G-42(a)-(d). 25. MSRB Rule G-42(e). 26. Notably, the SEC did not wait for Rule G-42 to become effective before enforcing
against a municipal advisor for breach of fiduciary duty. Relying on the 2010 Dodd-Frank Act provisions, as well as pre-existing MSRB rules, the SEC brought an administrative proceeding against a municipal advisor and certain associated persons alleging breach of fiduciary duty for failing to disclose certain conflicts. In the Matter of Central States Capital Markets, LLC, et al., Advisers Act Release No. 4352 (March 15, 2016) (settled).
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OTHER SOURCES OF FIDUCIARY DUTY
Although the focus of this whitepaper is advisers as they are reg-ulated under the Advisers Act, investment advisers have – or may have – fiduciary duties to their clients emanating from other sources as well, several of which are summarized below:
Sections 36(a) and 36(b) of the Investment Company Act of 1940:
Under Section 36(a) of the Investment Company Act of 1940, an adviser can be liable for breach of fiduciary duty “involving personal misconduct” in respect of any registered investment company for which it serves as adviser. Section 36(a) has been described as a “reservoir of fiduciary obligations” that is designed to protect shareholders from the many subtle abuses that are not separately prohibited in the Investment Company Act.27 However, despite decades of litigation involving Section 36(a),28 there is still no definitive understanding of what it means for a breach of fiduciary duty to “involve personal misconduct.” While actual intent to violate the law may not be required, there is authority suggesting that nonfeasance of duty or abdication of responsibility may be enough.29
In addition to Section 36(a), Section 36(b) of the Investment Company Act makes advisers to registered investment companies liable for breach of fiduciary duty if they receive excessive compensation. With the intense focus on fund fees, this one of the most litigated sections under the Investment Company Act. However, the U.S. Supreme Court has now confirmed a decades-old standard applied to these cases, stating that “to face liability under Section 36(b), an investment adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.”30 While this makes it more difficult
27. See Brown v. Bullock, 194 F. Supp. 207, n.1 at 238-239 (S.D.N.Y.), aff’d, 294
F.2d 415 (2d Cir. 1961) (en banc). 28. See the cases cited in Bellikoff, et al. v. Eaton Vance Corp., et al., 481 F.3d 110
(2d Cir. 2007). 29. See the authorities referenced in Robert A. Robertson, Fund governance: legal
duties of investment company directors, § 9.01[2]. 30. Jones, et al. v. Harris Associates, L.P., 130 S.Ct. 1418 (2010) at 1426.
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for plaintiffs to successfully challenge fees as excessive under Section 36(b), litigation in this area continues.31
State Blue Sky Laws:
In many cases, securities statutes and regulations adopted by various states (so-called Blue Sky laws) prohibit conduct similar to that prohibited by Section 206 of the Advisers Act.32 Using the rationale spelled out by the Supreme Court in Capital Gains, it is possible these state provisions could be interpreted to impose a fiduciary duty on advisers as well.33
ERISA:
Under the Employee Retirement Income Security Act of 1974 (“ERISA”) and related provisions under the U.S. Tax Code, a per-son is a “fiduciary” to an ERISA plan/account or IRA to the extent that the person engages in certain activities, including rendering “investment advice for a fee or other compensation, direct or indi-rect, with respect to any moneys or other property of such
31. See, for example, Chill v. Calamos Advisors LLC, et. al., USDC, SDNY, Fed.
Sec. L. Rep. ¶99,047 (Mar. 28, 2016) (plaintiff’s Section 36(b) claims allowed to survive defendants’ motion to dismiss); Turner v. Davis Selected Advisers, LP, et al., Fed. Sec. L. Rep. ¶98,831, USCA (9th Cir.) (Sept. 29, 2015) (Court of Appeals affirms dismissal of plaintiff’s Section 36(b) claims against adviser and distributor); and SEC Litigation Release No. 22402 (June 27, 2012) concerning SEC v. AMMB Consultant Sendirian Berhad, Case No. 1:12-cv-01 052 (U.S. District Court for the District of Columbia, filed June 26, 2012) (adviser settled SEC charges without admitting or denying the allegations that it breached its fiduciary duty under Section 36(b) for excessive compensation, among other allegations).
32. See, for example, Section 33-1.A. and C. of the Texas Securities Act and Section 11-51-501(5) of the Colorado Securities Act.
33. See the Amicus Curiae Brief of North American Securities Administrators Association, Inc., filed in Richard Lee Van Dyke d/b/a Dick Van Dyke Registered Investment Advisor, Plaintiff-Appellant, v. Jesse White, in his official capacity as Illinois Secretary of State, The Illinois Department of Securities, and Tanya Solov, in her official capacity as the Director of the Illinois Department of Securities, Defendants-Appellees, Appellate Court of Illinois, Fourth District (Nov. 20, 2015) (arguing that anti-fraud Section 12J of the Illinois Securities Law of 1953, like Section 206 of the Advisers Act, provides the foundation of an investment adviser’s fiduciary duty to its clients). See also Patricia Burdett v. Robert S. Miller, 957 F.2d 1375, USCA (7th Cir.) (1992) (holding that an investment adviser is a fiduciary under Illinois common law, without reference to Capital Gains, Section 206 or any parallel Illinois state law).
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plan…[.]”34 Among other things, ERISA fiduciaries are held to a “prudent man” standard of care35 and the “exclusive benefit rule,”36 and must avoid “prohibited transactions,”37 as defined by ERISA and related Tax Code provisions and interpreted, applied and enforced by the DOL (Department of Labor) and the IRS (Internal Revenue Service). In some respects, the limits imposed on an ERISA fiduciary are considered stricter than those imposed on advisers under the Advisers Act.38
In April 2016, the DOL adopted amendments to the long-standing definition of ERISA “fiduciary,” and certain key exemp-tions from the ERISA “prohibited transaction” rules, for the purported purpose of better protecting plans, participants, bene-ficiaries and IRA owners from conflicts of interest, imprudence and disloyalty.39 These changes impact advisers and other financial providers who fall within the new definition, relative to ERISA plans/accounts and IRAs for which they are deemed to be “fidu-ciaries.” In the coming months, as the new rules come into effect
34. ERISA § 3(21)(A). 35. ERISA § 404(a)(1)(B), 29 U.S.C. § 1104(a), provides that “a fiduciary shall
discharge his duties with respect to a plan . . . with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims . . . .” Some states have enacted their own version of the “prudent man” rule or the more modern “prudent investor rule” applicable generally to “trustees.” See Uniform Law Commission, Uniform Prudent Investor Act at: http://www.uniformlaws.org/shared/docs/prudent%20 investor/upia_final_94.pdf.
36. ERISA § 404(a)(1)(B) also provides that “a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries….”
37. Key prohibited transaction rules appear in ERISA § 406(a) and (b) and in parallel provisions in § 4975 of the U.S. Tax Code.
38. See, for example, Ron Rhoades, Columnist, “One-Man Think Tank: Inside the legal issues of the Goldman Sachs hearings,” RIABiz, Wednesday 5.5.10 : “It should be noted that the Advisers Act has always adopted the ‘best interests’ standard found in the Investment Advisers Act of 1940, which is a codification of state common law. In contrast, ERISA largely adopted a ‘sole interests’ standard – which is a stricter form of fiduciary obligation. Hence, financial advisors providing clients advice on accounts subject to ERISA may possess additional duties under their status as an ERISA fiduciary.” See also, Richard K. Matta, “ERISA for securities professionals: 2008 update,” Journal of Investment Com-pliance (Vol. 10, No. 1, 1999, pp. 4-34).
39. See the Final Rule available at https://www.federalregister.gov/articles/2016/04/08/ 2016-07924/definition-of-the-term-fiduciary-conflict-of-interest-rule-retirement-investment-advice#footnote-9 and related releases.
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and compliance is required, the implications of these changes will be more evident.40
Broker-Dealer Laws:
Dual-registered adviser/brokers may have other duties to their clients that emanate from their status as a broker-dealer, under the broker-dealer laws or SRO rules, such as those imposed by FINRA (the Financial Industry Regulatory Authority). The nature of those duties will depend on the nature of the relationship between the adviser/broker and its client but may include duties characterized as “fiduciary.”41 The SEC has been more focused recently on the duties imposed on brokers as compared to those imposed on advis-ers and whether they should be harmonized in some areas,42 particularly since the Dodd-Frank Section 913 study referenced above recommends a uniform fiduciary standard for all brokers,
40. More information on being an ERISA fiduciary can be found on the DOL’s
website at: http://www.dol.gov/ebsa/publications/fiduciaryresponsibility.html. 41. See generally James Hamilton, J.D., LL.M, “SEC Regulation of Investment
Advisers and Brokers in the Brave New World,” Practical Compliance & Risk Management for the Securities Industry (May-June 2008) (Brave New World). See also In the Matter of Department of Enforcement vs. William B. Fretz, Jr., John P. Freeman, and The Keystone Equities Group, LP, FINRA National Adjudicatory Council, Complaint No. 2010024889501 (December 17, 2015) (respondents found, among other things, to have breached their fiduciary duties to investors by engaging in business-related misconduct that is inconsistent with just and equitable principles of trade in violation of NASD Rule 2110 and FINRA Rule 2010). This conduct was also found by the SEC to have breached Section 206 of the Advisers Act. See In the Matter of William B. Fretz, Jr., John P. Freeman, Covenant Capital Management Partners, L.P., and Covenant Partners, L.P., Advisers Act Release No. 4206 (September 23, 2015) (settled).
42. For a more complete discussion of a broker’s duties as compared to those of advisers, see Brave New World, supra note 41. In particular, note this regarding brokers’ duties even under the law prior to the Dodd-Frank Act: “Accordingly, brokers who handle discretionary accounts are generally thought to owe fiduciary obligations to their clients. Not only do such duties transcend the basic regulatory constraints placed on the broker, but they also give rise to individual enforcement rights by the client. In contrast, brokers handling nondiscretionary accounts are generally thought to owe much more limited duties to the customer, principally concerning many of the rules that apply to all registrants, including prompt order execution, knowing one’s security, knowing one’s customer, disclosing conflicts of interest, and refraining from engaging in securities fraud.” (footnotes omitted) See also Investor and Industry Perspectives on Investment Advisers and Broker-Dealers, Rand Institute for Social Justice (the so-called “Rand Report”) (2008) discussing investor beliefs about whether advisers and other financial professionals were required to act in their best interest or were required to act as fiduciaries.
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dealers and investment advisers, at least when they are providing personalized investment advice about securities to retail cus-tomers.43
Notably, as mentioned above with regard to advisers, the Dodd-Frank Act does not expressly say brokers will actually have a “fiduciary duty” to their customers, although the “best interest” standard, disclosure and consent requirements and references to Section 206 seem to be aiming in that direction.44
WHAT ARE THE BASIC FIDUCIARY DUTIES AN ADVISER OWES TO ITS CLIENTS?
A single definitive list of an adviser’s fiduciary duties is not found in either the common law or the Advisers Act.45 However, duties of care and loyalty46 are the most fundamental advisers are generally held to owe. Some authorities also refer to an adviser’s duty of obedience.47 Still others refer to a duty to act in good faith,48 and a duty of disclosure.49
43. See the Dodd-Frank Section 913 study referenced supra, note 18. 44. Notably, SEC Chair Mary Jo White has expressed her personal view that broker-
dealers and investment advisers should be subject to a uniform fiduciary standard of conduct when providing personalized securities advice to retail investors. See Testimony on Examining the SEC’s Agenda, Operations and FY 2016 Budget Request, before the U.S. House of Representatives Committee on Financial Services (March 24, 2015).
45. See “Fiduciary Duty: Return to First Principles,” Remarks of Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations (February 27, 2006) (Richards Fiduciary Speech): “How do the responsibilities of a fiduciary translate into an adviser’s obligations to clients each and every day? This is a key question. Probably no statute or set of rules could contemplate the variety of factual situations and decisions that an advisory firm faces. Can you imagine the number of rules and releases and regulations that this would require?”.
46. See IAA, supra note 1: “As a fiduciary, an investment adviser has an affirmative duty of care, loyalty, honesty, and good faith to act in the best interests of its clients.”
47. See, for example, “Will the Investment Company and Investment Advisory Industry Win an Academy Award?” remarks of Kathryn B. McGrath, Director of the SEC Division of Investment Management (1987) (McGrath Remarks), at 7: “The words ‘fiduciary duty’ refer to the duties, of first, obedience to the terms of one’s trust, second, diligence and care in the carrying out of one’s fiduciary functions, and third, undivided loyalty to the beneficiaries of one’s trust.” Other authorities do not list the duty of obedience separately, but rather consider it within the framework of the other basic duties of care and loyalty.
48. See Capital Gains, supra note 1, at text surrounding footnote 44. See also Ron A. Rhoades, JD, CFP®, in “What Are The Specific Fiduciary Duties of Financial
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Whether these are viewed individually as separate duties, or grouped together in some way and analyzed as facets of one another, they are certainly among the most frequently cited fiduciary duties an adviser is held to owe. Each of these duties is discussed in more detail in suc-ceeding sections, along with more granular illustrations of what those duties might mean to an adviser when applied in practice.
HOW DO THESE BASIC DUTIES APPLY TO A PARTICULAR ADVISER?
How fiduciary duties apply to any particular adviser will vary depending on the circumstances, including the adviser’s business model, clientele, services, arrangements and other factors.50 For example, whether an adviser has satisfied its duty of disclosure to a client might depend on whether the client is sophisticated. Retail clients may warrant more basic, detailed disclosure than institutional clients who have more internal expertise and can better fend for themselves. As a result, just as there is no single definitive list of an adviser’s fiduciary duties, there is also no single source defining how an adviser’s fiduciary duties will apply in all circumstances. Instead, the scope, contours and application of an adviser’s fiduciary duties in any given situation is contextual and must be deter-mined on a case-by-case basis.51
Advisors?” (January 1, 2008) who, among others, refers to the duties of care, loyalty and good faith as a “triad” of duties. Compare Stone ex rel. AmSouth Bancorporation v. Ritter, 911 A.2d 362, 370 (Del. 2006), explaining that the duty of good faith is essentially a subset of the duty of loyalty.
49. Capital Gains, supra note 1, at the text surrounding footnote 44: “Courts have imposed on a fiduciary an affirmative duty of… full and fair disclosure of all material facts.” Others consider the duty of disclosure part and parcel of the duty of loyalty, since disclosure is usually required where non-disclosure would otherwise mislead a client or leave the client uninformed about (and therefore not consenting to) a conflict of interest.
50. IAA, supra note 1: “The parameters of an investment adviser’s fiduciary duty depend on the scope of the advisory relationship….” Also, Michael S. Caccese, “Portfolio Manager Lift-Outs, Investment Performance Portability, and the CFA Institute Member,” Securities Regulation Law Journal [Vol. 34:31 2005] at 33: “The specific contours of the fiduciary duties owed by investment advisers to their clients will vary depending on the particular circumstances present in the relationship between the fiduciary and its client.”.
51. As noted in Theory of Fiduciary Duty, supra note 2, theories vary on which elements of vulnerability, discretion and other factors are required before a relationship will be considered “fiduciary.” The variability of these elements from theory to theory helps to explain why an adviser’s fiduciary obligations can vary from client to client, depending on how many of those elements are present in any
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CAN AN ADVISER’S FIDUCIARY DUTIES BE ALTERED OR WAIVED?
Generally speaking, an adviser’s fiduciary duties can be altered or waived, with the client’s consent. This is the case under common law52 as well as federal law.53
Investment advisers usually obtain client consent to a fiduciary alter-ation or waiver by one or more methods. They might, for example, obtain express consent through provisions in the investment advisory agreement or contract signed by the client. More commonly, client consent is implied or inferred when the adviser discloses its practices to the client in Form ADV or elsewhere, allowing the client to decide whether to proceed with the advisory relationship or not, in light of the matters disclosed. Clients that choose to proceed are generally viewed as having consented to the practices disclosed.54 However, in order for a
given adviser-client relationship and to what degree. For a case illustrating this point, see Western Reserve Life Assur. v. Graben, 233 S.W.3d 360, 373-375 (Tex.App.–Fort Worth 2007, no pet. h.), where the court analyzed the cir-cumstances that made the financial advisor in that case a “fiduciary” and what evidence supported the plaintiffs’ breach of fiduciary duty claim.
52. See Theory of Fiduciary Duty, supra note 2, at 1492: “[I]n most fiduciary settings, parties may modify default rules of fiduciary duty through contract.” (citations omitted). See also Restatement (Third) of Agency § 8.06 (2006), specifying generally that conduct by an agent (fiduciary) that would otherwise constitute a breach of duty does not constitute a breach if the principal (beneficiary) consents to the conduct, provided certain parameters are met.
53. See, for example, Hughes, supra note 1: “To prevent any conflict and the possible subordination of this duty to act solely for the benefit of his principal, a fiduciary at common law is forbidden to deal as an adverse party with his principal. An exception is made, however, where the principal gives his informed consent to such dealings….[Thus], if registrant chooses to assume a role in which she is motivated by conflicting interests, under the exception we have discussed she may do so if, but only if, she obtains her client’s consent after disclosure.” (emphasis added); also Information for Newly-Registered Investment Advisers, Prepared by the Staff of the SEC’s Division of Investment Management and OCIE: “[Y]ou are a ‘fiduciary’ to your advisory clients. This means…you cannot use your clients’ assets for your own benefit or the benefit of other clients, at least without client consent.” (emphasis added).
54. See Knut A. Rostad, “Conflicts of Interest and the Duty of Loyalty, at the Secu-rities and Exchange Commission,” The Investment Lawyer, Vol. 22, No. 9 Sept. 2015) (Rostad), quoting Robert Plaze, former Associate Director of the SEC’s Division of Investment Management: “In the vast amount of cases the Commission or a court will infer consent from disclosure, such as disclosure in the [Form ADV Part 2A] brochure—even if the client hasn’t read it.”.
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client’s consent to be effective, it must be informed, meaning that it must be based on full and frank disclosure.55
Which of an adviser’s fiduciary duties may be altered and to what degree – perhaps to the point of being waived altogether – is the subject of some controversy.56 Certainly in some cases, courts and regulators have invalidated an adviser’s attempt to alter or waive fiduciary obli-gations, most often by finding inadequate disclosure (which would render client consent ineffective)57 or by determining that the alteration or waiver would violate public policy,58 including those policies deter-mined to underpin other express legal provisions.59
55. See Capital Gains, supra note 1, at II (an adviser’s disclosure must be “full and frank”); and Form ADV, Part 2, General Instruction 3: “[Your fiduciary obli-gation] requires that you provide the client with sufficiently specific facts so that the client is able to understand the conflicts of interest you have and the business practices in which you engage, and can give informed consent to such conflicts or practices or reject them.” See also Restatement (Third) of Agency § 8.06(1)(a)(ii) (2006), specifying generally that a principal’s consent to conduct that would otherwise constitute a breach of duty requires the agent to disclose all material facts that the agent knows, has reason to know, or should know would reasonably affect the principal’s judgment.
56. For a more complete discussion of the decades old “war” between the “con-tractarian” school of thought, which generally holds that fiduciary duties may be reduced or eliminated by contract, and the “anticontractarian” school of thought, which generally views fiduciary duties as unwaivable, see Paul S. Miller, Congress, Corporate Boards, and Oversight: A Public/Private Law Comparison, 44 U. Rich. L. Rev. 771, 792-94 (2010) (Miller); and Ann E. Conaway, Why No Respect? The Contractual Duties of Good Faith and Fair Dealing in Delaware, Widener University Delaware Law School (June 17, 2007).
57. See Capital Gains, supra note 1 (adviser failed to disclose material facts about personal transactions and conduct therefore operated as a fraud or deceit upon clients, in violation of Section 206); and other cases cited throughout these notes finding adviser’s disclosure inadequate. See also Rostad, supra note 54, at 3 (quoting quoting Robert Plaze, former Associate Director of the SEC’s Division of Investment Management): “Can you ever have fraud when there has been full disclosure? [I] think the answer is that you can have fraud if the SEC or court does not infer client consent from the disclosure. Let me give you an example. In the middle of a brochure or other client communication, the adviser explains that he will use your money to pay his mortgage if he is short some month. I think a court would not infer consent.”.
58. See, for example, the Massachusetts Securities Division, Policy Statement on Robo-Advisers and State Investment Adviser Registration (Updated April 1, 2016) (MA Robo-Advisers Policy Statement), expressing concern about the broad disclaimers and waivers the Division has seen from certain robo-advisers: “Many fully automated robo-advisers appear implicitly to take the position that the fiduciary duty of care (including the requirement to provide personalized and appropriate investment advice) can be significantly disclaimed with the written consent of the client. However, a complete and blanket disclaimer of any fiduciary
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Notwithstanding these concerns, alterations and waivers of fiduciary duties are commonplace in the advisory industry. Here are examples:
Advisers prohibited under strict fiduciary principles from engaging in principal transactions with their clients nonetheless do so, by following Advisers Act Section 206(3) and the consent procedures called for under that section.
Advisers that might otherwise be prohibited under fiduciary prin-ciples from benefitting themselves through the use of client assets nonetheless do so, at least indirectly, when they invest clients in affiliated mutual funds, after making full disclosure of the conflict of interest that presents.
Institutional advisers hired as sub-adviser to a client’s primary adviser might disclaim the otherwise applicable fiduciary obligation to determine suitability of a particular investment or investment strategy for the client, leaving suitability to be determined by the client’s primary adviser, who knows and manages the client’s overall financial picture.
These are but a few of the numerous examples of fiduciary alterations and waivers that are routine in the advisory industry.60 Indeed, most of
relationship would be ineffective. For the same reason, while the nature of a client’s contractual relationship with an adviser can, to an extent, be narrowed by written agreement, the Division will not permit the core fiduciary relationship to be eliminated.” (citations omitted).
59. For example, one could easily envision a court or regulator, on public policy or similar grounds, not allowing an adviser to contract or disclose away its basic fiduciary obligations as embedded in other affirmative provisions of law, such as: an adviser attempting to use a contractual provision allowing it to engage in an ERISA “prohibited transaction” without adhering to an available exemption; or an adviser attempting to disclose away the conflict of interest that would exist if it directed fund client brokerage commissions to pay for fund distribution in a manner inconsistent with Investment Company Act Rule 12b-1(h). Moreover, Advisers Act Section 215(a) voids any provision binding any person to waive compliance with the Advisers Act or related rules. Therefore, any conduct that would be considered a breach of fiduciary duty under Section 206 cannot be contracted or disclosed away, such as an adviser attempting to disclaim its basic duty of disclosure as embodied in Section 206, or an adviser seeking waiver of the conflict that would exist if the adviser made political contributions and then accepted compensation from a government entity inconsistent with the Advisers Act “pay-to-play” rule (Rule 206(4)-5).
60. See also the heading below “What Standard of Conduct Applies to an Adviser’s Fiduciary Duty?” for a discussion of the use of “hedge clauses” common in advisory contracts, altering the otherwise applicable fiduciary duty of care.
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the examples of adviser fiduciary duties listed in the next section are subject to alteration or waiver, at least to some degree, by obtaining a client’s consent, often through the disclosure process. Alterations and waivers are necessary and desirable if advisers and clients are to be afforded the flexibility to shape their relationships as they wish.61
WHAT ARE SPECIFIC EXAMPLES OF AN ADVISER’S FIDUCIARY DUTIES?
Despite the absence of a single source defining an adviser’s fiduciary duties, there are authorities that can be consulted for guidance on what an adviser’s duties are and how they might apply in particular circumstances. These include statements of the common law,62 state and federal case law,63 legislative history,64 guidance from the SEC65 and other regulators,66 industry commentators67 and other thought leaders.68 The list of duties
61. This concept is at the heart of the “contractarian” school of thought in fiduciary
law. See Miller, supra note 56. See also Rostad, supra note 54, at 4, quoting Robert Plaze, former Associate Director of the SEC’s Division of Investment Management, who indicates that if consent were not inferred from disclosure (thereby allowing an adviser’s conflicts to be waived by clients), the advisory business itself would be impossible to conduct, and further indicating that the question of what is in the client’s “best interest” is left to the client to decide after full disclosure: “The Advisers Act involves clients who are in most cases fully capable of providing consent. Failure to recognize that would send the SEC down a road of substituting its (or its staff’s) judgments about best interest for the client’s.”.
62. Often as codified in the Restatements, such as the Restatement (Third) of Agency (2006).
63. See, for example, the cases cited throughout these notes. 64. See, for example, the legislative history behind the Advisers Act discussed in
Transamerica, supra note 12. With regard to the legislative history of Section 913 of the Dodd-Frank Act, see Jim Hamilton, “Senator Johnson Clarifies Compromise on Broker Duty of Care,” Wolters Kluwer CCH Financial Reform News Center at: http://financialreform.wolterskluwerlb.com/2010/07/senator-johnson-clarifies-compromise-on-broker-duty-of-care.html#more.
65. This would include guidance from the SEC Staff, such as that appearing in the SEC Staff Outline, supra note 6, as well as in SEC Staff remarks, IM Guidance Updates and OCIE Risk Alerts cited throughout these notes, recognizing that the views of SEC Staff are not necessarily the views of other SEC Staff members, individual SEC Commissioners or the Commission as a whole.
66. See, for example, the statements from state Blue Sky regulators, FINRA, DOL and MSRB cited throughout these notes.
67. See, for example, Scott A. Meyers and James G. Martignon, “The Post-Madoff Emergence of a Fiduciary Duty of Due Diligence - Recent Regulatory Enforcement Actions and Their Impact on Best Practices for Investment Managers,” Practical
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below was compiled from those sources and is sorted under each of the major duties mentioned previously, accompanied in each case by illus-trative examples.
Importantly, the examples below are intended to be instructive, but should be used only as a starting point for analysis. In other words, an adviser will not necessarily have breached its fiduciary duty if it acts inconsistently with these examples, given the need – discussed in prior sections – for each circumstance to be considered in context and on a case-by-case basis.
DUTY OF CARE:
An adviser’s fiduciary duty of care generally requires the adviser to –
Exercise due care (prudence and reasonableness) when acting on behalf of clients.69 Examples of this might include – ○ eliciting from clients a sufficient amount of information at
the inception of the relationship (and updated thereafter peri-odically) to make a reasonable assessment of their sophis-tication in investment matters and risk tolerance70
Compliance and Risk Management for the Securities Industry (Sep. 1, 2009) (Duty of Due Diligence article).
68. Thought leaders in this arena include the Investment Adviser Association, a trade organization for SEC-registered advisers, referenced supra in note 1; and the Institute for a Fiduciary Standard (http://www.thefiduciaryinstitute.org), which advocates six key fiduciary duties for advisers: (1) Serve the client’s best interest, (2) Act in utmost good faith, (3) Act prudently – with the care, skill and judgment of a professional, (4) Avoid conflicts of interest, (5) Disclose all material facts, and (6) Control investment expenses. Others active in the discussion of an adviser’s fiduciary duties include fi360 and its associated Center for Fiduciary Studies (http://www.fi360.com), the Center for Fiduciary Excellence (CEFEX) (https://www.cefex.org/) and 3Ethos (http://3ethos.com/).
69. See the discussion below about the standard of care (negligence versus gross negligence) applicable in any given case.
70. See the MA Robo-Advisers Policy Statement, supra note 58, which expresses doubt that robo-advisers, as least as currently structured, could properly discharge their fiduciary duty to their clients in part because of the brief questionnaires used to gather client information.
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○ acting with due care when assessing a client’s risk tolerance, selecting investments consistent with that risk level71 and reasonably monitoring for risk
○ ensuring that new client assets are invested reasonably promptly72
Employ reasonable care to avoid misleading clients.73 Examples of this might include – ○ using due care when completing Form ADV and making
other disclosures to clients and prospective clients74 ○ calculating performance with due care when preparing mar-
keting materials, pitch books, website presentations and other materials provided to clients and prospective clients75
○ comparing adviser account performance to appropriate bench-mark indexes selected with due care to ensure a meaningful and balanced presentation76
Have a reasonable basis for investment advice.77
71. See Riad/Swanson, supra note 6 (portfolio managers’ actions, which shifted the fund away from its disclosed principal strategy and changed its fundamental risk footprint, showed a ‘highly unreasonable’ and ‘extreme departure from the standards of ordinary care,’ in violation of the fiduciary duty owed by an investment adviser).
72. See FDIC Trust Examination Manual, at Section F.1.b.: “Fiduciaries are obligated to keep funds productive…. [F]ailure to invest cash when appropriate and practicable should be considered imprudent and a breach of fiduciary duty subject to criticism. In those cases where the fiduciary is responsible for the investment of cash, it is difficult for a fiduciary to justify permitting cash to remain idle when it is possible to make it productive.”.
73. Capital Gains, supra note 1, at text surrounding footnote 45. 74. See Riad/Swanson, supra note 6 (portfolio managers’ ‘extreme departure from the
standards of ordinary care’ resulted in material misrepresentations and omissions in a fund client’s annual and semiannual reports).
75. See In the Matter of Virtus Investment Advisers, Inc., Advisers Act Release No. 4266 (November 15, 2015) (settled) (Virtus) (adviser found to have been negligent in not knowing that the performance track record adviser used, which was supplied by its sub-adviser, was false).
76. See Factors to be Considered in Connection with Investment Company Advisory Contracts Containing Incentive Fee Arrangements, Advisers Act Release No. 315 (April 6, 1972), discussing how the selection of an inappropriate index in per-formance fee arrangements can raise Advisers Act issues, as well as fiduciary issues. See also Compliance Issues for Investment Advisers Today, remarks of Lori A. Richards, Director of the SEC’s OCIE (April 28, 2003) (Richards Com-pliance Issues) (where comparing performance to an inappropriate index is listed among recurring problems found during adviser examinations).
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Examples of this might include – ○ using due diligence to research investments and making
selections and recommendations with due care78 ○ monitoring investments with reasonable frequency for poten-
tial changes, consistent with the adviser’s contractual and discretionary obligations79
○ using only investments and techniques in which the adviser and its personnel are reasonably skilled, experienced and competent and avoiding investments and techniques where they are not80
Seek best execution81 of client trades (seek the best net price and terms reasonably available under the circumstances).
77. IAA, supra note 1. 78. See In the Matter of Larry C. Grossman and Gregory J. Adams, Initial Decision
Release No. 727, Administrative Proceeding File No. 3-15657 (December 23, 2014) (among other things, adviser found to have breached his fiduciary duty of care by not performing reasonable due diligence on investments recommended to investors) . See also In the Matter of Total Wealth Management, Inc., Jacob Keith Cooper, Nathan McNamee, and Douglas David Shoemaker, Advisers Act Release No. 3818 (April 15, 2014) (Total Wealth Management) (respondents alleged to have breached their fiduciary duties by failing to conduct the due diligence they claimed they were doing and making misrepresentations about the due diligence they performed).
79. See the document entitled “There They Go Again” prepared by the IAA, et al.: “[A] fiduciary obligation to monitor the account is triggered in circumstances in which there is a promise of ongoing account management or advice.” See also Leib v. Merrill Lynch, Pierce, Fenner & Smith, 461 F. Supp. 951 (E.D. Mich. 1978) (a broker handling a discretionary account becomes a fiduciary and has a duty to monitor).
80. See Use of Derivatives by Registered Investment Companies and Business Development Companies, Release No. IC-31933 (December 11, 2015), proposing new rules for funds investing in derivatives and proposing that certain funds be required to designate a derivates risk manager, who is sufficiently knowl-edgeable about the risks and use of derivatives that he or she can effectively fulfill the responsibilities of their position; and Investment Adviser Due Diligence Processes for Selecting Alternative Investments and Their Respective Managers, OCIE National Exam Program Risk Alert, Vol. IV, Issue 1 (January 28, 2014) (Alternative Investments Risk Alert), listing indicators observed firms used to identify risks with the use of alternative investments, including manager personnel that appeared to be insufficiently knowledgeable about a sophisticated strategy they were purportedly implementing.
81. Advisers have long been held to have a duty to seek best execution of client trades and this duty is commonly referred to as “fiduciary” in nature. See, for example, Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 270-271
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Examples of this might include – ○ using due care when selecting brokers and other trading
venues with a view to maximizing the net result for the client’s trade
○ investing clients in the lowest cost mutual fund share class available for which the client is eligible, and investing con-sistently with disclosures about costs, trading practices and best execution82
○ periodically and systematically evaluating the quality of the execution being provided by the brokers selected, to ensure that they are continuing to provide best execution83
(3d Cir. 1998), which says: “The duty of best execution, which predates the federal securities laws, has its roots in the common law agency obligations of undivided loyalty and reasonable care that an agent owes to his principal.” See also Com-mission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934, Release No. 34-54165 (July 18, 2006): “Fiduciary principles require money managers to seek the best execution for client trades….”; and In the Matter of Everhart Financial Group, Inc., Richard Scott Everhart, and Matthew James Romeo, Advisers Act Release No. 4314 (January 14, 2016) (settled) (Everhart Financial): “Section 206 of the Advisers Act imposes on investment advisers a fiduciary duty to act for the benefit of their clients. That duty includes, among other things, an obligation to seek best execution for client transactions – i.e., ‘to seek the most favorable terms reasonably available under the circumstances.’” (citations omitted). Lastly, see Rule 206(3)-2(c) under the Advisers Act, which refers to the adviser’s duty to act in the best interests of its clients, including the duty “with respect to best price and execution” for client transactions.
82. See Everhart Financial, supra note 81 (adviser found to have failed to seek best execution when it did not choose lowest cost mutual fund share classes for which clients were eligible and failed to disclose that best execution would not be sought for mutual funds with multiple share classes). See also In the Matter of Manarin Investment Counsel, Ltd., Advisers Act Release No. 3686 (October 2, 2013) (settled) and In the Matter of Pekin Singer Strauss Asset Management.
Inc., Advisers Act Release No. 4126 (June 23, 2015) (settled). 83. The SEC has made it abundantly clear that advisers should be assessing their best
execution “periodically and systematically.” See Remarks of Lori Richards, Director of the SEC’s Office of Compliance, Inspections and Examinations (June 14, 2001): “To ensure that advisers are fulfilling their duty of best execution, they are required to ‘periodically and systematically’ evaluate the quality of execution services received from the broker-dealers that are used to execute …trades.” See also, In the Matter of Portfolio Advisory Services, LLC, and Cedd L. Moses, Advisers Act Release No. 2038 (June 20, 2002) (PAS) at III.I, citing Interpretive Release Concerning Scope of Section 28(e) of the Securities Exchange Act of 1934, Release No. 34-23170 (April 23, 1986) (money managers should periodically and
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○ staying apprised of and using reasonably available alternative trading venues (for example, ATSs, ECNs and dark pools) to execute trades when they offer best execution84
DUTY OF LOYALTY:
An adviser’s fiduciary duty of loyalty is generally viewed as requiring the adviser to –
Act in the best interest of clients.85 Examples of this might include – ○ recommending only suitable investments for clients, based
on an appropriate understanding of each client’s circum-stances, goals and risk tolerance86
systematically evaluate the execution performance of broker-dealers executing their transactions).
84. The SEC has indicated that the prices and other benefits offered by ECNs (electronic communications networks) should be considered when seeking best execution. See Order Execution Obligations, Release No. 34-37619A (September 6, 1996) at 176: “[T]he Commission believes that because technology is rapidly making [electronic] systems more accessible, broker-dealers must regularly eval-uate whether prices or other benefits offered by these systems are reasonably available for purposes of seeking best execution of these customer orders.” Although that release refers to the obligations of broker-dealers in executing transactions, the proposition is no less relevant to advisers, who have their own duty to seek best execution. Note also that the release refers to a broker-dealer’s duty of best execution as “fiduciary.”.
85. See ADV Release, supra note 5, at 3: “Under the Advisers Act, an adviser is a fiduciary whose duty is to serve the best interests of its clients….” See also Commission Guidance Regarding the Duties and Responsibilities of Investment Company Boards of Directors with Respect to Investment Adviser Portfolio Trading Practices, Advisers Act Release No. 2763 (July 30, 2008) (2008 Proposed Director Guidance on Soft Dollars), at n. 64: “Under sections 206(1) and (2), in particular, an adviser must discharge its duties in the best interest of its clients….”.
86. See In the Matter of Gregory L. Merrick, Advisers Act Release No. 4366 (April 13, 2016) (settled) (federal collateral bar imposed against adviser who breached his fiduciary duty to clients under Ohio law by liquidating their securities so they could buy insurance products, without conducting a reasonable inquiry into the clients’ investment objectives and financial situation and without sufficient infor-mation to determine if the liquidation was suitable); and In the Matter of Neal R. Greenberg, Advisers Act Release No. 3079 (September 7, 2010) (adviser alleged to have breached its fiduciary duty by recommending hedge funds for investment by conservative, older investors near or in retirement, who wanted low-risk investments offering significant capital protection).
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○ not interpositioning a broker into client trades for the purpose of compensating the broker for referring the client to the adviser, when the broker does not have a role in executing, clearing or settling the trade87
Place the interest of clients above its own.88 Examples of this might include – ○ making decisions to buy or sell securities for a client’s
account on the basis of the client’s best interest and not on the basis of the adviser’s opportunity to earn a commission89 or other fees from the transaction
○ sequencing a client’s trade ahead of the adviser’s proprietary trade, or aggregating the trades together only with full dis-closure and client consent90
○ allocating profitable trades to client accounts rather than to proprietary accounts, or allocating trades to proprietary accounts only when using a fully disclosed, fair, consistently applied methodology91
87. See PAS, supra note 83 (adviser found liable for failing to seek best execution
when broker was interpositioned). 88. The SEC has characterized this as an adviser’s obligation “not to subrogate
clients’ interests to its own.” ADV Release, supra note 5, at 3. See also “Without Fiduciary Protections, It’s ‘Buyer Beware’ for Investors,” Press Release issued by the CFP Board, et al., June 15, 2010, available at: https://www.cfp.net/news-events/latest-news/2010/06/15/without-fiduciary-protections-it’s-buyer-beware-for-investors.
89. In addressing the conflict created by commission-based arrangements, the SEC stated: “The [Form ADV disclosure] item simply recognizes that an adviser that accepts compensation from the sale to a client of securities has an incentive to base investment recommendations on the amount of compensation it will receive, rather than on the client’s best interests, and thus involves a significant conflict of interest.” ADV Release, supra note 5, at 18.
90. See SMC Capital, Inc., SEC Staff No-Action Letter (pub. avail. September 5, 1995) (SEC staff will not recommend enforcement action for breach of fiduciary duty under Section 206 if adviser allocates aggregated trade orders as described in the letter, so long as the practice of aggregating orders will be fully disclosed and no advisory client will be favored over any other client, including those clients in which the adviser or persons associated with the adviser have a direct or indirect beneficial interest).
91. See In the Matter of TPG Advisors LLC d/b/a The Phillips Group Advisors, and Larry M. Phillips, Advisers Act Release No. 4372 (April 19, 2016) (adviser alleged to have breached its fiduciary duty and violated Section 206 by cherry-picking profitable trades and allocating them to favored accounts). Similarly, In the Matter
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○ offering an investment opportunity to clients first, before deciding to take the opportunity for the adviser or its per-sonnel92
○ not improperly inflating client asset values, with the effect of increasing advisory fees93
Avoid conflicts of interest,94 or if not avoided altogether, obtain clients’ informed consent to conflicts after full and frank dis-closure.95 Examples of this might include – ○ not using “soft dollars” (client commissions) to obtain
research from brokers that is used by the adviser for man-aging other accounts and that the adviser would otherwise have to pay for using “hard dollars” out of its own pocket,96
of Bruce A. Hartshorn, Advisers Act Release No. 4371 (April 19, 2016) (settled); In the Matter of Welhouse & Associates, Inc., and Mark P. Welhouse, Advisers Act Release No. 4231 (October 16, 2015) (settled); and In the Matter of J.S. Oliver Capital Management, L.P., Ian O. Mausner, and Douglas F. Drennan, Advisers Act Release No. 3658 (August 30, 2013).
92. See In the Matter of Ronald V. Speaker and Janus Capital Corporation, Release No. IA-1605 (January 13, 1997) (settled) at 4: “[Portfolio manager] breached his fiduciary duty to the fund by taking the investment opportunity in the debentures without disclosing the opportunity to and obtaining the prior consent of the fund (or a disinterested Janus employee authorized to waive this opportunity on the fund’s behalf).”.
93. See In the Matter of Alphabridge Capital Management, LLC, Thomas T. Kutzen, and Michael J. Carino, Advisers Act Release No. 4135 (July 1, 2015) (settled) (adviser found to have breached fiduciary duty by fraudulently inflating valuation of accounts, thereby boosting management and performance fees).
94. See In the Matter of Guggenheim Partners Investment Management, LLC, Advisers Act Release No. 4163 (August 10, 2015) (settled) (adviser found to have breached its fiduciary duty by failing to disclose that one of its senior executives approached an advisory client and received a $50 million loan in order for him to participate personally in an acquisition led by the adviser’s parent).
95. ADV Release, supra note 5, at 3. While in some contexts, disclosure (and consent) has been recognized to “cure” conflicts, the disclosure must be full and frank: “If dual interests are to be served, the disclosure to be effective must lay bare the truth, without ambiguity or reservation, in all its stark significance.” See McGrath Remarks, supra note 47, citing Scott, The Fiduciary Principle, 37 Calif. L. Rev. 539, 544 (1949). See also Conflicts, Conflicts Everywhere, Remarks of Julie M. Riewe, Co-Chief, Asset Management Unit of the SEC Division of Enforcement (Feb. 26, 2015) (Conflicts Remarks), which contains a list of ques-tions advisers should be asking in order to help identify and address conflicts.
96. ADV Release, supra note 5, at 33 and 35.
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or doing so only after making full disclosure of the conflict of interest posed97
○ not investing clients in affiliated mutual funds,98 at least not without waiving fees so as to avoid “double dipping” or, at a minimum, making full disclosure of the conflicts of interest posed99
○ not running side-by-side accounts that invest in the same universe of securities but pay the adviser a differential in fees100 at least not without client consent after disclosure
○ not investing simultaneously in the same securities with clients or, as noted, at least not without client consent101
97. Soft dollars may inherently raise fiduciary issues unless the adviser is also
adhering to Section 28(e) under the Securities Exchange Act of 1934, the so-called soft dollars “safe harbor.” See more on Section 28(e) infra note 104.
98. See ADV Release, supra note 5, at 30: “Conflicts could arise, for example, when an adviser recommends that clients invest in a pooled investment vehicle that the firm advises….” See also In the Matter of JPMorgan Chase Bank, N.A. and J.P. Morgan Securities LLC, Advisers Act Release No. 4295 (December 18, 2015) (settled) (among other things, adviser found to have breached its fiduciary duty by failing to disclose that it designed and operated a retail investment account program with a preference for investing in proprietary mutual funds).
99. See Various Securities Issue Developments, remarks of SEC Commissioner Richard Y. Roberts (June 12, 1993), noting that there is the possibility of “double-dipping” when a portfolio manager places money with in-house mutual funds. See also In the Matter of Sarkauskas and Associates, Inc. and James M. Sarkauskas, Advisers Act Release No. 3669 (September 13, 2003) (settled) (adviser found to have violated Sections 206(1) and (2) by choosing to invest client assets in units that bore transactional sales charges, without disclosing that identical no-load units were available and disclosing the conflict created for adviser and its personnel by receiving transactional fees in addition to asset management fees).
100. Side-by-side management of performance fee accounts with non-performance fee accounts is now a specific disclosure item in Form ADV, Part 2A, Item 6. In proposing this requirement, the Commission stated: “An adviser charging per-formance fees to some accounts faces a variety of conflicts because the adviser can potentially receive greater fees from its accounts having a performance-based compensation structure than from those accounts it charges a fee unrelated to performance (e.g., an asset-based fee). As a result, the adviser may have an incentive to direct the best investment ideas to, or to allocate or sequence trades in favor of, the account that pays a performance fee.” Amendments to Form ADV, Release No. IA-2711 (March 3, 2008) at 19.
101. See Conflicts Remarks, supra note 95, listing a number of questions advisers should ask when identifying conflicts, including does the adviser engage in proprietary trading or investing and, if so, has the firm disclosed its potential
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○ providing to the Board of a mutual fund client any material information about an adviser’s conflicted interest in a proposal102
Not compromise best execution by placing client trades with a broker that provides benefits for the adviser – or the adviser’s other clients103 – at least not without client consent after full and frank disclosure.104 Examples of this might include – ○ not steering clients to custody or trade their advised accounts
with certain brokers that provide the adviser benefits, in the form of research or other advantages (software, back office support, training, promotional assistance, etc.)105
biases and that its investment advice could be tainted by compensation received from any third parties or from proprietary investing?.
102. See IM Guidance Update No. 2016-01 (January 2016): “[T]he staff believes that [an adviser’s] fiduciary duty requires advisers either refrain from recommending the payment of mutual fund assets for distribution or to provide complete information to the mutual fund directors so that they can evaluate the conflict, and determine whether the payment should be made pursuant to a 12b-1 plan.”.
103. See 2008 Proposed Director Guidance on Soft Dollars, supra note 85, noting that there may be incentives for an adviser to compromise its fiduciary obligations to a fund client in its trading activities in order to obtain certain benefits that serve the adviser’s own interests or the interests of other clients, including clients that do not generate brokerage commissions (such as fixed-income funds) and others.
104. Protection from the fiduciary breach that might otherwise occur in that scenario is the basis for the protection afforded under the Section 28(e) safe harbor in the Securities Exchange Act of 1934, when advisers cause clients to “pay up” in order to obtain research or brokerage benefits. See Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Release No. 34- 23170 (April 23, 1986) (footnotes omitted): “In con-nection with the abolition of fixed commission rates on May 1, 1975, money managers and broker-dealers expressed concern that, if money managers were to pay more than the lowest commission rate available to a broker-dealer in return for services other than execution, such as research, they would be exposed to charges that they had breached a fiduciary duty. This concern was based on the traditional fiduciary principle that a fiduciary cannot use trust assets to benefit himself. The purchase of research with the commission dollars of a beneficiary or a client, even if used for the benefit of the beneficiary or the client, could be viewed as also benefiting the money manager in that he was being relieved of the obligation to produce the research himself or to purchase it with his own money.”.
105. See Form ADV, Part 2A, Item 12.D.3.a. requiring advisers to disclose if they have an economic relationship that creates a material conflict of interest with any
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○ not suggesting, recommending or requiring that clients cus-tody and trade their advised accounts with the adviser (if a dual-registered adviser/broker) or the adviser’s affiliated broker, unless commissions are waived or unless commissions are usual and customarily and represent best execution106
○ not using client commissions to pay “give-ups,” that is, to make concealed payments to a broker-dealer that did not provide any services to benefit the advised accounts107
Eliminate all conflicts of interest that might incline the adviser – consciously or unconsciously – to render advice that is not dis-interested, absent appropriate informed consent.108 Examples of this might include – ○ if both types of fee arrangements are available and otherwise
in the client’s best interest, charging commission-based fees to buy-and-hold clients (inactively traded accounts), thereby eliminating the prospect of charging the clients unnecessary on-going fees for very little time, attention and work asso-ciated with their accounts; and charging asset-based fees to clients whose accounts are actively traded, thereby eliminat-ing the prospect of over-trading the accounts and generating
broker-dealer that the adviser routinely recommends, requests or requires that clients direct the adviser to use.
106. See In the Matter of Goelzer Investment Management, Inc. and Gregory W. Goelzer, Advisers Act Release No. 3638 (July 21, 2013) (settled) (although adviser disclosed that transactions for advisory clients would generally be effected through itself as broker, adviser nonetheless found to have failed to seek best execution because it did not assess itself as broker for its clients, did not compare what it offered clients to the services and costs available at other brokerage firms or generally take steps to ensure that it was seeking best price and execution).
107. See SEC Interpretive Release: Commission Guidance Regarding Client Com-mission Practices Under Section 28(e) of the Securities Exchange Act of 1934, SEC Release No. 34-54165 (July 24, 2006) (2006 Soft Dollar Interpretation) at 53-54: “A principal concern regarding ‘give-ups’ was that managers used them to direct client commissions to broker-dealers in exchange for providing services that benefited the money manager but had no benefit for his clients – such as to reward broker-dealers for distribution or for steering clients to the manager.”.
108. See In the Matter of Dawson-Samberg Capital Management, Inc., Now Known as Dawson-Giammalva Capital Management, Inc. and Judith A. Mack, Advisers Act Release No. 1889 (August 3, 2000) (Dawson-Samberg), citing Capital Gains, 375 U.S. at 191-92.
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commissions in excess of what an a typical asset-based fee account would pay over time109
○ not shorting securities that are held long in other client accounts managed by the adviser110
○ not setting higher pay-outs or other incentives for personnel to place client assets into the adviser’s proprietary mutual funds or funds that pay extra fees to the adviser, rather than other available fund choices111
109. See People Handling Other Peoples’ Money, remarks of Andrew J. Bowden,
Director of SEC’s OCIE (March 6, 2014): “[O]ne of the areas where we are actively looking for undisclosed and unmitigated conflicts is the trend among dually registered firms to move their clients’ assets from commission-based bro-kerage accounts to fee-based wrap accounts that offer advice and no-commission trading for one bundled asset-based fee.” See also Examination Priorities for 2016, SEC Office of Compliance and Examinations (OCIE) (2016 Exam Pri-orities), noting that OCIE will continue to make fee selection and reverse churning a priority, examining advisers and dually-registered adviser/brokers that offer a variety of fee arrangements (such as asset-based fees and commissions) to see if recommendations of account types are in the best interest of the investor at the inception of the arrangement and thereafter, including fees charged, services provided and disclosures made about the arrangements.
110. In addition to breaching its fiduciary duty by buying securities for its own account, then selling them after the price increase resulting from its recom-mendations that clients buy, the adviser in the Capital Gains case, supra note 1, also engaged in short selling against its clients. According to the Court’s opinion, on at least one occasion, the adviser sold short some shares of a security immediately before stating in a report that the security was overpriced. After the publication of the report, the adviser covered its short sales at a price lower than the sale price. See Capital Gains case, supra note 1, Appendix to the Opinion of the Court.
111. See In the Matter of Banc of America Investment Services Inc. and Columbia Management Advisors, LLC, Advisers Act Release No. 2733 (May 1, 2008) (settled) (adviser found to have breached its fiduciary duty to wrap fee clients by favoring affiliated funds in investing process, inconsistent with disclosures); and Everhart Financial, supra note 81 (adviser found to have failed to disclose that 12b-1 fees paid by certain funds to adviser and its personnel created incentive for them to select those funds or classes for client accounts over others with lower expenses). See also Morgan Stanley DW Inc., Securities Exchange Act Release No. 48789 (November 17, 2003) (settled) (respondent did not adequately disclose conflict involved in program payments made to its financial advisors that incentivized them to encourage customers to make and retain investments in funds participating in the program over other available funds).
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Not use clients’ assets for the adviser’s own benefit112 or the benefit of other clients, at least without client consent. Examples of this might include – ○ not using client commissions to obtain perks or benefits
from brokers, such as gifts, travel or entertainment, personal benefits or other gratuities113
○ not excessively trading a client’s account for the purpose of generating soft dollar credits used to benefit the adviser114
○ not using client commissions to reward brokers for referring clients to the adviser115
Avoid self-dealing (absent appropriate consent).116 Examples of this might include – ○ not engaging in principal trades with client accounts117 or
doing so only in accordance with Section 206(3) of the Advisers Act118
○ not executing trades for the adviser’s own clients (if the adviser is a dual-registered adviser/broker) or using the adviser’s affiliated broker for executing client trades, unless
112. See 2008 Proposed Director Guidance on Soft Dollars, supra note 85, at 23:
“Second, investment advisers, as fiduciaries, generally are prohibited from receiving any benefit from the use of fund assets….”.
113. See FMR, supra note 6 (Fidelity found to have breached its fiduciary duties to clients by allowing traders to accept excessive travel, entertainment, gifts and gratuities from brokers with whom client trades were placed, resulting in a sub-stantial possibility of higher execution costs).
114. See Securities and Exchange Commission v. Gordon J. Rollert (USDC D. Mass.), No. 01-Civ.-10237-JLT, SEC Lit. Release No. 18687 (April 29, 2004).
115. ADV Release, supra note 5, at 36. 116. Brave New World, supra note 41, at 4. 117. See In the Matter of Citigroup Global Markets, Inc., Advisers Act Release
No. 4178 (August 19, 2015) (settled) (adviser found to have failed to detect and prevent improper principal transactions); and In the Matter of Strategic Capital Group, LLC and N. Gary Price, Advisers Act Release No. 3924 (Sept. 18, 2014) (settled) (found that principal transactions executed through adviser’s affiliated broker violated Section 206(3)).
118. See In the Matter of Shadron L. Stastney, Advisers Act Release No. 3671 (September 18, 2013) (Stastney) (settled) (adviser found to have breached his fiduciary duty to fund advisory client by failing to disclose a material conflict of interest to the Trustee of the fund and engaging in an undisclosed principal transaction with the fund).
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commissions are waived or unless commissions are usual and customarily and represent best execution119
○ not hiring affiliates of the adviser to service client accounts at the client’s expense, unless they are the lowest cost provider for the appropriate type, scope and quality of service120
DUTY OF OBEDIENCE:
As noted previously, there are sources that refer to an adviser’s duty of obedience separately from its duty of care and loyalty. Under this duty, an adviser must –
Adhere to the terms of any governing trust or organic legal documentation.121 Examples of this might include – ○ investing client assets only in securities and other invest-
ments in accordance with legal requirements,122 the client’s
119. See In the Matter of Alan Gavornik, Nicholas Mariniello and Lee Argush, Advisers Act Release No. 3972 (November 24, 2014) (settled) (adviser and principals found to have breached their fiduciary duty to clients by arranging for unaffiliated broker to execute client trades for a $0.04 - $0.06 per share, then paying all commissions in excess of $0.01 per share over to adviser’s affiliated broker as an undisclosed “referral fee”); and In the Matter of Goelzer Investment Management, Inc. and Gregory W. Goelzer, Advisers Act Release No. 3638 (July 21, 2013) (settled) (although adviser disclosed that transactions for advisory clients would generally be effected through itself as broker, disclosure was nonetheless found to be misleading because it said execution would be consistent with adviser’s duty of ‘best execution’ even though adviser did not did not assess itself as broker for its clients, did not compare what it offered clients to the services and costs available at other brokerage firms or generally take steps to ensure that it was seeking best price and execution).
120. In the Matter of Smith Barney Fund Management LLC and Citigroup Global Markets, Inc., Advisers Act Release No. 2390 (May 31, 2005) (settled) (adviser found to have put its interests ahead of its client’s when, without full disclosure to fund Board, adviser recommended fund hire adviser’s affiliate as transfer agent, in an arrangement that allowed affiliate to keep significant profits even though it was merely sub-contracting with an unaffiliated transfer agent to do the bulk of the work at a deeply discounted rate).
121. McGrath Remarks, supra note 47, at p.7. 122. See In the Matter of Gray Financial Group, Inc., Laurence O. Gray and Robert
C. Hubbard, IV, Advisers Act Release No. 4094 (May 21, 2015) (pension consultant adviser alleged to have breached its fiduciary duty to Georgia-based public pension fund client by recommending and selling to it propriety fund-of-fund investments that were in violation of Georgia law); and Ambassador Capital, supra note 6 (adviser and portfolio manager alleged to have caused
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trust instrument, charter, investment policy statement or dis-closure documents123
○ providing all data, notices, reports and other information called for from the adviser in governing documents
Follow any instructions or guidelines provided by the client.124 Examples of this might include – ○ adhering to instructions from clients concerning imper-
missible investments (such as socially-screened investments), managing their accounts (such as approved brokers or directed brokerage)125 and handling transactions in their accounts (such as account transfers, liquidations, aggregated assets, tax lot considerations, and the like)
DUTY TO ACT IN GOOD FAITH:
Sources that address an adviser’s duty to act in good faith indicate that an adviser must126 –
money market fund’s failure to comply with risk limits imposed by Investment Company Act Rule 2a-7).
123. See Riad/Swanson, supra note 6 (by failing to invest fund assets consistently with fund’s disclosed principal investment strategy, portfolio managers caused fund and adviser to violate various securities statutes and rules); similarly, In the Matter of Chariot Advisors, LLC and Elliott L. Shifman, Advisers Act Release No. 3653 (August 21, 2013).
124. See Richards Fiduciary Speech, supra note 45, discussing an adviser’s fiduciary duties and measures some advisers take in order to ensure that portfolio trans-actions are consistent with disclosures to and instructions from the client.
125. Advisers adhering to client instructions regarding directed brokerage must also make appropriate disclosures regarding the effect of directing brokerage on other fiduciary matters such as the adviser’s ability to achieve the most favorable execution. See Form ADV, Part 2A, Item 12.D.; and In the Matter of Mark Bailey & Co. and Mark Bailey, Advisers Act Release No. 1105 (February 24, 1988).
126. In the corporate context, one court explained: “A failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fidu-ciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. There may be other examples of bad faith yet to be proven or alleged, but these three are the most salient.” Stone ex rel. AmSouth Bancorporation v. Ritter, 911 A.2d 362 (Del. 2006) at text surrounding footnote 26 (footnote omitted). This same court concluded that the duty of good faith is essentially a subset of the duty of loyalty.
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Act honestly toward clients with candor and utmost good faith.127 Examples of this might include – ○ being materially truthful and accurate in all communications
and disclosures128 ○ being forthright about issues, mistakes and conflicts of
interest129 ○ providing fund directors with all information in the adviser’s
possession that reasonably bears on a fund Board decision, particularly where the adviser has a personal interest in the outcome or other conflict of interest130
Treat clients fairly.131 Examples of this might include – ○ adopting investment opportunity, aggregation, allocation and
other trading procedures and applying them consistently over
127. Capital Gains, supra note 1, at text surrounding footnote 44. 128. See In the Matter of Blackstone Management Partners L.L.C., et al., Advisers
Act Release No. 4219 (October 7, 2015) (settled) (advisers agreed to pay nearly $39 million to settle allegations that they breached their fiduciary duty to investors in violation of Advisers Act Section 206 by failing to properly disclose fees).
129. See SEC v. Anand Sekaran and Wasson Capital Advisors Ltd., Case No. 12-civ- 8199 (USDC SDNY, filed Nov. 9, 2012) (settled) referenced in the SEC’s Press Release 2012-224 (Nov. 9, 2012): “An investment adviser’s fiduciary duty applies equally in good times and bad….Sekaran breached that duty when he concealed trading losses and misled clients rather than simply admitting that his investment strategy was unsuccessful.”.
130. See In the Matter of BlackRock Advisors, LLC, and Bartholomew A. Battista, Advisers Act Release No. 4065 (April 20, 2015) (settled) (adviser found to have breached its fiduciary duty to fund and advisory clients by not disclosing a material conflict); and Stastney, supra note 118 (adviser alleged to have breached his fiduciary duty to fund advisory client by failing to disclose a material conflict of interest to the Trustee of the fund and engaging in an undisclosed principal transaction with the fund).
131. ADV Release, supra note 5, at 3. See also Private Equity Enforcement Concerns, remarks of Bruce Karpati, Chief, SEC Enforcement Division’s Asset Management Unit (Jan. 23, 2013), expressing concern that private equity fund managers who offer co-investment opportunities only to certain favored clients may be violating their fiduciary duty to other clients who may also be interested in such opportunities.
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time so that no client or group of clients is systematically disadvantaged132
○ allocating shared costs fairly across accounts using a rational methodology applied consistently over time133
○ seeking a fair and prompt resolution of all legitimate client complaints
DUTY OF DISCLOSURE:
Today, an adviser’s duty to disclose goes beyond its fiduciary duty and has been expanded by numerous specific regulatory require-ments, such as Form ADV. However, viewed even at a fundamental fiduciary level, an adviser must –
Provide full and fair disclosure of all material facts to clients and prospective clients.134 Examples of this might include – ○ ensuring that disclosures contain all facts that a reasonable
investor ought to know in order to make an informed deci-sion about investing135
○ ensuring that communications and disclosures are materially complete so as to provide a fair and balanced picture136
132. See In the Matter of Western Asset Management Co., Advisers Act Release
No. 3762 (January 27, 2014) (settled) (by cross trading securities among client accounts at the bid, rather than at an average between the bid and the ask, adviser found to have favored the buyers in the transactions over the sellers, even though both were advisory clients and owed the same fiduciary duty).
133. See In the Matter of Lincolnshire Management, Inc., Advisers Act Release No. 3927 (Sep. 22, 2014) (settled) (expense allocation policy among advised private equity funds was not followed, resulting in one portfolio company (and indirectly the fund that owned it) paying more than its share of certain expenses, in turn resulting in a breach of the adviser’s fiduciary duty to the funds and violation of Section 206(2) of the Advisers Act); and In the Matter of Clean Energy Capital, LLC and Scott A. Brittenham, Advisers Act Release No. 3955 (October 17, 2015) (settled) (adviser found to have misallocated expenses among funds).
134. Capital Gains, supra note 1, at text surrounding footnote 44. 135. See Dawson-Samberg, supra note 108 (adviser and officer found liable for
failing to adequately disclose soft dollar arrangements, violating Section 206(2) among other provisions).
136. See In the Matter of The Dreyfus Corporation and Michael L. Schonberg, Advisers Act Release No. 1870 (May 10, 2000) (adviser and portfolio manager found
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○ disclosing all pertinent information about an adviser’s com-pensation137
Not mislead clients.138 Examples of this might include – ○ avoiding advertisements, communications and other disclo-
sures139 that contain only a partial truth, leaving an exagger-ated, unwarranted or other potentially misleading impression140
Certainly, the above list of fiduciary duties is not exhaustive, but it does include many of the common duties that an adviser might face, along with examples intended illustrate how they might apply in practice.
liable under Section 206(2) for not disclosing IPO practices that had a material effect on fund’s performance).
137. See Total Wealth Management, supra note 78 (respondents alleged to have breached their fiduciary duty to clients by failing to adequately disclose material information about revenue sharing fee arrangements and the conflicts of interest posed by these arrangements; Form ADV merely stated adviser “may” receive revenue sharing fees, but failed to state adviser was already receiving those fees and inform investors about the sources, recipients, amounts and duration of the fees).
138. Capital Gains, supra note 1, at text surrounding footnote 45. See also In the Matter of Oxford Investment Partners, LLC and Walter J. Clarke, Advisers Act Release No. 3412 (May 30, 2012) (adviser alleged to have repeatedly breached its fiduciary duty by recommending investments without telling clients about his personal stake and exploiting a client who was buying an ownership share in the firm).
139. See In the Matter of Raymond L. Lucia Companies, Inc., and Raymond J. Lucia, Sr., Advisers Act Release No. 4190 (September 3, 2015) (adviser found to have violated his fiduciary duties to prospective clients and betrayed their trust and confidence by misleading use of “backtested” performance information in slideshow presentations).
140. See the report entitled “Protecting Senior Investors: Report of Examinations of Securities Firms Providing ‘Free Lunch’ Sales Seminars,” issued by the SEC in conjunction with FINRA and NASAA (September 2007), finding numerous securities firms using advertisements with exaggerated and unwarranted claims. See also In the Matter of Alpha Fiduciary, Inc., and Arthur T. Doglione, Advisers Act Release No. 4283 (November 30, 2015) (settled) (adviser found in violation of Section 206 by using misleading advertisements); and In the Matter of Richard W. Suter and Richard W. Suter d/b/a National Investment Publishing Company, Administrative Proceeding File No. 3-6038 (August 27, 1982) (adviser did not meet applicable standards as fiduciary when using advertisements that contained exaggerated statements about how investors would profit).
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WHAT EMERGING ISSUES IMPACT AN ADVISER’S FIDUCIARY DUTIES?
Recent regulatory developments and high-profile industry scandals have raised questions about whether an adviser’s fiduciary duty applies – or can be adequately discharged – in various emerging areas of concern. A number of these are addressed below.
Duty to Oversee Sub-Advisers and Other Service Providers
The largest Ponzi scheme in history – the Bernard Madoff affair – sharpened questions about whether the advisers and fund managers that placed their clients’ assets with Madoff could be held liable for failing to properly vet and oversee his operations. Cases raising these issues141 have led to the basic question of whether an adviser’s fidu-ciary duties include – or should include – the duty to conduct adequate due diligence on and oversight of sub-advisers with whom an adviser invests a client’s assets.142
141. See, for example, Anwar, et al., v. Fairfield Greenwich Limited, et al., USDC
SDNY, 2015 U.S. Dist. LEXIS 100773 (July 29, 2015), in which the court stated: “In numerous rulings in this litigation, the Court has repeatedly held that alle-gations that the Standard Chartered Defendants conducted no due diligence…or that the Defendants failed to monitor investments after aggressively recom-mending continued investment in the Funds, satisfactorily plead breach of fiduciary duty.” See also In the Matter of Hennessee Group LLC and Charles J. Gradante, Advisers Act Release No. 2871 (April 22, 2009) (settled) (adviser/ hedge fund consultant found to have violated Section 206(2) for failing to perform due diligence on the Bayou Fund, which subsequently collapsed; SEC order stated that respondents, in their capacity as investment advisers, “owed fiduciary duties to their clients to perform the services that they represented they would provide and to disclose all material departures from the representations that they made to their client”); In the Matter of Fairfield Greenwich Advisors LLC and Fairfield Greenwich (Bermuda) Ltd., Consent Order of the Com-monwealth of Massachusetts Office of Attorney General, Docket No. 2009-0028 (September 8, 2009) (settled) (state action against feeder fund manager that funneled investor funds to Madoff without conducting represented due diligence); and People of the State of New York v. J. Ezra Merkin, et al., 26 Misc.3d 1237(A), 2010 WL 936208 (N.Y.Sup.) (slip op. Feb. 8, 2010) (state action charged fund manager with, among other things, breach of fiduciary duty for failing to conduct due diligence, supervise, or monitor and manage investments in Madoff funds). Also SEC v. Stanley Chais, SEC Litigation Release No. 21096 (SDNY Civ. 09 CV 5681) (June 22, 2009) (securities fraud charged against manager of feeder funds for intentionally or recklessly ignoring signs of Madoff’s fraud).
142. See Duty of Due Diligence article, supra note 67.
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Even before Madoff, there seemed to be little doubt that an adviser could be held liable if it did not conduct adequate due dil-igence on sub-advisers, in particular if it represented to clients that it would vet the firms and would conduct periodic oversight as well.143 Depending on the case, however, the adviser’s violation might be characterized as breach of a fiduciary duty, or as a violation of statutory law,144 fraud provisions (misleading disclosures), contract provisions, SEC rules or orders or other violations.145 Today, however, the risk of an adviser being found liable for sub-adviser failures – under one theory or another – is greater than ever.146 Notably, the SEC staff has characterized an adviser’s duty to select and oversee other advisers as “fiduciary” and has observed that those duties also
143. In a case that long preceded Madoff, Patrick V. Morris, et al. v. Wachovia
Securities, Inc., 277 F. Supp. 2d 622 (E.D. Va. 2003), private plaintiffs sued an adviser alleging, among other things, failure to adequately monitor the portfolio managers that were handling the plaintiff’s account as part of a program offered by the adviser. The court permitted the plaintiff’s claim for rescission of the advisory agreement to go forward on the basis of a violation of Section 206(2) of the Advisers Act, on the theory that the adviser fraudulently induced the plaintiff to enter its program with untrue promises to monitor the portfolio managers for performance and for adherence to their advertised strategies. The plaintiffs’ claims under Rule 10b-5 were not permitted to go forward on pleadings grounds. In a subsequent ruling, summary judgment was granted in favor of the defendant on all remaining claims.
144. See, for example, In the Matter of Morgan Stanley & Co., Inc., Admin. Proc. File No. 3-13588 (SEC July 20, 2009) (firm sanctioned for violating Advisers Act Section 206(2), among other provisions, by breaching its fiduciary duty to certain clients and prospective clients by telling them that recommended investment managers had been approved through the firm’s due diligence and on-going monitoring process when they had not).
145. For a more complete discussion of an adviser’s potential liability for failure to oversee sub-advisers, see Lorna A. Schnase, “Can an Adviser be Liable for the Wrongdoing of Another Adviser?” IAA Newsletter Compliance Corner (April 2009). For a case where a broker representative’s lack of due diligence was found to have aided and abetted violations by an adviser, see Rolf v. Blyth, Eastman Dillon & Co., Inc., and Michael Scott, 570 F.2d 38 (2nd Cir.), cert. denied, 439 U.S. 1039 (1978) (rep constantly reassured client about adviser “without investigation and with utter disregard for whether there was a basis for the assertions,” and rendered substantial assistance to adviser in the fraudulent mismanagement of client’s portfolio by engaging in a “hand-holding operation” to prevent client from discovering the fraud).
146. See Virtus, supra note 75 (adviser found in violation of various provisions in Section 206 for misleading performance information provided by sub-adviser and for not having adequate due diligence procedures in place for hiring and retaining sub-advisers and ensuring the accuracy of third-party produced per-formance information and marketing materials).
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extend to other service providers – custodians, administrators, auditors and the like – to which the client’s assets are exposed.147
Duty to Vote Proxies
For years, advisers often did not vote proxies on behalf of client accounts, believing that the task was too costly and time consuming and that their clients’ small holdings were unlikely to make a dif-ference in the outcome anyway. Instead, they reportedly followed the “Wall Street Rule” that if they became dissatisfied with management, they simply sold the stock.148
However, more recently advisers and other institutional share-holders have been criticized for not voting proxies given their enormous collective voting power, along with their ability in some cases to affect the outcome of shareholder votes and influence corporate governance.149 In other cases, advisers were criticized for voting proxies in a manner that may inure to the adviser’s own benefit, but not necessarily to the client’s benefit.150
147. See Alternative Investments Risk Alert, supra note 80, noting that advisers are
fiduciaries and must act in their clients’ best interest, including in the due dili-gence process of selecting alternative investments and their managers. See also Richards Compliance Issues, supra note 76, noting that advisers are fiduciaries and discussing an adviser’s supervision of service providers – including sub-advisers – and indicating that on a continuing basis, the adviser must concern itself with whether sub-advisers are providing the level of fiduciary care that the adviser itself provides to its clients. See also In the Matter of Western Asset Management Co. and Legg Mason Fund Adviser, Inc., Advisers Act Release No. 1980 (Sept. 28, 2001) (settled) (adviser found to have failed to supervise employee of sub-adviser under Section 203(e)(6)).
148. See the “Wall Street Rule” referenced in SEC Release No. 33-8188 (Jan. 13, 2003). 149. For example, see the discussion in Burton Rothberg and Steven Lilien, “Mutual
Funds and Proxy Voting: New Evidence on Corporate Governance,” Journal of Business & Technology Law (Vol. 1, No. 1 2006).
150. This was one theme behind the allegations against an adviser and its COO in the administrative proceeding In the Matter of INTECH Investment Management LLC and David E. Hurley, Advisers Act Release No. 2872 (May 7, 2009) (settled), where the adviser had directed a proxy voting firm to use AFL-CIO-based proxy voting guidelines for voting proxies in all its client accounts, not just union-related accounts, at the same time that the adviser was participating in an AFL-CIO adviser ranking survey that ranked advisers based on their adherence to AFL-CIO recommendations on certain votes. An improved score on the survey could ostensibly help the adviser to retain and attract more business from union-related clients. This conflict of interest, according to the SEC order, was not addressed adequately in the adviser’s proxy voting procedures. See also letter from Douglas Scheidt, Associate Director and Chief Counsel, SEC Division of
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These criticisms came to a head, leading to the SEC’s adoption of Rule 206(4)-6 under the Advisers Act,151 which in substance makes it fraudulent for an adviser to exercise proxy voting authority without having procedures reasonably designed to ensure that the adviser votes in the best interest of clients, including procedures to address material conflicts that may arise between the adviser’s interests and those of its clients.
In this process, the SEC confirmed that advisers with discretion to vote proxies have a fiduciary duty with respect to their proxy voting authority. In the Adopting Release, the SEC said:
“The federal securities laws do not specifically address how an adviser must exercise its proxy voting authority for its clients. Under the Advisers Act, however, an adviser is a fiduciary that owes each of its clients duties of care and loyalty with respect to all services undertaken on the client’s behalf, including proxy voting. The duty of care requires an adviser with proxy voting authority to monitor corporate events and to vote the proxies. To satisfy its duty of loyalty, the adviser must cast the proxy votes in a manner consistent with the best interest of its client and must not sub-rogate client interests to its own.”152
This does not mean that advisers would necessarily breach their fiduciary duty if they did not vote a particular proxy. The SEC acknowledged this when adopting Rule 206(4)-6 by stating:
“We do not suggest that an adviser that fails to vote every proxy would necessarily violate its fiduciary obligations. There may even be times when refraining from voting a proxy is in the client’s best interest, such as when the adviser determines that the cost of voting the proxy exceeds the expected benefit to the client. An adviser may not, however, ignore or be negligent in fulfilling the obligation it has assumed to vote client proxies.”153
These developments have been a catalyst for advisers to rethink their approach to voting proxies.154 Meanwhile, similar issues have
Investment Management, to Egan-Jones Proxy Services (May 27, 2004), addressing an adviser’s fiduciary duty in voting proxies.
151. Similar companion rules were also adopted for funds under the Investment Company Act. See Release No. 33-8188 (Jan. 13, 2003).
152. Proxy Voting by Investment Advisers, Release No. IA-2106 (Jan. 31, 2003) (Proxy Adopting Release) (footnotes omitted). An adviser’s fiduciary duties with respect to proxy voting were reiterated in Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms, SEC Staff Legal Bulletin No. 20 (IM/CF) (June 30, 2014) (SLB20).
153. Proxy Adopting Release, supra note 152 (footnotes omitted). See also SLB20, supra note 152, at Question 2.
154. See Rebecca C. Grapsas, “New Proxy Advisory Firm Developments: What They Mean for Corporate Issuers,” Insights: The Corporate & Securities Law Advisor -
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been raised with regard to an adviser’s duty to act on behalf of client accounts in class action lawsuits (filing proofs of claim), tender offers, mergers, bankruptcies and similar shareholder actions.155
Duty to Assess a Client’s Mental Competence
Regulators have been very vocal recently about “seniors issues,” with the aim of protecting older investors who may be more vulnerable to fraud or abuse.156 As part of this effort, the SEC, NASAA and FINRA identified and published in a 2008 report approaches that some financial firms use to address seniors issues, including elder financial abuse and the sensitive and sometimes subtle issue of dimin-ished mental capacity.157
It is not very surprising that advisers could be held liable if they defraud or otherwise “abuse” an elderly client financially speaking. However, holding advisers responsible – under fiduciary principles or any other legal theory – for assessing a client’s mental competence would seem to be a radical departure from anything advisers have been held responsible for in the past and outside the professional competence of most advisers.158
Nevertheless, more issues in this area are likely to arise in the coming years as an increasing number of investors reach senior status
Goodman (August 31, 2014), which discusses the Q&As in SLB20, supra note 152, relating to compliance by investment advisers with proxy voting fiduciary duties.
155. See Steven W. Stone and Ryan F. Helmrich, “The Role of Investment Advisers in Client Class Action Claims,” article published by Morgan, Lewis & Bockius LLP (2005), arguing that advisers should not be lawfully responsible for these sorts of matters absent a contractual understanding to the contrary.
156. The SEC has held a number of Senior Summits, in conjunction with FINRA, NASAA and AARP, as part of an overarching effort to protect the nation’s seniors. See Senior Events and Enforcement Actions at: http://www.sec.gov/ investor/seniors/seniorsevents.htm. See also “For Seniors” on the SEC’s website at: http://www.sec.gov/investor/seniors.shtml.
157. The full report can be found here: http://www.sec.gov/spotlight/seniors/ seniorspracticesreport092208.pdf. Some of these and similar measures are outlined in the FPA/AARP publication “A Financial Professional’s Guide to Working with Older Clients.”.
158. Even the cases cited by a regulators’ Investor Alert for seniors seem to be based on fraud or suitability issues, and not on the more difficult issue of whether the adviser failed to detect that the investor lacked the mental capacity to consent. See “Investor Alert – Investment Products and Sales Practices Commonly Used to Defraud Seniors: Stories from the Front Line,” at http://www.sec.gov/ spotlight/seniors/elderfraud.pdf.
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and questions are raised about whether advisers have taken advantage of them or otherwise treated them improperly in light of their dimin-ished mental capacity. Incompetence is already covered in the law generally159 although many states are now supplementing existing laws by enacting Elder Abuse statutes160 addressing abuse, capacity and similar issues specifically with respect to “vulnerable adults.” In most cases, however, liability to an adviser under those statutes would result only in the case of fraud, deception or, perhaps in a more subtle case, where the adviser “knows, or should know” that the vulnerable adult lacks the capacity to consent.161
One case discussing these issues faces head-on the question of whether a financial advisor has the duty to assess a client’s mental capacity. There, the court held that at least stockbrokers do not,162 stating:
[W]e acknowledge that the risk that an elderly person may not appreciate the significance of a stock transaction is neither improbable nor unfore-seeable, but this risk must be balanced against the utility of affording an elderly person the same services available without question to younger people…. There simply is no responsibility on the part of service pro-viders in general or stockbrokers in particular to determine the competence of their clients.
…
Another factor in the duty equation is burden of the duty. Stockbrokers and other service providers cannot be expected to have any expertise in assessing mental capacity. The burden of making this assessment is thus especially great. A service provider should not be put to choosing between refusing to assist an elderly person with legitimate transactions and incur-ring liability for providing such assistance when the provider lacks any qualification for determining competence. A stockbroker’s fiduciary obli-gation to a client does not include the duty to ascertain the client’s mental competence.163
159. The legal effect of dealing with parties lacking capacity may be addressed in the
law of contracts, or under consumer protection or deceptive trade practice statutes. See the discussion in Section II.B. and n. 85 of Lisa A. Catalano and Christine Lazaro, “Financial Abuse of the Elderly: Protecting the Vulnerable,” PISABA Bar Journal (Fall 2008), pp. 11-15 (Elder Abuse article).
160. For a discussion of various statutes passed or under consideration by various states, see Elder Abuse article, supra note 159, pp. 11-15.
161. Id. 162. Edward D. Jones & Company, and Delmar “Bo” McKinney, Petitioners, v. Pat
Letcher, Independent Executrix of the Estate of Beatrice Clark Cairns, Deceased, Respondent, 975 S.W.2d 539 (Tex. Sup. Ct. 1998) (Edward Jones Case).
163. Id. at 544 (emphasis added).
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It is not clear whether this case would have come out differently if the financial advisor was an investment adviser rather than a stockbroker. One view is that it would not, given that the court spoke broadly about stockbrokers and other “service providers” and that the court’s rationale (service providers have no expertise to assess mental capacity) would apply to both advisers and brokers.164 Moreover, the most logical basis for holding advisers to any standard different than brokers would be the adviser’s fiduciary duty, and the court in this case specifically stated that stockbrokers owe fiduciary obligations to their clients, even though that does not include a duty to assess mental competence.165 However, until the law is more fully developed nation-wide, it remains to be seen whether advisers under any circumstance will be held to have a legal duty – fiduciary or other – to ascertain a client’s mental competence.
Importantly, some advisers are not waiting for the law to develop in this area, but rather are being proactive to head off problems with their aging clients by adopting specific compliance policies and pro-cedures. For example, some focus on the client on-boarding process, making sure that individual clients provide the adviser with a copy of any power of attorney or similar instrument the client has already signed designating an attorney, trustee or other fiduciary to act on the client’s behalf in the event of incapacity. If none already exists, advisers may get the client’s written consent to having the adviser contact a trusted friend or family member in the event the adviser suspects capacity issues.166
Other advisers are training employees to spot “red flags” that may evidence financial abuse and diminished capacity,167 along the lines outlined in the regulators’ 2008 report referred to above. Note,
164. This raises the further issue of what would have happened if the stockbroker had
held himself out as a “senior certified” expert or credentialed in some other way on retirement, elderly or senior matters, which has been the subject of recent regulatory concern as well. See NASAA Model Rule on the Use of Senior-Specific Certifications and Professional Designations (Adopted March 20, 2008) at http://www.nasaa.org/wp-content/uploads/2011/07/3-Senior_Model_Rule_ Adopted.pdf.
165. Edward Jones Case, supra note 162, at 544. 166. See FINRA Notice 15-37 Financial Exploitation of Seniors and Other
Vulnerable Adults (October 2015), with similar proposals along these lines for broker-dealers.
167. See, for example, the Morgan Stanley slide presentation on Working with Senior Investors, at: http://www.sec.gov/investor/seniors/workingwseniors.pdf, including steps to take when signs of diminished mental capacity or elder financial abuse are detected.
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however, that actions taken in response to “red flags” can themselves raise difficult issues, such as potential claims for breach of the duty of obedience by not adhering to the client’s instructions and/or breach of privacy rights if suspicions of diminished capacity are brought to the attention of other family members or outsiders without the client’s consent. As such, advisers may be better served by developing internal policies and procedures to guide employees on the appropriate response to capacity issues, which may well include escalating the matter to the firm’s legal or compliance personnel.168
Duty to Protect Client Assets from Business Disruptions
Advisers have long been urged to consider business continuity planning (“BCP”) in the process of formulating their compliance policies and procedures under the Advisers Act Rule 206(4)-7, the adviser compliance rule.169 BCP has been described to include pro-tecting client assets from disruptions that could occur, for example, in the aftermath of a natural disaster or in the event of the unavailability of critical firm personnel.170 Importantly, the obligation to have a rea-sonably designed business continuity plan is viewed as “fiduciary.”171
Since adoption of the compliance rule in 2003, advisers have gained considerable BCP experience in handling disruptions due to
168. See Protecting Older Investors: The Challenge of Diminished Capacity, AARP
Policy Institute Research Report (November 2011) at 18, stating firms surveyed differ in their responses to diminished client capacity, but most included escalation to a supervisor or compliance department.
169. In brief, the compliance rule requires advisers to implement compliance policies and procedures reasonably designed to prevent, detect and correct violations of the Advisers Act. See Advisers Act Rule 206(4)-7 and the Adopting Release for the rule at Compliance Programs of Investment Companies and Investment Advisers, Release No. IA-2204 (Dec. 17, 2003) (Compliance Programs Adopting Release), where BCP was listed as one of 10 key areas advisers should address when designing their compliance programs.
170. See Compliance Programs Adopting Release, supra note 169 at footnote 22: “We believe that an adviser’s fiduciary obligation to its clients includes the obligation to take steps to protect the clients’ interests from being placed at risk as a result of the adviser’s inability to provide advisory services after, for example, a natural disaster or, in the case of some smaller firms, the death of the owner or key personnel. The clients of an adviser that is engaged in the active management of their assets would ordinarily be placed at risk if the adviser ceased operations.”.
171. Id.
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natural disasters.172 However, concerns linger in two areas regarding BCP:
First, concerns linger over the protection of computers and other technology that serve as the backbone for systems relied on by advisers as well as others in the financial services industry, particularly due to threats stemming from a man-made cause. As such, the SEC has turned laser-like attention to cybersecurity in recent years, urging advisers to address cybersecurity in connection with their BCP.173 Cybersecurity is expected to remain a high priority for SEC exam-inations of advisers174 as well as for other regulators.175
Second, concerns also linger in the area of “transition planning,” that is, planning for business disruptions that are so significant that transitioning client assets away from an adviser is warranted.176 In contrast to a business continuity plan that focuses on natural disasters or computer outages, transition plans would focus more on risks unique to a particular adviser’s business, such as the death or departure of
172. See, for example, the SEC ComplianceAlert (June 2007), discussing lessons
learned from Hurricane Katrina, as observed by the SEC staff; and SEC Examinations of Business Continuity Plans of Certain Advisers Following Oper-ational Disruptions Caused by Weather-Related Events Last Year, OCIE National Exam Program Risk Alert, Vol. II, Issue 3 (August 27, 2013), discuss-ing the examination of 40 advisers’ business continuity plans in the wake of Superstorm Sandy.
173. See Cybersecurity Guidance, IM Guidance Update No. 2015-02 (April 2015): “[T]he compliance program of a fund or an adviser could address cybersecurity risk as it relates to identity theft and data protection, fraud, and business continuity, as well as other disruptions in service that could affect, for instance, a fund’s ability to process shareholder transactions….” (citations omitted).
174. See 2016 Exam Priorities, supra note 109 at III. 175. See FINRA Report on Cybersecurity Practices (Feb. 2015); Compilation of
Results of a Pilot Survey of Cybersecurity Practices of Small and Mid‐Sized Investment Adviser Firms from the North American Securities Administrators Association (NASAA) (Sept. 2014); and CFTC Unanimously Approves Proposed Enhanced Rules on Cybersecurity, CFTC Press Release PR7293-15 (December 16, 2015).
176. See Five Years On: Regulation of Private Fund Advisers After Dodd-Frank, Keynote Address of SEC Chair Mary Jo White at the Managed Fund Association (October 16, 2015); and Enhancing Risk Monitoring and Regulatory Safeguards for the Asset Management Industry, speech of SEC Chair Mary Jo White (December 11, 2014). The SEC staff has stated it is considering a recommen-dation to the Commission for advisers to be required to create transition plans to prepare for this type of disruption. See Remarks of David Grim, Acting Director, SEC Division of Investment Management to 2015 IAA Compliance Conference (March 6, 2015) (Grim Remarks).
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key personnel, or disruptions resulting from an adviser’s dissolution.177 While advisers routinely exit the market without significant market impact, operational and other challenges can occur when an adviser or related investment vehicle winds up its affairs, particularly if there are restrictions on a client’s ability to access or move assets or if there are practical limitations on liquidating positions due to market conditions or due to restrictions inherent in the securities being liquidated. Time will tell if the SEC proposes new rules in this area.
Robo-Advisers and Fiduciary Duty
The recent explosion of so-called robo-advisers178 has raised con-cerns about whether and how the adviser can properly discharge its fiduciary obligations to clients while interacting in an online-only or digital environment.179 Some have expressed skepticism that a fully-automated platform can actually be a fiduciary,180 in light of the personal, more intimate relationship that has historically been under-stood to entail. Questions are raised in particular about whether
177. Grim Remarks, supra note 176. 178. “Robo-adviser” as used here means any automated investment platform or
service that offers wealth management or other types of investment advisory services to clients. Robo-advisers are often viewed as low-cost, easy-access alternatives to traditional investment advisers and brokers, employing computer-driven asset-allocation models and algorithms to invest client portfolios with little or no human interaction. For more on robo-advisers and related compliance issues, see Raef Lee, “The Next Wave of Financial Planning: The Effect of Robo-Advisors,” Practical Compliance and Risk Management for the Securities Industry (May-June 2015).
179. See “Surfing the Wave: Technology, Innovation, and Competition,” Remarks of Commissioner Kara M. Stein at Harvard Law School’s Fidelity Guest Lecture Series (Nov. 9, 2015): “What does a fiduciary duty even look like or mean for a robo advisor? The idea of a robotic entity that automatically generates invest-ment advice certainly bumps up against what we would traditionally think of as a fiduciary. As this innovation gains more market share (as it seems poised to do), we should be asking whether these new robo advisors can be neatly placed within our existing laws. Or, do we need certain tweaks and revisions? Do investors using robo advisors appreciate that, for all their benefits, robo advisors will not be on the phone providing counsel if there is a market crash?”.
180. Skeptics include William Galvin, Secretary of the Commonwealth of Massa-chusetts, whose Securities Division has issued a Policy Statement saying that fully automated robo-advisers, as currently structured, “may be inherently unable to act as fiduciaries” and further indicating that robo-advisers seeking registration in Massachusetts will be evaluated on a case-by-case basis under the guidelines set out in the Statement. See the MA Robo-Advisers Policy State-ment, supra note 58.
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roboadvisers do or can conduct adequate due diligence in order to render clients appropriately individualized investment advice, especially if they are using only brief on-boarding questionnaires to gather information from clients. Concerns are heightened if the adviser then disclaims responsibility for more extensive or personalized services, such as consideration of assets outside the robo-account, or the need for updated advice in the wake of significant changes affecting the client’s financial circumstances.181
Other commentators take a more analytical approach toward the question of whether robo-advisers can be fiduciaries, saying that robo-advisers are in many respects no different than traditional advisers and noting that interactions with a “live” adviser about a client’s financial goals, risk tolerance and sophistication can be more or less robust, just as the client information gathered electronically by robo-advisers can be.182 Still others point out that the impersonal nature of robo-advisers may actually help to avoid conflicts of interest that other advisers face when giving advice.183
The SEC is examining robo-advisers in order to deepen their knowledge of the range of services provided, as well as the challenges associated with different automated models.184 Time will tell how an adviser’s fiduciary obligations come to be applied (or not) in this rapidly-evolving area of the financial services industry. However, given the public’s ever-increasing preference for all things digital, it seems unlikely that demand for robo-advisory services is going to diminish any time soon,185 perhaps no matter what shortcomings come to light from a fiduciary point-of-view.
181. See the MA Robo-Advisers Policy Statement, supra note 58, at 3. 182. Notably, this includes Mary Jo White, Chairman of the SEC, in her Keynote
Address at the SEC-Rock Center for Corporate Governance - “Protecting Investors in an Innovative Financial Marketplace” (March 31, 2016) (White Robo-Adviser Remarks).
183. See, for example, “DOL Secretary Perez touts Wealthfront as paragon of low-cost, fiduciary advice, Holds up online-advice provider as exemplar of low-cost, fiduciary advice,” InvestmentNews (June 19, 2015). However, compare “Robo-Advisors: A Closer Look,” by Melanie L. Fein, paper prepared for Federated Investors, Inc. (June 30, 2015).
184. White Robo-Adviser Remarks, supra note 182. See also the SEC’s Investor Alert on Automated Investment Tools (May 8, 2015) aiming to alert the investing public to some of the risks and limitations of robo-advisers: https://www.sec. gov/oiea/investor-alerts-bulletins/autolistingtoolshtm.html.
185. One study predicts that the dramatic increase in robo-advised assets in recent years is going to continue, estimating that over $2 trillion dollars will be managed under robo-advisers by 2020, which would comprise about 5.6% of all
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WHAT STANDARD OF CONDUCT APPLIES TO AN ADVISER’S FIDUCIARY DUTY?
Negligence vs. Gross Negligence
As discussed previously, an adviser owes a fiduciary duty of care to its clients and must act with “due care” in discharging its advisory functions. This begs the question, however, of exactly what care is “due,” meaning what standard of care is owed or would be considered sufficient to discharge the duty owed.
At common law, an agent is generally held to a standard of care commensurate with that exercised by persons in similar circumstances:
Subject to any agreement with the principal, an agent has a duty to the principal to act with the care, competence, and diligence normally exercised by agents in similar circumstances. Special skills or knowledge possessed by an agent are circumstances to be taken into account in determining whether the agent acted with due care and diligence. If an agent claims to possess special skills or knowledge, the agent has a duty to the principal to act with the care, competence, and diligence normally exercised by agents with such skills or knowledge.186
As a consequence, when an adviser is acting in a professional capacity, it will generally be held to the standard of care normally exercised by other similarly situated investment professionals. None-theless, it is not necessarily enough to prove merely that an adviser adhered to industry custom or practice to avoid liability for breach of its duty of care. Rather, it is just one factor to be considered.187
Although not without controversy,188 an adviser’s duty of care may be altered by agreement in most cases, as indicated by the
investment assets in the United States. See Hype vs. Reality: The Coming Waves of “Robo” Adoption (June 2015) summarizing results of the A.T. Kearney Robo Advisory Services Study https://www.atkearney.com/financial-institutions/robo-advisory-services-study.
186. Restatement 3d Agency § 8.08. 187. See In the Matter of Mark David Anderson, Initial Decision Release No. 203,
Administrative Proceeding File No. 3-9499 (April 30, 2002), where, in deter-mining whether a broker’s markups/markdowns were unreasonable or excessive, the ALJ took into account industry practice, but said: “[D]eviation from industry practice constitutes only one factor that must be considered.” See also Restatement 2d Torts § 295A comment b.: “Any such custom of the community in general, or of other persons in like circumstances, is always a factor to be taken into account in determining whether the actor has been negligent.”.
188. See the discussion above under the heading “Can an Adviser’s Fiduciary Duties be Altered or Waived?” for a more complete discussion of alterations and waivers. See also the discussion on both sides of this issue in Harvey E. Bines and Steve
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boldfaced phrase in the quotation above. Indeed, it is not uncommon for investment advisory agreements to contain provisions that limit the liability of the adviser for certain conduct. For example, a broad version of this clause might read:
“[Adviser] shall not be liable for any error of judgment or mistake of law or for any loss arising out of any investment, or for any act or omission taken with respect to the Account, except for willful misfeasance, bad faith or gross negligence in the performance of its duties, or by reason of reckless disregard of its obligations and duties hereunder and except to the extent otherwise provided by law.”189
Despite SEC190 and state191 regulatory concerns about the use of “hedge clauses” – clauses that “hedge” or limit the adviser’s liability to the client, whether in the form of exculpatory clauses like the liability limitation above, or indemnities, waivers or other limiting provisions – these clauses are still in widespread use. On its surface, the sample clause above appears to exculpate the adviser from liability at least for simple negligence.192 Historically, liability limitations of this type were intended to shield advisers from claims of negligence in the selection of particular portfolio securities, which involves the exercise of professional judgment and could be subjected to endless
Thel, Investment management law and regulation (Bines and Thel) § 5.01 Unenforceable Provisions Generally.
189. Narrower versions of this clause exculpate the adviser from liability for losses arising from the adviser’s “mistake of investment judgment” and still others for losses suffered as a result of “any error of judgment or mistake of law in connection with [the Adviser’s] performance” under the advisory agreement.
190. See SEC Staff Outline, supra note 6, at 53-54 explaining the SEC’s historical view of “hedge clauses” and its current view as embodied in Heitman Capital Management, LLC, SEC No-Action Letter (pub. available Feb. 12, 2007) (hedge clause is not “per se” fraudulent but can be fraudulent depending on the facts and circumstances). Note, however, that the clause referenced in the Heitman letter was an “indemnification” and “hold harmless” clause, and the SEC Staff’s concern in that letter seems to be whether this type of clause might mislead the client into believing that any rights they may have to pursue the adviser under the securities laws would be cut off, rather than whether it is permissible to use this type of clause to alter the otherwise applicable standard of care in general.
191. See, for example, Investment Advisers Cautioned on Use of Hedge Clauses, Connecticut Department of Banking, at http://www.ct.gov/dob/cwp/view.asp? a=2252&q=299222.
192. At least for a registered fund client, an adviser ostensibly would not be held to a standard more lax than that provided in Section 17(i) of the Investment Company Act of 1940, which by statute prohibits an adviser being protected from liability for willful misfeasance, bad faith or gross negligence in the performance of its duties, or by reason of reckless disregard of its obligations and duties under the advisory agreement.
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second-guessing after the fact with the benefit of 20/20 hindsight. As a result, customary exculpatory clauses evolved holding advisers only to the more lax, gross negligence standard, at least for actions involv-ing professional judgment.
Nonetheless, it is unclear whether and how these clauses would be applied to shield the adviser from a breach of fiduciary duty. All things being equal, such a limitation might or might not be effective against a claim for breach of the common law duty of care based on negligence.193
The distinction between negligence and gross negligence could be critically important in a dispute where the level of care taken by an adviser becomes an issue.194 Case law often defines gross negligence as conduct so extreme that it may be difficult to hold an adviser liable for failing to take the requisite care unless the adviser has completely abdicated its responsibility or has established a pattern of repeated failures tending to show conscious indifference.195
Regardless of how an exculpatory clause might apply to common law claims, it is less likely to be given effect to limit liability for a breach of duty emanating from Advisers Act Section 206 or other statute. There are a number of reasons why, among them:
193. However, see Bines and Thel, supra note 188, at 228: “Investment managers
should not be confident that exculpatory clauses will permit them to avoid the consequences of ordinary negligence.” As those authors point out, exculpation for negligence may be particularly difficult, if not impossible, for advisers acting as trustees, as fiduciaries of ERISA plan assets or as advisers to private foundations.
194. In contrast, negligence versus gross negligence is less likely to be an issue when advisers are determining prospectively how to discharge their fiduciary obligations, to the extent that they would be aiming to exercise at least ordinary care in their daily activities, regardless of how the advisory agreement reads.
195. What constitutes gross negligence in any given case would be determined under the substantive law applicable in that case. However, proving gross negligence is generally considered fairly difficult. Cases often define gross negligence as “the failure to show even the slightest amount of care” or a “gross deviation from what an ordinary person would do under the same circumstances” or some similar formulation that often includes an element of intentionality, willfulness or reck-lessness. See Prosser and Keaton on the Law of Torts, Ch. 5 §34 (5th ed. 1984); and Modern Tort Law §10.19 (rev. ed.). For example, in Texas, gross negligence has been defined as the “entire want of care which would raise the belief that the act or omission complained of was the result of a conscious indifference to the right or welfare of the person or persons to be affected by it.” Robert Young, et al. v. Nationwide Life Insurance Company, et al., 2 F.Supp.2d 914, 929 (S.D. Tex. 1998), quoting Bennett v. Howard, 170 S.W.2d 709, 713 (Tex. 1943).
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1) Exculpatory clauses – like the sample clause quoted above and many others like it – by their terms often limit liability for claims “except to the extent otherwise provided by law” (or similar carve-out).196 This carve-out would arguably preserve any rights a client has against the adviser under, for example, the Advisers Act or other federal securities laws, notwithstanding the limitation.
2) Section 206 is, at its core, an anti-fraud provision and courts have long voided clauses – often in the form of indemnifications – that purport to shift away anti-fraud liabilities, on the theory that they violate public policy.197 If such indemnities were enforced, the reasoning goes, the anti-fraud provisions would lose their prophylactic effect.198 If that is the rationale with respect to liability shifting provisions like indemnities, it could easily be the rationale with respect to exculpatory clauses as well.
196. These carve-outs are often inserted with two aims: (i) to avoid misleading clients
into believing that the exculpatory clause cuts off claims they might have against the adviser that are not based on willful misfeasance, bad faith, gross negligence or reckless disregard, but that may be essentially strict liability claims for vio-lating federal or state law; and (ii) so that the clause itself is not potentially construed as entering into a contract in violation of the Advisers Act (for example, exculpating the adviser for negligent or other violations of the securities laws) or the continuation of a relationship or practice in violation of the Advisers Act and therefore void under Section 215.
197. See Globus, Inc. v. Law Research Serv., Inc., 418 F.2d 1276 (2d Cir. 1969) (Globus). Although the court specifically noted that the case involved behavior that went beyond mere negligence, the court’s opinion indicated that the provisions at issue there were designed to deter negligence. Moreover, the court’s reasoning has been extended to prophylactic provisions under other federal securities statutes, such as Section 16(b) under the Securities Exchange Act of 1934. See First Golden Bancorporation v. Ronald F. Weiszmann v. Morgan Stanley & Co., Incorporated, et al., 942 F.2d 726 (10th Cir. 1991) and cases cited there.
198. Globus, supra note 197, at Section III: “Civil liability under section 11 and similar provisions was designed not so much to compensate the defrauded pur-chaser as to promote enforcement of the Act and to deter negligence by providing a penalty for those who fail in their duties…. Thus, what Professor Loss terms the ‘in terrorem effect’ of civil liability… might well be thwarted if underwriters were free to pass their liability on to the issuer. Underwriters who knew they could be indemnified simply by showing that the issuer was ‘more liable’ than they (a process not too difficult when the issuer is inevitably closer to the facts) would have a tendency to be lax in their independent investi-gations.…Cases upholding indemnity for negligence in other fields are not necessarily apposite. The goal in such cases is to compensate the injured party. But the Securities Act is more concerned with prevention than cure.”.
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3) If Section 206 is deemed to cover negligent conduct,199 and the exculpatory clause were interpreted to be a waiver of compliance with Section 206 to that extent, then the exculpatory clause could be void under Section 215(a) of the Advisers Act, which voids any provision binding any person to waive compliance with the Advisers Act or related rules.
4) There is generally no private right of action under the Advisers Act.200 This makes the SEC the most likely party to claim breach of Section 206. Any exculpatory clause in the advisory agreement would, of course, not be binding on the SEC. No matter what their effect in a case involving the fiduciary duty
of care, a limitation of liability, exculpatory clause or disclaimer is less likely to protect an adviser from claims of breach of other fiduciary duties,201 especially the duty of loyalty in a case of involving undis-closed conflict of interest, self-dealing or bad faith.202
State of Mind; Scienter; Willfulness
Whether an adviser has breached its duty of care will generally depend on whether the adviser has met the requisite standard of care as discussed above. In contrast, claims based on breaches of other fiduciary duties, such loyalty or good faith,203 more often focus on the fiduciary’s state of mind, intent or motivations.
199. The U.S. Supreme Court has already held in Capital Gains, supra note 1, that
scienter is not required under Section 206(2). Therefore, mere negligence may be enough to prove liability, at least under that section. Lower courts have also held that scienter is not required under Section 206(4). See SEC v. Steadman, 967 F.2d 636 (US App DC 1992).
200. Transamerica, supra note 12, at 24: “[W]e hold that there exists a limited private remedy under the Investment Advisers Act of 1940 to void an investment advisers contract [under section 215], but that the Act confers no other private causes of action, legal or equitable.”.
201. See MA Robo-Advisers Policy Statement, supra note 58, at 7-8: “[A] complete and blanket disclaimer of any fiduciary relationship would be ineffective….[T]he Division will not permit the core fiduciary relationship to be eliminated.”.
202. See SEC Staff Outline, supra note 6: “The [adviser’s fiduciary] duty is not specifically set forth in the Act, established by SEC rules, or a result of a contract between the adviser and the client (and thus it cannot be negotiated away).” See also the “contractarian” and “anticontractarian” schools of thought in fiduciary law, discussed generally in Miller, supra note 56.
203. Without doubt, breaches of care are not always readily distinguishable from breaches of loyalty or other fiduciary breaches. See Carter G. Bishop, “A Good Faith Revival of Duty of Care Liability in Business Organization Law,” Tulsa
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In cases decided under common law,204 authorities do not uniformly agree on whether the duty of loyalty can be violated unintention-ally,205 or if some culpable state of mind is required, exactly what it is.206 Some authorities argue that “good faith” is a separate fiduciary duty, others that is not a separate duty at all, but really just the key element in defining the state of mind that must motivate a loyal fiduciary.207 As a result, cases pressing breach of loyalty or good faith claims under common law can vary widely in approach from juris-diction to jurisdiction.
In contrast, in cases involving breach under the Advisers Act, the issue about state of mind most commonly boils down to whether proof of “scienter” is required to make a claim. Scienter refers to a certain culpable state of mind that implies intent.208 It is often a required element when proving violations under anti-fraud provisions of the federal securities laws.209 However, in the case of the
Law Review (Vol. 41: 2006) (Bishop) at 490: “However, there remains reasonable disagreement over whether there are adequate measures to properly distinguish breach of loyalty from breach of care claims. These are often contextual but nonetheless illustrate the difficulty in easily categorizing a claim as purely care or purely loyalty.”.
204. Many of the salient cases in this arena are decided under corporate law as applied to directors and officers, which may have elements of both common law and state corporate statutory law.
205. See Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988) (citations omitted): “I therefore conclude, even finding that the action taken was taken in good faith, it constituted an unintended violation of the duty of loyalty….I parenthetically note that the concept of an unintended breach of the duty of loyalty is unusual but not novel.”.
206. See the discussion of duty of loyalty generally in Bishop, supra note 203, at II.B. 207. Leo E. Strine, Jr., Lawrence A. Hamermesh, R. Franklin Balotti, and Jeffrey
M. Gorris, “Loyalty’s Core Demand: The Defining Role of Good Faith in Corporation Law,” The Georgetown Law Journal (Vol. 98:629 2010) at 633.
208. Case law has established that conduct more culpable than mere negligence is required to prove scienter, Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), although recklessness may be enough. See Louis Loss & Joel Seligman, Securi-ties Regulation, Vol. VIII, ch.9, § B(6), at 3665-67 n. 521 (3d ed.1991) (noting decisions of eleven circuits that hold recklessness can constitute sufficient scienter).
209. See, for example, Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976) (holding that scienter is required for any private cause of action for damages under Rule 10b-5 and Section 10(b) of the Securities Exchange Act of 1934); and Aaron v. Securities Exchange Commission, 446 U.S. 680 (1980) (holding that scienter is required to enforce the antifraud provisions of Rule 10b-5 and Section 10(b) of the 1934 Act, but that scienter is not required for the
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anti-fraud provisions in Section 206 of the Advisers Act, courts have held that scienter is a required element for a claim under Section 206(1),210 but is not for a claim under Section 206(2).211
Another “state of mind” factor in SEC proceedings under Section 206 is whether the adviser’s violation was “willful.” When a violation is “willful,” different212 and more severe213 penalties can be imposed. Significantly, the SEC has long applied a very weak def-inition of “willful” under the securities laws, stating that it means merely “that the person charged with the duty knows what he is doing.”214 There is no requirement that the person “also be aware that he is violating one of the Rules or Acts.”215
government to establish a violation of Section 17(a) of the 1933 Act concerning untrue or omitted statements of material facts).
210. Steadman v. SEC, 603 F.2d 1126, 1134 (5th Cir. 1979) (Steadman). 211. SEC v. Moran, 922 F. Supp. 867, 896-898 (S.D.N.Y. 1996), citing Steadman,
Capital Gains and others. As the SEC put it: “If the misstatement or omission of a material fact is negligent, then Section 206(2) is violated; if the misstatement or omission is made with scienter, then Section 206(1) is violated.” In the Matter of Jamison, Eaton & Wood, Inc., Advisers Act Release No. 2129 (May 15, 2003) (citations omitted). Moreover, there are also authorities supporting the view that “scienter” is not a required element for liability under Section 206(4) either. See Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles, Advisers Act Release No. 2628 (August 3, 2007) and cases cited there, including Steadman, supra note 210.
212. See Advisers Act Section 203(e) (censure, denial or suspension of registration), (f) (bar or suspension of association with an investment adviser) and (i) (civil monetary penalties) for penalties available for “willful” violations.
213. See, for example, Section 217 of the Advisers Act, which says: “Any person who willfully violates any provision of this title, or any rule, regulation, or order promulgated by the Commission under authority thereof, shall, upon conviction, be fined not more than $10,000, imprisoned for not more than five years, or both.” The Dodd-Frank Act also extends the statute of limitations for violations of Section 217 from 5 years to 6 years.
214. Wonsover v. SEC, 205 F.3d 408, 414 (D.C. Cir. 2000), citing Hughes v. SEC, 174 F.2d 969, 977 (D.C. Cir. 1949).
215. Id., citing Gearhart & Otis, Inc. v. SEC, 348 F.2d 798, 803 (D.C. Cir. 1965). Although many of these prior cases involved violations under other securities statutes, this is the position the SEC takes with regard to willful violations under the Advisers Act as well. See, for example, In the Matter of Royal Alliance Associates, Inc., SagePoint Financial, Inc. and FSC Securities Corporation, Advisers Act Release No. 4351 (March 14, 2016) at 7.
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WHAT MIGHT ADVISERS DO TO HELP ENSURE THEY DISCHARGE THEIR FIDUCIARY DUTIES?
In short, to help ensure they discharge their fiduciary duties, advisers can adopt effective policies and procedures and can train their personnel on what it means to have a fiduciary duty in practice.
Policies and Procedures
Rarely do advisers adopt a procedure entitled “Fiduciary Duties” attempting to list all the fiduciary duties owed to clients, given that there are so many and so many ways that they might arise.216 Instead, fiduciary duties are more typically addressed in the general portions of an adviser’s policies and procedures, where the “tone at the top” is established along with the firm’s general standards of conduct appli-cable to all personnel. General standards of conduct with a fiduciary flavor might include requiring personnel to:
Put clients’ interests first,
Avoid taking unfair advantage of clients, and
Avoid abusing the adviser’s position of trust and confidence. These general standards may appear in the general or introductory
section of the firm’s Compliance Manual. Or, they may appear in the adviser’s Code of Ethics, which is required to contain standards of business conduct that the adviser requires of its supervised persons and that reflect the adviser’s fiduciary obligations.217 In addition to general standards of conduct, the Compliance Manual or Code might contain specific controls aimed at helping to ensure fiduciary duties are being discharged properly. Controls advisers often adopt include:
Restrictions on personal trading by firm personnel, which may include outright bans, pre-clearance requirements or other restric-tive measures, along with reporting requirements to facilitate monitoring
Prohibitions on insider trading (improper use of material, non-public information), with appropriate monitoring
216. As was noted in the Richards Fiduciary Speech, supra note 45. 217. Advisers Act Rule 204A-1(a)(1).
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Restrictions on the giving and receiving of gifts, entertainment, gratuities and business courtesies, along with reporting require-ments to facilitate monitoring
Restrictions on the ability of personnel to conduct outside business activities and other securities-related activities, including pre-clearance and periodic reporting, and
Restrictions on the ability of personnel to become a board member of other entities, including pre-clearance and periodic reporting. Advisers often also address fiduciary duties in specific proce-
dures throughout their Compliance Manual where fiduciary duties are likely to arise and be particularly acute, such as those governing best execution, soft dollars, trade allocations and dealing with senior investors.218 Controls adopted in these procedures vary from firm to firm, depending on their business model and risks.
Training
In addition to merely adopting standards and procedures, many advisers train their personnel on what it means to have a fiduciary duty, including not only what an adviser’s fiduciary duties are, but how those duties might arise and be handled in practice.219 Discussing hypothetical scenarios that personnel might face can facilitate an understanding of otherwise theoretical points. Sample hypotheticals appear below in Appendix A.
* * * Attention remains focused on the fiduciary duties advisers owe to
their clients as the SEC and other regulators work to decide which types of financial service providers should be subject to a fiduciary duty and what that should entail in practice. Regardless of the out-come of that debate, the duties of care, loyalty, obedience, good faith and disclosure underpin an adviser’s basic fiduciary obligations and offer an effective framework for analyzing new duties as the law and circumstances evolve.
218. Certain policies and procedures relating to client diminished mental capacity are
mentioned above under the heading “Duty to Assess a Client’s Mental Competence.”.
219. See above under the heading “Duty to Assess a Client’s Mental Competence” for examples of training that some advisers are instituting to help employees spot a client’s diminished capacity.
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This information is provided strictly as a courtesy to readers for educational purposes. This information does not constitute legal advice, nor does it establish or further an attorney-client relationship. All facts and matters reflected in this paper should be independently verified and should not be taken as a substitute for individualized legal advice.
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APPENDIX A
AN INVESTMENT ADVISER’S FIDUCIARY DUTY
HYPOTHETICAL Q & A SCENARIOS
(Caveat: The comments provided offer only one interpretation of these scenarios. Other interpretations may be valid as well.)
1. In exchange for substantial long-term investments in other accounts managed by the ADVISER, the ADVISER allows certain investors to make profitable market-timing trades (quick in-and-out trading) in one of the mutual funds managed by the ADVISER, in contra-vention of the fund’s policies on market timing. – Is that a breach of fiduciary duty and, if so, what duty? Comments: This is intended to be a classic market timing case,
raising breach of fiduciary duty of LOYALTY issues (among others). The adviser has caused a client fund to violate its own policies on market timing, potentially to the detriment of fund shareholders. Given that this was done ostensibly to benefit the adviser (who would earn additional fees managing the assets that the timer has agreed to bring to the adviser in other accounts), the adviser’s duty of GOOD FAITH is also called into question.
2. One of the investments an ADVISER is considering for an ADVISER client account is a Singapore bank CD paying interest 2% higher than that paid by any U.S. bank for a similar CD. – Can the ADVISER buy that CD for its client accounts con-
sistent with its fiduciary duty? Comments: If it looks too good to be true, it probably is….so
the old saying goes. If nothing else, the outsized interest rate being offered on this CD heightens an adviser’s duty of DUE DILIGENCE on this investment before the adviser should recommend it to its clients. Buying the CD without adequate assurances that the bank is solvent, is able to pay that interest rate for the foreseeable term, and is sufficiently regulated to not be overly risky for the client’s account, could constitute a breach of the duty of CARE (lacking a reasonable basis for the investment/inadequate due diligence on an investment). (Note that this similar to the allegations made in the case
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brought against the Stanford firm and its affiliated bank in Antigua….)
3. An ADVISER is considering whether to hire Manager X as a sub-adviser for one of the ADVISER Funds. The only information the ADVISER has about Manager X is the following:
Manager X has sent marketing materials showing startlingly smooth and high returns that Manager X has generated for other clients over decades.
Manager X is widely-known in the industry.
Manager X was previously employed by the SEC.
Manager X belongs to the same country club as the ADVISER.
Manager X is known as a “great guy.” – Would hiring Manager X on that basis be a fiduciary breach?
If so, of what duty? Comments: This is intended to be a variation on the Bernard
Madoff situation, raising issues about an adviser’s duty of DUE DILIGENCE to investigate sub-advisers and other service providers hired to manage client assets. If this is the only information the adviser has about Manager X, then the adviser might not be taking adequate CARE in selecting that sub-adviser. Indeed, the startlingly smooth and high returns shown by Manager X waves a red flag that the adviser should investigate further before hiring Manager X, on the “if it looks too good to be true, it probably is” theory.
4. A broker that executes trades for the ADVISER Funds calls the ADVISER with the opportunity to invest in a new offering of bonds. The ADVISER thinks it sounds like a good opportunity, so the ADVISER buys some of the bonds in its personal or proprietary account. – Is that trade permissible? – If not, what if none of the ADVISER’s client accounts are
permitted to invest in that type of bonds? Is it then permissible? Comments: This raises a question of the fiduciary duty of
LOYALTY. Fiduciary principles would dictate that this investment opportunity be offered FIRST to the adviser’s
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clients. If the investment is not permissible for them, or otherwise not in their best interest, the adviser could then consider taking the opportunity for itself. An adviser that takes for itself investment opportunities for which its clients are potentially eligible has a conflict of interest. An adviser’s duty of DISCLOSURE would dictate that the conflict be fully disclosed.
5. ADVISER is deciding whether to recommend to the ADVISER Funds Board that it continue using the current Third-Party Admin-istrator for the Funds. If rehired, the Third-Party Administrator says it is willing to pay over to the ADVISER half of the administrative services fee it is paid by the Funds in order to help the ADVISER expand its investment management business. – Can the ADVISER pursue that arrangement consistent with
its fiduciary duty? Comment: This raises questions about an adviser’s fiduciary
duty of LOYALTY and GOOD FAITH. The adviser has a fiduciary obligation to act with candor and utmost good faith with the Board, making full disclosure of all material facts. If the adviser’s recommendation to the Board to retain the current Third Party Administrator is biased because the Third Party Administrator has offered to share revenues with the adviser so the adviser can fund its own business expansion, then the adviser’s loyalty has been compromised and it would not be acting in good faith. At a minimum, the adviser should make FULL DISCLOSURE to the Board of the conflict of interest posed by the revenue sharing arrangement, so the Board can take that into account when assessing the adviser’s recommendation. (Note that this is similar to the allegations made in the BISYS Fund Services proceeding in 2006.)
6. An ADVISER genuinely likes the future prospects of X Co. and therefore buys some shares of X Co. for its proprietary account. Shortly thereafter, the ADVISER recommends that the shares of X Co. be purchased into every ADVISER Fund and client account where the stock is suitable. The ADVISER also recommends the stock to all its newsletter subscribers and everyone who follows ADVISER on Facebook and Twitter. The stock almost immediately increases in price, whereupon the ADVISER sells its shares of X Co. in its proprietary account to lock in its gains.
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– Is that trade permissible? – If not, what could be done to make it permissible? Comments: This is very similar to the “scalping” scenario that
led to the Capital Gains Research case decided by the U.S. Supreme Court in 1963. In that case, the adviser was found to have breached its fiduciary duty UNDER SECTION 206 of the Advisers Act by defrauding its clients, meaning failing to disclose to them beforehand that the adviser engaged in this type of practice so they could take that into consideration when assessing the adviser’s recommendations. The case implies that full disclosure would have avoided this violation. However, it is hard to imagine disclosure that would both be deemed adequate and would allow an adviser to take advantage of fully informed clients using this type of practice.
7. Broker X and Broker Y can both provide equally favorable exe-cution of a client trade, except that Broker X charges more in commissions. ADVISER nonetheless selects Broker X to execute the client’s trade because ADVISER thinks the higher commission is worth it, given that Broker X provides ADVISER with valuable research to use in making investment decisions for that client’s account and all ADVISER’s other clients’ accounts. – Is that a breach of fiduciary duty? – If so, what duty? – If so, how could a breach be avoided? Comment: This is intended to be a classic soft dollar scenario.
Without more, this practice could constitute a breach of the duty of LOYALTY, in that the adviser is using a client’s asset (its brokerage commissions) for the adviser’s own benefit, by paying for research that the adviser would otherwise have to pay for out of its own pocket. This situation is complicated by the fact that the research also benefits the adviser’s other clients, so that one client’s asset (its brokerage commissions) is now being used to subsidize benefits to a different client. These issues could potentially be avoided if the adviser engaged in this practice only in accordance with Section 28(e) under the Securities Exchange Act of 1934, which creates a safe harbor from fiduciary breaches that might otherwise arise by “paying
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up” with soft dollars. Both Section 28(e) and fiduciary prin-ciples would dictate that the conflict of interest inherent in this practice be fully disclosed to clients.
8. ADVISER reads in famous investor Walter Buford’s annual letter to his company’s shareholders (publicly available) that Buford thinks U.S. airlines have become overly risky long-term invest-ments and that he has just sold his major ownership stake in a major U.S. airline that he owned. ADVISER decides to sell out of its proprietary account all shares of that U.S. airline that ADVISER owns too. – Is that trade permissible? – What if ADVISER knows there are shares of that U.S. airline
in ADVISER Funds or other ADVISER client accounts, but nonetheless sells the airline shares out of its proprietary account before selling them out of its clients’ accounts?
Comment: If the adviser decides, based on Buford’s announce-ment, that the airline’s shares should be sold, selling the adviser’s own proprietary stake before selling the shares owned in client accounts could constitute a breach of the fiduciary duty of LOYALTY, by essentially “front running” the clients’ trades (i.e., trading ahead of clients which could mean that the adviser would get a better price for its shares than the clients would for theirs). There may also be a question of CARE raised if an adviser acts solely on the basis of what another investor does, even a famous investor, without doing its own due diligence to confirm that conclusion.
9. ADVISER is recommending mutual funds to purchase in order to satisfy a client’s asset allocation into equities. ADVISER recom-mends a proprietary ADVISER Fund even though there are similar unaffiliated funds that would be equally suitable for this purpose that the client could buy in their account. – Would that recommendation be a fiduciary breach? – If so, how could the breach be avoided? Comment: This raises issues about the adviser’s duty of
LOYALTY and duty of DISCLOSURE. One question is whether the adviser is unduly biased toward recommending its own funds because of the added management fees it would earn from having additional assets in the funds. The adviser
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should fully disclose to its clients this inherent conflict of interest and consider whether fees at the advised account level or the fund level should be waived in order to avoid an unfair “double dipping” on fees where the client essentially pays twice, at both levels, for the same service. Compliance mon-itoring should also test to make sure recommendations of proprietary funds are being made appropriately.
10. ADVISER is explaining investment alternatives to a senior client, who is acting a bit erratically on this day. The client does not seem to be absorbing the information provided, but is adamant about which alternative they want to pursue. – Would it be a fiduciary breach to pursue the alternative selected
by the client if the client turned out to have a diminished mental capacity?
– Would it be a fiduciary breach if the ADVISER chose not to act on client’s selection but to wait until another time when the client was more focused to try explaining the alternatives again?
– Would it be a breach for ADVISER to contact the client’s adult children to explain that client is acting this way and ask them what to do about the financial alternatives facing the client?
Comment: This raises difficult issues about the duty to ASSESS A CLIENT’S MENTAL COMPETENCE. Whether or not courts impose on advisers a fiduciary duty to assess mental competence, the client is exhibiting “red flags” indi-cating that competence might be an issue. Therefore, the adviser would be wise to act cautiously in this situation. Failing to act as directed by the client could raise duty of OBEDIENCE issues. Contacting the client’s adult children could be a breach of the client’s privacy rights. Moreover, substituting the children’s decision for that of the client could raise LOYALTY and OBEDIENCE issues (among many others). Instead, it might be in the client’s best interest to revisit the alternatives with the client at another time when the client is more focused.
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Advisor Reliance on Compliance Consultants Hangs in the Balance (October 29, 2015)
Chris Stanley
Loring Ward
© 2016 Beach Street Legal ®
http://beachstreetlegal.com/advisor-reliance-on-compliance-consultants-hangs-in-the-balance/
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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October 26th marked the final day of briefing before the SEC in what could be a very precedential case for investments advisors, compliance officers and the independent compliance consulting community. In the Matter of The Robare Group, Ltd. began its life in September 20141 as an order instituting administrative and cease-and-desist proceedings against a Houston-based advisor and its principals for alleged undisclosed conflicts of interest.
In June 20152, an administrative law judge found that the SEC’s Division of Enforcement failed to meet its burden in proving Robare’s alleged violations, and dismissed the matter in its entirety. It was a rare win by a defendant in the much-maligned administrative proceeding process, but the victory was short lived: the Division of Enforcement filed a petition for review of the dismissal, which was granted in August 20153. Now that briefing by both sides is complete, Robare’s fate is back in the hands of the SEC.
What’s intriguing about this case – and what makes it all the more important – is the way that it has morphed from a “simple” alleged undisclosed conflicts of interest case into a case that calls into the question reliance on compliance consultants.
In his lengthy and articulate assessment of the facts and the law, the administrative law judge that rebuked the Division of Enforcement noted that Robare “relied in good faith on compliance consultants.” He went on to conclude that “So long as the advice given is facially valid… and based on [Robare’s] full and honest disclosure, [Robare] could rely on that advice in good faith.”
In other words, the SEC shouldn’t be allowed to play Monday morning quarterback to an advisor that justifiably relies on the counsel and judgment of a compliance consultant. This should especially hold true when the advisor has not acted with a knowing intent to mislead (aka, scienter).
If Robare had concealed facts from its compliance consultants or if the advice rendered by the compliance consultants was patently wrong, then the reliance defense is out the window. But that’s not the facts of Robare, and that’s not what the administrative law judge is saying; reliance on “facially valid” advice must be in “good faith” based on “full and honest disclosure.”
1. https://www.sec.gov/litigation/admin/2014/34-72950.pdf. 2. http://www.sec.gov/alj/aljdec/2015/id806jeg.pdf. 3. https://www.sec.gov/litigation/opinions/2015/34-75686.pdf.
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The Division of Enforcement disagrees, and asserts that the admin-istrative law judge’s findings “significantly weaken the long-standing fiduciary standards applicable to investment advisers.” By using the magical F-word (no, not that one), the Division of Enforcement seemingly convinced its regulatory compatriots that advisors’ reliance on compliance consultants is an “important matter of public interest” that warrants full appellate review. Curiouser and curiouser.
The logic is effectively one of inappropriate burden-shifting; advisors can’t assign their fiduciary duty to somebody outside the purview of the ’40 Act and then act with reckless abandon. And this is true. But to make the inferential leap that reliance-on-counsel equals fiduciary evisceration requires a bridge too long and fragile to cross.
Tapping into the experience and expertise of the compliance con-sulting community has become mainstream for advisors whether the SEC likes it or not, and the fact that many such consulting firms are flourishing is due in large part to the SEC itself.
With an ever-increasing regulatory burden and a moving target of enforcement, it’s no wonder that advisors need outside expertise to stay on top of their compliance programs. Without the ability to justifiably rely on such outside compliance expertise in good faith, there becomes a disincentive to retain such expertise in the first place – which in turn could limit the full potential of advisors’ compliance programs.
Partnering with a compliance consultant (many of whom are SEC alumni) appears to this observer to be something that should be encour-aged as in the investing public’s best interest.
Again, this is not to suggest that the role of compliance consultants is to hand out “get out of jail free” cards to their clients, and the SEC would be right to impose appropriate limitations on the reliance defense (facially valid advice followed in good faith based on full and honest disclosure). Third-party delegation should not act as a liability shield for the malicious or the willfully ignorant.
In the end, this article may be much ado about nothing and the SEC may reaffirm the administrative law judge’s initial decision without addressing what it suggested was an “important matter of public interest.”
But for both investment advisors and the compliance consultants they retain, the final episode of the Robare saga will be one to watch.
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SEC to RIAs: Beware the Ides of ‘May’ (April 9, 2015)
Chris Stanley
Loring Ward
© 2016 Beach Street Legal ®
http://beachstreetlegal.com/sec-to-rias-beware- the-ides-of-may/
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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A recent string of SEC enforcement actions should prompt advisors to carefully review their Form ADV for one potentially dangerous word: “may.” It likely appears many times throughout various sections, and in most instances is likely perfectly appropriate. Where it isn’t appropriate, the SEC has made clear, is when it is used to describe an existing com-pensation arrangement that creates a conflict of interest.
In her remarks to the IA Watch 17th Annual IA Compliance Confer-ence in February, Julie Riewe, Co-Chief of the SEC’s Asset Management Unit within the Division of Enforcement, dedicated significant speaking time to what she described as “conflicts, conflicts everywhere.”1 She explained that “In nearly every ongoing matter in the Asset Management Unit, we are examining, at least in part, whether the adviser in question has discharged its fiduciary obligation to identify its conflicts of interest and either (1) eliminate them, or (2) mitigate them and disclose their existence to boards or investors. Over and over again we see advisers failing properly to identify and then address their conflicts.”
Identification of conflicts of interest is only half the battle; disclosing them completely and accurately (e.g., in Form ADV) is equally as important. This focus on complete and accurate conflicts disclosure is ostensibly a result of the Asset Management Unit’s “Undisclosed Adviser Revenue risk-analytic initiative,” which has been finding exactly what it was looking for.
Three specific cases are cited as examples: In re Shelton Financial Group, Inc. (Jan. 13, 2015)2, In re The Robare Group, Ltd. et al. (Sept. 2, 2014)3, and In re Focus Point Solutions, Inc. (Sept. 6, 2012)4. I’d add an additional case as well: In re Alan Gavornik et al. (November 24, 2014)5. All are worth a read, and all center on unidentified or improperly dis-closed conflicts of interest. In instances when conflicts were properly identified but improperly disclosed, the SEC cited the respondents’ use of “may” in Form ADV as misleading: Robare: “In addition, the revised disclosure is inadequate because it states that Robare Group may receive compensation from Broker when it was, in fact, receiving payments from Broker.”
1. http://www.sec.gov/news/speech/conflicts-everywhere-full-360-view.html#.VRqi
4dVVhBd. 2. http://www.sec.gov/litigation/admin/2015/ia-3993.pdf. 3. http://www.sec.gov/litigation/admin/2014/34-72950.pdf. 4. http://www.sec.gov/litigation/admin/2012/ia-3458.pdf. 5. http://www.sec.gov/litigation/admin/2014/34-73678.pdf.
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Focus Point: “In addition, the use of the prospective ‘may’… is mislead-ing because it suggested the mere possibility that Tore would make a referral and/or be paid ‘referral fees’ at a later point, when in fact a com-mission sharing arrangement was already in place and generating income to Tore and Respondents.” Bottom line: if a conflict-ridden compensation arrangement or revenue stream already exists and is actually being realized by the advisor, even if not in all conceivable circumstances, use of the word “may” or other prospective language is inappropriate. Assertive, definitive, and non-conditional language should be used when crafting conflicts disclosure in Form ADV, as examiners are clearly paying attention to each and every chosen word.
SEMANTICS MATTER
As Ms. Riewe suggests, query whether conflicts are disclosed “in a manner that allows clients or investors to understand the conflict, its magnitude, and the particular risk it presents.” In other words: state the conflict unambiguously, explain why it is a conflict and why the client should care, give some sense of scale, and describe how the advisor has taken steps to mitigate the conflict.
For examples of common conflicts in the advisory space, take a peek at my conflicts article6 a little over a year ago.
Just in case you think this is a passing SEC fad, think again: “On the horizon, we expect to recommend a number of conflicts cases for enforce-ment action,” Ms. Riewe concludes.
Julius Caesar was warned by a soothsayer to beware the ides of March; consider yourself warned regarding may.
6. http://beachstreetlegal.com/advisor-conflicts-of-interest-finding-and-mitigating-
them/.
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When and Why to Make Form ADV Updates (April 25, 2014)
Chris Stanley
Loring Ward
© 2016 Beach Street Legal ®
http://beachstreetlegal.com/when-and-why-to-make-form-adv-updates/
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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By this point, all advisors with a Dec. 31 fiscal year-end should have filed their annual updating amendment to Forms ADV Part 1 and 2 with the Securities and Exchange Commission through the Investment Adviser Registration Depository. If any material changes occurred since the last annual updating amendment, advisors should have also delivered to clients at least a summary of such material changes by this point as well.
Nothing needs to be updated until this time next year, right? Not necessarily. As Confucius once said, “Only the wisest and stupidest of advisors never change.”
Okay, maybe Confucius said “men” instead of “advisors,” but you get the point: things happen, and it’s the SEC’s position that clients need to know promptly when certain of those things happen.
The bush I’m beating around is what’s known as an other-than-annual amendment to Forms ADV Part 1 and/or 2; more simply, it’s an updated version of an advisor’s ADV that is filed with the SEC at any point in between annual updating amendments. The question becomes, what trig-gers such an other-than-annual amendment to an advisor’s ADV?
The SEC addresses this very issue in section four of its general instructions to Form ADV1, sections two and four of its instructions for ADV Part 2A2, and its IARD FAQs3. The instructions are specific and vague at the same time, as explained below.
FILING REQUIREMENTS
For ADV Part 1, an amendment is triggered depending on the particular item number. Specifically, Items 1, 3, 9 (except 9.A.(2), 9.B.(2), 9.E., and 9.F.), or 11 of Part 1A or Items 1, 2.A. through 2.F., or 2.I. of Part 1B need to be updated promptly if a response to such item becomes inaccurate in any way. Notice that there is no materiality standard for this category of items — any inaccuracy triggers an amendment.
Items 4, 8, or 10 of Part 1A or Item 2.G. of Part 1B, on the other hand, need to be amended if such item becomes materially inaccurate. An advisor is not required to update its responses to Items 2, 5, 6, 7, 9.A.(2), 9.B.(2), 9.E., 9.F., or 12 of Part 1A or Items 2.H. or 2.J. of Part 1B even if the responses to those items have become inaccurate.
For ADV Part 2 (more commonly known as the brochure), an amendment is triggered any time information provided therein becomes
1. http://www.sec.gov/about/forms/formadv-instructions.pdf. 2. http://www.sec.gov/about/forms/formadv-part2.pdf. 3. http://www.sec.gov/divisions/investment/iard/iardfaq.shtml#filingother.
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materially inaccurate. Notice that the brochure has a blanket materiality standard for all items, unlike the item-by-item distinction in the Part 1.
It’s also important to note that an advisor need not amend its ADV solely because its assets under management or fee schedule have changed; however, if an advisor is updating other items in its ADV, it should go ahead and update AUM numbers and fee schedules as well, if they have changed.
DELIVERY REQUIREMENTS
Because the ADV Part 1 is not delivered to clients, an advisor should instead focus on what may trigger interim delivery of its brochure to clients. The SEC lists one specific instance in which an interim amendment must be delivered to clients promptly: Item 9 of ADV Part 2A (discipli-nary information). If there are any new legal or disciplinary events “that are material to a client’s or prospective client’s evaluation of your advisory business or the integrity of your management,” including but not limited to all the specific instances listed in Item 9, clients need to be informed of such events.
That said, the SEC also includes a “catch-all” provision that harkens to an advisor’s fiduciary duty: “As a fiduciary, you have an ongoing obligation to inform your clients of any material information that could affect the advisory relationship. As a result, between annual updating amendments you must disclose material changes to such information to clients even if those changes do not trigger delivery of an interim amendment.”
MATERIALITY AND PROMPTLY
Though the alphanumeric soup of triggers described earlier provides clear-cut guidance, the SEC’s references to “materially inaccurate” and “promptly” bask in the gray area of potential interpretive license. ADV amendments must be filed and delivered promptly, but the SEC has never specifically defined that time period. By reading other SEC guid-ance and rulemaking, one could reasonably interpret this to mean “as soon as reasonably practicable,” but this is still not a bright-line test.
The best I can offer is that an advisor should not lollygag and pro-crastinate when a specifically enumerated trigger occurs or when a disclosure becomes materially inaccurate. Knowingly withholding need-to-know information without a damn good excuse is not looked upon kindly by the SEC.
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The definition of materiality is equally as gray, but it might help if an advisor put him or herself in the client’s shoes when contemplating the materiality of an event, occurrence, or potential disclosure item — “X,” let’s call it. Query, for example: “If I were on the fence about whether or not to continue an advisory relationship with my financial advisor, would my knowledge of “X” sway my decision one way or the other?” If the answer is yes, err on the side of caution and always remember the fundamentals of fiduciary duty.
CONCLUSION
Failure to recognize when an other-than-annual amendment to Form ADV may be required can carry significant consequences, and failure to sync up various disclosure documents (including an individual advisor’s Form U4) will only make matters worse. Then again, if you’re one of the Con-fucian advisors that never changes, you may be the wisest (or stupidest) of us all.
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Advisor Conflicts of Interest: Finding and Mitigating Them (December 24, 2013)
Chris Stanley
Loring Ward
© 2016 Beach Street Legal ®
http://beachstreetlegal.com/advisor-conflicts-of-interest-finding-and-mitigating-them/
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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Conflicts of interest are inherent and at times inescapable in the financial services industry. The entire brokerage and commission-based industry was arguably built on one: a broker getting paid per transaction to sell certain products to clients (i.e., the broker is arguably incentivized to trade an account and recommend securities that generate a higher-commission payout). On the flip side, fee-based advisors may be incentivized to rec-ommend a fee-based account even though the account trades very infre-quently and/or invests in cash equivalents (i.e., “reverse churning,” as SEC OCIE Director Andrew Bowden noted recently1). The point is that conflicts of interest are hiding everywhere, and it is an advisor’s fiduciary responsibility to identify such conflicts for clients and mitigate them to the extent possible.
My trusty Black’s Law Dictionary defines a conflict of interest as “A real or seeming incompatibility between one’s private interests and one’s public or fiduciary duties.” Said another way, a conflict of interest exists if an advisor directly or indirectly benefits from a client’s particular course of action. A “seeming” conflict of interest may exist even if a client’s particular course of action is in fact in the client’s best interests. This is why conflicts needn’t always be avoided outright, but simply need to be disclosed to clients (typically in Form ADV Parts 1 and 2, ERISA’s 408(b)(2) disclosure document and/or advisory contracts). Perhaps the best way to illustrate potential conflicts of interest is by way of example:
AFFILIATES
It is not uncommon for larger advisors to control, be controlled by, or be under common control with another financial institution such as a broker-dealer, custodian, bank or insurance company. If an advisor recommends that a client’s securities transactions clear through an affiliated broker-dealer or be held by an affiliated custodian, e.g., the advisor will likely receive some sort of indirect compensation by virtue of the affiliation. The same can be said if an advisor recommends that clients purchase the products of an affiliated bank or insurance company.
REVENUE SHARING
Revenue sharing within the financial services industry goes by many different names: administration, marketing, shareholder servicing, con-ference support, shelf-space… the list goes on. The bottom line is that
1. http://www.reuters.com/article/sec-churning-idUSL1N0JP27I20131212.
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clients should know what types of vendors or investment providers an advisor is either paying or receiving payments from to understand where an advisor’s interests lie. An argument can be made that an advisor that receives payments from a fund company, for example, may be more likely to recommend that fund company’s products to the advisor’s clients. (I’m purposely avoiding the entire 12b-1 or “distribution in guise” dis-cussion, as that is an entirely different can of worms.)
COMPENSATION ARRANGEMENTS
If advisors are compensated in such a way that incentivizes them to recommend certain products or services to clients instead of other similar products or services, a seeming conflict of interest exists. Such conflicts are more overt in the commission space, but fee-based advisors may also be compensated by their employers in such a manner that encourages the use of proprietary products, which is discussed below. Compensation that also encourages unnecessary risk-taking to chase performance, e.g., may also not be in the client’s best interests.
PROPRIETARY PRODUCTS
Perhaps the most common—or at least the simplest—example of a proprietary product conflict exists in the mutual fund space. Advisors to mutual funds face particular conflicts if the advisor (or an affiliate) recommends that mutual fund to clients. Because the advisor receives investment advisory and other fees from the mutual fund itself, the advisor receives more revenue as the assets of the mutual fund grow. The more clients invest in the mutual fund, the more revenue the advisor receives from the mutual fund. The same conflict exists in any scenario where an advisor earns fees from a product separate and apart from the investment advisory fee or commission charged to a client.
WHAT ADVISORS CAN AND SHOULD DO
Advisors should consider a review of their policies and procedures related to gifts and entertainment, allocation of investment opportunities, outside business activities, political contributions, soft dollars and personal trading, as such areas are often ripe with seeming conflicts of interest as well. The examples above are far from exhaustive, and each conflict of interest assessment should be tailored specifically to each advisory practice.
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Certain conflicts (especially those involving personal trading and advisor conduct) are also appropriate to address in the advisor’s code of ethics.
The SEC takes conflicts of interest very seriously… so much so that it mentions conflicts of interest no less than twenty-one times in its ADV Part 2A Instructions. These same instructions highlight an advisor’s fiduciary responsibility with respect to disclosure of conflicts to clients:
As a fiduciary, you also must seek to avoid conflicts of interest with your clients, and, at a minimum, make full disclosure of all material conflicts of interest between you and your clients that could affect the advisory relationship. This obligation requires that you provide the client with sufficiently specific facts so that the client is able to understand the conflicts of interest you have and the business practices in which you engage, and can give informed consent to such conflicts or practices or reject them.
Keep it simple when it comes to conflicts: assess no less frequently than annually, avoid or mitigate to the extent possible, and disclose thor-oughly to clients.
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Form ADV: Uniform Application for Investment Adviser Registration and Report Form by Exempt Reporting Advisers
Submitted by: Clifford E. Kirsch
Sutherland Asbill & Brennan LLP
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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FORM ADV (Paper Version)
UNIFORM APPLICATION FOR INVESTMENT ADVISER REGISTRATION AND
REPORT BY EXEMPT REPORTING ADVISERS PART 1A
WARNING:
Item 1 Identifying Information
265
FORM ADV
266
FORM ADV
267
FORM ADV
Item 2
SEC Registration
at least one
large advisory firm
mid-sized advisory firm
268
FORM ADV
HERE
in Wyoming
outside the United States
an investment adviser (or sub-adviser) to an investment company
an investment adviser to a company which has elected to be a business development company
pension consultant
related adviser
newly formed adviser
multi-state adviser
Internet adviser
received an SEC order
no longer eligible
SEC Reporting by Exempt Reporting Advisers
269
FORM ADV
State Securities Authority Notice Filings and State Reporting by Exempt Reporting Advisers
Item 3 Form of Organization
270
FORM ADV
Item 4 Successions
Item 5 Information About Your Advisory Business
271
FORM ADV
272
FORM ADV
273
FORM ADV
274
FORM ADV
Item 6 Other Business Activities
Item 7 Financial Industry Affiliations and Private Fund Reporting
275
FORM ADV
Item 8 Participation or Interest in Client Transactions
276
FORM ADV
277
FORM ADV
Item 9 Custody
278
FORM ADV
279
FORM ADV
Item 10 Control Persons
Item 11 Disclosure Information
280
FORM ADV
281
FORM ADV
282
FORM ADV
Item 12 Small Businesses
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FORM ADV
Direct Owners and Executive Officers
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286
FORM ADV
Indirect Owners
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288
FORM ADV
Amendments to Schedules A and B
289
290
FORM ADV
.
291
FORM ADV
292
FORM ADV
293
FORM ADV
294
FORM ADV
295
FORM ADV
Information About the Private Fund
296
FORM ADV
297
FORM ADV
Ownership
Your Advisory Services
Private Offering
298
FORM ADV
Auditors
Prime Broker
Custodian
299
FORM ADV
Administrator
Marketers
300
FORM ADV
301
FORM ADV
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FORM ADV
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CRIMINAL DISCLOSURE REPORTING PAGE (ADV)
)
OR
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CRIMINAL DISCLOSURE REPORTING PAGE (ADV) (continuation)
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CRIMINAL DISCLOSURE REPORTING PAGE (ADV) (continuation)
307
308
REGULATORY ACTION DISCLOSURE REPORTING PAGE (ADV)
OR
309
REGULATORY ACTION DISCLOSURE REPORTING PAGE (ADV) (continuation)
310
REGULATORY ACTION DISCLOSURE REPORTING PAGE (ADV) (continuation)
311
REGULATORY ACTION DISCLOSURE REPORTING PAGE (ADV) (continuation)
312
CIVIL JUDICIAL ACTION DISCLOSURE REPORTING PAGE (ADV)
OR
313
CIVIL JUDICIAL ACTION DISCLOSURE REPORTING PAGE (ADV) (continuation)
314
CIVIL JUDICIAL ACTION DISCLOSURE REPORTING PAGE (ADV) (continuation)
315
CIVIL JUDICIAL ACTION DISCLOSURE REPORTING PAGE (ADV) (continuation)
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state securities authorities
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Wrap Fee Program Brochure
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state securities authorities
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Brochure Supplement
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state securities authorities
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NOTES
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NOTES
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Investment Advisers and New Client Relationships (May 9, 2016)
Heather L. Traeger
Teacher Retirement System of Texas
Daniel Malooly Debra Groisser
Prudential Insurance Company of America
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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I. OVERVIEW
Building an investment advisory business and onboarding new clients involves numerous regulatory and compliance considerations under the Investments Advisers Act of 1940 (“Advisers Act”) and other federal and state laws. This paper provides an overview of some of the primary compliance issues advisers face when beginning new client relationships, including solicitation arrangements, disclosure documents, investment man-agement agreements, custodial relationships, ERISA related regulations, and voting proxies1. The paper also will identify some parallel compliance requirements for advisers that must register with, and be subject to reg-ulation by, the Commodity Futures Trading Commission (“CFTC”).2
II. SOLICITATION
To recruit new clients, investment advisers often rely on the use of “solicitors,” a group that can include employees, advisory affiliates, third-party placement agents and broker-dealers. However, because solicitors are compensated by an adviser for their referrals to the adviser, the Securities and Exchange Commission (“SEC”) has long been concerned with conflicts of interest and a risk of fraud associated with such fee arrangements. Instead of prohibiting cash referral fees, the SEC adopted rules under the Advisers Act to protect and inform prospective clients of the compensatory nature of a solicitor’s activities.
A. Cash Solicitation Rule
Under Rule 206(4)-3 of the Advisers Act, an investment adviser may not pay cash fees to a solicitor unless four conditions are sat-isfied. The first three conditions apply to all cash referral fee payments subject to the rule. First, an investment adviser entering into a cash referral fee arrangement must be registered under the Advisers Act.
1. This paper is not an in-depth discussion of all regulatory and compliance require-ments facing advisers engaging in new client relationships. Application of the regulatory and compliance information in this paper may vary depending upon specific facts and circumstances and should not be relied upon without specific legal advice from counsel based on particular situations.
2. Advisers that operate or solicit funds for a commodity pool are commodity pool operators (“CPOs”) and those that advise as to the trading of commodity interests are commodity trading advisors (“CTAs”).
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The rule prohibits cash payments to a solicitor by an investment adviser that is required to register with the SEC but has not done so. Although the rule generally does not apply to persons excluded from the definition of an investment adviser, it would apply to an affiliate of the adviser paying a referral fee on the adviser’s behalf. Second, the solicitor retained by the adviser must not be statutorily disquali-fied under the Advisers Act. Statutory disqualification includes, inter alia, having been convicted of certain felonies or being subject to an order, judgment or decree under certain sections of the Advisers Act. Third, the fee must be paid via a written agreement to which the adviser is a party.
Having satisfied the first three conditions, an adviser may still be prohibited from paying cash referral fees under the rule unless the fourth condition is satisfied. The fourth condition requires solicitors to make certain disclosures, which vary depending on the type of services provided and the relationship between the adviser and the solici-tor. A solicitor is not required to provide clients with any particular information regarding a fee referral arrangement with an adviser whose activities are limited to impersonal advisory services.3 Similarly, where the adviser offers both comprehensive and impersonal advisory services, the solicitor would not have to disclose any information regarding the referral fee arrangement as long as the solicitor recommends solely the impersonal advisory services of the adviser.4 The solicitor could not, however, recommend the adviser’s compre-hensive advisory services without fulfilling certain disclosure obligations under the rule. In addition, a solicitor who is a partner, officer, director or employee of the adviser or an affiliate of the adviser must disclose the status of the solicitor’s relationship with the adviser or the adviser’s affiliate at the time of the referral.
The most comprehensive disclosure obligation under the rule is placed on third-party solicitors that are not associated with the adviser or one of the adviser’s affiliates, and on solicitors that recommend an adviser for advisory services other than impersonal advisory services.
3. Advisers Act Rule 206(4)-3(d)(3) provides that impersonal advisory services mean: (1) written materials or oral statements which do not purport to meet the objectives or needs of specific clients; (2) statistical information containing no expression of opinions as to the investment merits of particular securities; or (3) any combination of the foregoing services.
4. See Requirements Governing Payments of Cash Referral Fees by Investment Advisers, Investment Advisers Act Release No. 688 (July 12, 1979).
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Such solicitors must, at the time of solicitation, provide a prospective client with a current copy of the adviser’s brochure (discussed below) and a separate written disclosure document containing the infor-mation prescribed by the rule. This information includes basic information about the fee referral arrangement such as the terms of compensation, whether the client will pay a specific charge or a higher advisory fee because of the solicitation arrangement, and the parties to and nature of the relationship. The rule also imposes height-ened requirements on an adviser in such instances. The adviser must receive from the client a signed and dated acknowledgement of receipt of the adviser’s brochure and the solicitor’s written disclosure document no later than inception of the advisory relationship. In addition, an adviser’s written agreement with a solicitor in such instances must contain specific provisions, including one requiring the solicitor to perform all solicitation activities in a manner con-sistent with the Advisers Act and rules thereunder. Further, the adviser must (1) make a bona fide effort to determine that the solicitor is in compliance with the fee referral agreement and (2) have a rea-sonable basis for such belief.
The SEC and its staff have provided guidance regarding the application of Rule 206(4)-3 to certain situations that present unique circumstances or are not squarely addressed by the rule. For example, the rule does not apply to sponsors of wrap fee programs who receive part of the wrap fee. It also does not apply to a cash solicitation agree-ment between a registered adviser and a solicitor solely for solici-tation of investors into an investment pool managed by the adviser.5 Although there is no explicit prohibition on the payment of non-cash referral fees to solicitors, the SEC has questioned the practice absent disclosure of the referral fee arrangement. The SEC staff has sug-gested that solicitors would not otherwise be subject to the Advisers Act if such solicitors received fees as directed by Rule 206(4)-3.
Independent of compliance with the rule, advisers should be aware of other rules that may be implicated by fee referral arrangements. The written agreement and other documentation created or received
5. An “investment pool” is an investment company, as defined under Section 3(a)(1) of the Investment Company Act of 1940 (“Company Act”), or a company that would be an investment company but for an exclusion from the definition of investment company provided by Section 3(c) of the Company Act. Mayer Brown LLP, SEC No-Action Letter (July 15, 2008).
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pursuant to Rule 206(4)-3 must be retained for an adviser’s books and records requirements under Rule 204-2(a)(10) and (a)(15). Depending on the solicitor’s activities and its relationship to the adviser, the solicitor may need to be registered as an investment adviser or broker-dealer at the federal or state level. In addition, solicitation of government or foreign officials may implicate “pay to play” as well as Foreign Corrupt Practices Act (“FCPA”) regulations, as discussed below.
B. “Pay to Play”
Registered investment advisers, exempt reporting advisers, and foreign private advisers as defined in Section 203(b)(3) of the Advisers Act are subject to Rule 206(4)-5, the SEC’s “pay to play” rule.6 Generally, the pay to play rule prohibits an adviser or its employees from directly or indirectly making contributions or other payments to public officials with the intent of generating investment advisory business. It does so by imposing a two-year ban on an adviser’s acceptance of compensation for conducting advisory services for a government client from when an impermissible contribution is made.7 The rule further prohibits an adviser from compensating third parties to solicit government entities for advisory services, unless such solicitor is a registered investment adviser, broker-dealer, or municipal advisor, in each case subject to pay to play restrictions.8 The pay to play rule
6. See generally Political Contributions by Certain Investment Advisers, Release No. IA-3043 (Jul. 1, 2010); see also Rules Implementing Amendments to the Invest-ment Advisers Act of 1940, Release No. IA-3222 (Jun. 22, 2011); Political Contributions by Certain Investment Advisers, Release No. IA-3418 (Jun. 8, 2012). The rule applies to subadvisers but does not apply to small advisers that are reg-istered with the state securities authorities and certain other advisers that are exempt from SEC registration.
7. Rule 206(4)-5 includes a de minimis provision allowing contributions of up to $350 per election per candidate if the contributor is entitled to vote for the can-didate and up to $150 per election per candidate if the contributor is not entitled to vote for the candidate.
8. In November 2014, the Financial Industry Regulatory Authority (“FINRA”) requested comment on a proposal to establish pay to play and related rules that would regulate the activities of member firms that engage in distribution or solicitation activities for compensation with government entities on behalf of investment advisers that provide or are seeking to provide investment advisory services to such government entities within two years after a contribution to an official of the government entity is made by the member firm or a covered
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also makes it unlawful for an adviser to solicit or coordinate (1) contributions for a government official to whom the adviser is seeking to provide advisory services or (2) payments to a political party of a state or locality where the adviser is providing or seeking to provide advisory services to a government entity.
Advisers should closely review the numerous definitions found in the rule to ensure proper compliance. Under the rule, advisory services include (1) directly managing or advising government funds or (2) managing or advising through an investment pool. Government funds include, among others, all public pension plans and other collective government funds, including participant-directed plans such as 403(b), 457 and 529 plans. Covered investment pools include mutual funds, hedge funds, private equity funds, venture capital funds, and other collective investment pools. Mutual funds, however, are only subject to the rule to the extent that the funds are an investment option of a participant-directed plan or program of a government entity.9 A con-tribution includes any gift, subscription, loan, advance, deposit of money, or anything of value made for the purpose of influencing an election for a federal, state, or local office, including any payments for debts incurred in such an election. In addition to the adviser, employees covered by the rule, called “covered associates,” are defined as the adviser’s general partners, managing members, executive officers, and other individuals with a similar status or function; any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employee; and any PAC controlled by the investment adviser or by another covered associate.
associate. FINRA Regulatory Notice 14-50 (Nov. 2014). A year later, FINRA refiled the proposed rules after responding to commenters concerns raising constitutional challenges to alleged limitations on political contributions. FINRA Regulatory Notice 15-56 (Dec. 2015). The SEC currently has instituted pro-ceedings to adopt or disapprove the refiled proposed rules and, specifically, is seeking additional comment on the rules. Securities Exchange Act Release No. 77465 (Mar. 29, 2016). The MSRB’s pay to play rules for municipal advisers were deemed approved by the SEC and will become effective August 17, 2016. See Securities Exchange Act Release No. 70462 (Sept. 20, 2013), and MSRB Regu-latory Notice 2014-15 (Aug. 18, 2014) and 2016-06 (Feb. 17, 2016).
9. If an adviser is selected by a government entity to advise a government-sponsored plan, regardless of whether the plan selects one of the pools the adviser offers or manages as an option available under its plan, the prohibitions of the rule directly apply to the adviser.
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Rule 204-2(a)(18) of the Advisers Act requires investment advisers to keep certain records of contributions.10 These records are required to be listed in chronological order identifying, among other items, each contributor and recipient and the amount and dates of the con-tributions. An adviser must document all government entities for which it has provided advisory services, or which were investors in an investment pool to which the adviser has provided advisory services, in the past five years. In addition, an adviser must document each regulated person to whom it agrees to provide payment to solicit a government entity for advisory services on its behalf.
In addition to the SEC’s pay to play rule, advisers may be subject to restrictions on solicitation of investment advisory business at the state and municipal level. These limitations may extend to the adviser, its employees, affiliates and third-party solicitors. For example, MSRB Rule G-37 prohibits brokers, dealers, and municipal securities dealers from engaging in municipal securities business with issuers for a period of two years after certain political contributions are made to officials of such issuers. Rule G-37 also prohibits payments to third parties who make such contributions, and prohibits the coordination of payments to officials. The rule includes a de minimis exemption of $250 and provides for exemptions in certain circumstances, upon application. Finally, the rule requires annual reporting on Form G-37 of certain information related to political contributions by brokers, dealers, and municipal securities dealers. Many states also regulate the political contributions of advisers. California, for example, enacted comprehensive pay-to-play regulations that are substantially similar to the SEC’s pay-to- play rules. Advisers should be attuned to the likelihood of different pay to play, gift and lobbying laws from federal, state, and municipal sources as well as public pension plans and regularly monitor for changes in applicable regulations and policies.
While similar to the SEC’s pay to play rule, the CFTC version of a pay to play rule targets only swap dealers, and, to a limited extent, major swap participants.11 CFTC Regulation 23.451 restricts swap
10. Advisers to mutual funds may employ an alternative set of recordkeeping require-ments to the extent a government entity’s participation in an investment pool is through an intermediary. See Investment Company Institute, SEC No-Action Letter (Sept. 12, 2011).
11. Depending on their swap activities, advisers may qualify as a swap dealer or major swap participant or be associated therewith.
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dealers from engaging in swap business with a government entity if they (or a covered associate) made or solicited political contributions to an official of such government entity during the preceding two years. The regulation also requires that swap dealers and major swap participants have a reasonable basis to believe that third-party repre-sentatives of government special entity counterparties are subject to pay to play restrictions imposed by the CFTC, SEC, or a self-regu-latory organization subject to CFTC or SEC jurisdiction. Among other departures from the SEC’s rule, the CFTC Regulation includes an exemption for swaps that are initiated on an exchange and for which the swap dealer does not know the identity of the counterparty prior to execution. It also prohibits a swap dealer from offering to engage in covered swap business following an impermissible con-tribution, going beyond the SEC’s prohibition on receipt of com-pensation during the two-year ban.
C. FCPA
The use of solicitors may trigger obligations under the FCPA. Pursuant to the FCPA, advisers and solicitors are prohibited from giving payments or other benefits, such as entertainment, to a foreign official in return for the official’s influence within his or her gov-ernment. The FCPA most affects advisers and solicitors obtaining investments by sovereign wealth funds or foreign state-owned pension plans.12
D. Enforcement Actions
In State Street Bank and Trust, the SEC settled charges that the bank conducted a pay-to-play scheme through a senior-vice president and a hired lobbyist to make illicit cash payments and political cam-paign contributions to win contracts to service state pension funds. The conduct was prior to the implementation of Rule 206(4)-5 so it was brought under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. In Hutchens Investment Management, Inc.
12. See e.g., In the Matter of Bank of New York Mellon Corporation, Securities Exchange Act Release No. 75720 (August 18, 2015), charging violations of the FCPA for providing valuable student internships to family members of foreign government officials affiliated with a Middle Eastern sovereign wealth fund.
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(“HIM”),13 the SEC entered an order censuring the investment adviser and suspending for three months the investment adviser’s principal for violations of Section 206(4) and Rule 206(4)-3 after finding that the investment adviser paid a cash fee to a solicitor that was not paid pursuant to a written agreement to which HIM was a party and made no bona fide effort to ascertain whether the solicitor provided a separate written disclosure document to the clients. The SEC found that the investment adviser violated Section 206(4) of the Advisers Act and Rule 206(4)-3 thereunder and that its principal aided and abetted such violations.
In June 2014, the SEC announced its first enforcement action under Rule 206(4)-5 against an adviser to venture capital funds.14 In TL Ventures, Inc. the SEC entered a settlement order stating that TL Ventures violated the pay to play rule by continuing to provide com-pensatory advisory services to city and state pension funds after a “covered associate” had made campaign contributions to the Mayor of Philadelphia and the Governor of Pennsylvania.
The SEC staff also has issued several exemptive orders for vio-lations of its pay to play rule, and has several pending exemptive applications. In these orders, advisers have received relief from the two year prohibition on receipt of advisory fees notwithstanding a contribution to a government official by one of the adviser’s covered persons.15
In addition, in late 2012, Goldman, Sachs & Co. (“Goldman”) reached a $12 million settlement with the SEC in connection with alleged pay to play violations, involving MSRB Rule G-37.16 Accord-ing to the SEC’s charges, a vice-president in Goldman’s Boston office solicited underwriting business from the Massachusetts treasurer
13. Hutchens Investment Management, Inc. and William Hutchens, Investment Advisers Act Release No. 2514, (May 9, 2006).
14. In the Matter of TL Ventures, Inc., Investment Advisers Act Release No. 3859 (June 20, 2014)
15. See In the Matter of Brookfield Asset Management Private Institutional Capital Adviser US, LLC et. al., Investment Advisers Act Release No. 4355 (March 21, 2016), In the Matter of Crestview Advisors, LLC., Investment Advisers Act Release No. 3997 (January 14, 2015), In the Matter of T. Rowe Price Associates, Inc., and T. Rowe Price International Ltd., Investment Advisers Act Release No. 4058 (April 8, 2015), and In the Matter of Ares Real Estate Management Holdings, LLC, Investment Advisers Act Release No. 3969 (November 18, 2014).
16. In the Matter of Goldman, Sachs & Co. (Sep. 27, 2012), Securities Exchange Act Release No. 67934.
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while working on the treasurer’s campaign for governor. The vice-president conducted such campaign activities during work hours and used Goldman resources. Such use of Goldman work time and resources constituted in-kind campaign contributions to the treasurer that were attributable to Goldman and disqualified the firm from engaging in municipal underwriting business with certain Massachusetts municipal issuers for two years. Goldman, however, participated in 30 pro-hibited underwritings with Massachusetts issuers.
The SEC also settled pay to play litigation involving New York’s largest pension plan fund.17 The SEC charged an investment manage-ment firm with entering into undisclosed financial arrangements that benefited two principals of the New York State Common Retirement Fund in order to win investment business. One of the allegations implicated an executive at the investment management firm paying more than $1 million in sham “finder” fees to one of the Retirement Fund’s principals.
Questions to consider:
• Do you review your solicitor’s disclosures for compliance with Rule 206(4)-3 before the solicitor provides a copy to prospective clients?
• Is your relationship with, and compensation of, a solicitor con-sistent with the disclosures provided to prospective clients? If your arrangement has changed, have you re-evaluated the dis-closures and asked the solicitor to modify them as necessary?
• Do you have written pay to play policies and procedures in place and are they reasonably designed to prevent violations of the rule? Do you train your employees on the policies and procedures?
• If your policy permits contributions, what process do you have in place to test compliance with the de minimis provisions in the pay to play rule?
17. SEC v. Quadrangle Group LLC, et al., 10-CV-3192 (S.D.N.Y. Apr. 15, 2010); SEC Litigation Release No. 21487 (Apr. 15, 2010), available at http://www.sec.gov/ litigation/litreleases/2010/lr21487.htm.
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III. DISCLOSURE - BROCHURE RULES
Rule 204-3 under the Advisers Act requires a registered investment adviser to provide current and potential clients with written disclosure document(s).18 This is achieved by providing a copy of Part 2 of an adviser’s Form ADV, commonly known as the adviser’s “brochure” (i.e., Part 2A) and the “brochure supplement” (i.e., Part 2B).
A. Generally
The information in the brochure will vary, depending on the adviser’s business, but the brochure should be, at a minimum, informa-tive about the adviser’s practices, services, fee structure, and other mandatory items prescribed by the General Instructions to Form ADV.19 Advisers should adhere closely to these instructions when drafting their brochure, including instructions that the information must not be materially inaccurate.20 Registered advisers must also provide current and prospective investors with brochure supplements that disclose the education, business background, and other infor-mation about certain supervised advisory personnel.21
Pursuant to Rule 204-3, an adviser’s brochure and brochure sup-plements are required to be delivered initially, and annually thereafter. The initial delivery must occur before or at the time an advisory contract is entered into with a client. Similarly, the brochure supple-ments must be delivered before or at the time the advisory personnel begin providing services to the client. Thereafter, within 120 days after the adviser’s fiscal year-end, the adviser must deliver (1) a copy of the adviser’s updated brochure or (2) a summary of any material
18. See Amendments to Form ADV, Release No. IA-3060 (Jul. 28, 2010); see also Investment Adviser Requirements Concerning Disclosure, Recordkeeping, Appli-cations for Registration and Annual Filings, Release No. 664 (Jan. 30, 1979).
19. Advisers to wrap fee programs must furnish a written disclosure document that contains the information identified in Part 2A, Appendix I, of Form ADV instead of the brochure. The timing requirements related to delivery of the disclosure docu-ment are the same as those for the brochure and brochure supplements.
20. To the extent an adviser offers substantially different types of advisory services to different types of clients, it may use a tailored brochure for each category of client.
21. When advisory services are provided by a team of more than five supervised persons, Rule 204-3 provides that a current brochure supplement need only be deliv-ered for the five supervised persons with the most significant responsibility for the day-to-day advice provided to the client.
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changes to the brochure that also includes information on how the client can obtain a copy of the updated brochure and where the client can obtain information about the adviser through the Invest-ment Adviser Public Disclosure (“IAPD”) system. Separate from the annual requirement, if there is a new disciplinary event related to the adviser or a supervised person that requires disclosure, or a material change in the legal and disciplinary disclosure information, an adviser must promptly deliver to each client an amended brochure or brochure supplement, as applicable, or a statement describing the material facts of the changed information.22 Similar rules apply when there is a material change in the information about the disciplinary portion of the brochure supplement. Delivery may be accomplished through paper or electronic media.
There are several exceptions to the brochure and brochure sup-plement delivery requirements. An adviser is not required to deliver a brochure to a client that is a registered investment company or a business development company or who receives only impersonal invest-ment advice for which the adviser charges less than $500 per year. An adviser does not have to deliver a brochure supplement to a client: to whom it does not have to deliver a brochure; who receives only impersonal advice; or who is an officer, employee, or other person related to the adviser that would be a “qualified client” of the adviser.23
Rule 204-2(a)(14) under the Advisers Act requires advisers to maintain a copy of each disclosure document, and each amendment or revision, that was given or sent to clients or prospective clients as well as the dates on which the document(s) were distributed to a client or prospective client who later became a client. Importantly, Rule 204-3 is not the only rule governing advisers’ disclosure obli-gations. An adviser must comply with any disclosure obligations it has under other federal or state laws. In particular, it must disclose all material facts about the advisory relationship.
Investment advisers are permitted to distribute their brochure and brochure supplements by electronic media, provided advisers make it known to clients that the information is available electronically and
22. For example, an adviser may disclose in a supplement delivered electronically that the supervised person has a disciplinary event and provide a hyperlink to either FINRA’s BrokerCheck system or the IAPD system. See Amendments to Form ADV, Release No. IA-3060 (Jul. 28, 2010).
23. An adviser does not have to deliver a brochure to investors in private funds.
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any requisite software is available for free. Furthermore, clients must have the ability to access and retain such information. Investment advis-ers should also obtain informed consent from clients regarding electronic delivery, as well as evidence of receipt.
B. CFTC
The CFTC also incorporates disclosure and recordkeeping obliga-tions into its regulatory requirements for advisers, found in CFTC Regulations 4.21 through 4.26 with respect to CPOs and Regulations 4.31 through 4.36 with respect to CTAs.24 Generally, a CPO must deliver a comprehensive “Disclosure Document” to a prospective pool investor prior to or when it delivers the subscription agreement to the participant, and must obtain an acknowledgement of receipt of the Disclosure Document signed and dated by the participant. While the intent and delivery requirements for a Disclosure Document are similar to the SEC’s rules, the CFTC arguably is more prescrip-tive in its regulation of the content of the Disclosure Document, prescribing specific text for a number of the disclosures as dictated by the types of activity undertaken by the pool and the CPO. Among other topics, the Disclosure Document must provide background information related to the pool, CPO, and other entities providing services to the fund, information on the investment program, use of proceeds, fee disclosures, risk factors, conflicts of interest, the break-even point, related party transactions and principal trading, ownership interests, and performance information. The CFTC’s recordkeeping obligations for CPOs require, among other records, retention of books and records prepared in connection with the activities as a CPO, including written materials distributed to the pool or pro-spective pool participants.
A CPO may qualify for an exemption under CFTC Regulations 4.7 or 4.12 from certain disclosure and recordkeeping obligations. Regulation 4.7 provides relief to CPOs who manage pools that are offered or sold solely to persons that meet the definition of Qualified Eligible Persons (“QEPs”) in a private offering which qualifies for an exemption from the registration requirements of the Securities Act of 1933. A QEP is conceptually similar to an qualified client or qualified
24. See Disclosure Documents: A Guide for CPOs and CTAs, National Futures Association (Apr. 2015).
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purchaser as used in the Advisers Act and associated rules and, in fact, does include qualified purchasers as that term is defined in the Company Act. Certain QEPs must meet portfolio threshold requirements while others have no such requirement; CPOs must maintain records of their determination that a pool investor is a QEP. Having satisfied the QEP requirement, a CPO does not have to satisfy the general Disclosure Document requirements. Instead, the CPO must provide specified disclosure on the cover page of its offering memorandum, or above the signature line in its subscription document if no offering memorandum is used, that notifies investors of the CPO’s use of the exemption. Further, it must ensure that all necessary disclosures have been made to ensure the information in the memorandum or sub-scription document is not misleading. CPOs must claim the exemption by making an electronic filing with the National Futures Association (“NFA”). If the CPO does not know with certainty that it will qualify for the exemption once it has completed sales of interests in the fund, the CPO should satisfy the Disclosure Document requirements to ensure compliance with CFTC and NFA regulations.
Regulation 4.12 provides another opportunity for relief from certain disclosure and recordkeeping obligations for CPOs that are unable to meet the QEP requirement in Regulation 4.7. This may include CPOs to funds that rely on the exclusion from the definition of investment company found in Section 3(c)(1) of the Company Act. Pool operators should be mindful that Regulation 4.12 includes more conditions for availability and fewer exemptions from the disclosure and recordkeeping obligations associated with Regulation 4.7. CPOs must electronically file with the NFA to claim the exemption.
CTAs generally must provide a Disclosure Document to each prospective client no later than the time the CTA delivers an advisory agreement to the prospective client. The disclosures required of CTAs, similar to those required of CPOs, include information about the CTA and each of its principals, information about the trading program pursuant to which the CTA will direct the client account, risk factors, fees, conflicts of interest, related party transactions and principal trading, and performance information. Similar to SEC-regulated invest-ment advisers, CFTC-regulated CTAs also must disclose all material information to existing or prospective clients even if such information is not specifically required by CFTC regulations. The CFTC’s record-keeping obligations for CTAs require the retention of records con-cerning the CTA’s clients and any powers of attorney executed by such clients, written agreements entered into by the CTA, transactions
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effected for clients and related trade confirmations, and advertisements, among other records. Similar to the relief provided to CPOs, CFTC Regulation 4.7 provides relief from certain disclosure and record reten-tion requirements for CTAs with respect to the accounts of QEPs. When relying on the exemption in this regulation, CTAs also must disclose above the signature line of the advisory agreement, if no brochure or other disclosure document is prepared and provided, that the CTA is relying on an exemption and must disclose certain other limited information. Such disclosures may be made in a brochure rather than the advisory agreement if the CTA prepares and provides one to the QEP client. Like CPOs, CTAs must electronically file a claim for such exemption with the NFA before relying on the relief provided in it.
C. Enforcement Actions
Enforcement cases in this area focus on the delivery and timing of delivery as well as content. Last year, the SEC settled an action with an adviser for failure to timely deliver its Part 2B, which included at least eight disciplinary events required to be disclosed, even after SEC examination staff notified the adviser that it was not in com-pliance.25 It also settled a proceeding with an adviser for, among other violations, failure to deliver timely its Part 2A of its Form ADV and to deliver its Part 2B to existing clients.26 Previously, the SEC charged two advisers and their advisory firm, Sovereign International Asset Management, with violations of Rule 204-3.27 The SEC alleged that the advisory firm did not timely provide the brochure to all its clients and its clients did not otherwise consent to delivery through a website. Further, the SEC alleged that the brochures either omitted, or contained misleading statements regarding conflicts of interest related to additional compensation received from another adviser for making investment recommendations into that adviser’s funds. In
25. In the Matter of National Asset Management, Inc., Investment Advisers Act Release No. 4243 (October 26, 2015).
26. In the Matter of Du Pasquier & Co., Inc., Investment Advisers Act Release No. 4004 (January 21, 2015).
27. In the Matter of Larry C. Grossman and Gregory J. Adams, Investment Advisers Act Release No. 3720 (Nov. 20, 2013) and Initial Decision Release No. 727, Admin-istrative Proceeding File No. 3-15617 (Dec. 23, 2014). Mr. Adams has since settled the matter. See Investment Adviser Release No. 3811 (Apr. 7, 2014).
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Noonan Capital, LLC, the SEC brought proceedings against an adviser for failing to provide to any client Part 2 of Form ADV or any brochure containing the information required by Part 2.28
IV. PRIVACY RULES
The SEC’s privacy rules are contained in Regulations S-P, S-AM, and S-ID, and the CFTC’s privacy rules are contained in Regulations Part 160 and Part 162. Regulation S-P and its CFTC counterpart are designed to ensure that investment advisers and other financial entities have privacy policies and practices and provide notices to their customers about those policies and practices. Similarly, Regulation S-AM and its CFTC coun-terpart limit the ability of adviser affiliates to solicit a consumer for mar-keting purposes, unless that consumer has been given notice and a reasonable opportunity and simple method to opt-out of such solici-tations. The SEC and CFTC also jointly adopted identity theft red flags rules (SEC Regulation S-ID and CFTC Regulation Part 162 Subpart C) recently to further protect consumer information by requiring advisers to develop and implement written identity-theft prevention programs. In the context of an adviser on-boarding new clients, the privacy rules generally relate to the information that must be disclosed to prospective clients concerning the adviser’s existing privacy practices and the adviser’s use and maintenance of customers’ nonpublic personal information.29
A. Regulation S-P
The SEC’s Regulation S-P and the CFTC’s Part 160 apply to SEC-registered investment advisers and to CTAs and CPOs subject to CFTC regulation, respectively, whether or not registered with the CFTC.30 These regulations govern advisers’ treatment of consumer nonpublic personal information. The regulations make it unlawful to dis-close “nonpublic personal information” about consumers to nonaffiliated
28. In the Matter of Noonan Capital Management, LLC and Timothy George Noonan, Investment Advisers Act Release No. 3609 (May 17, 2013).
29. When thinking about the various privacy rules, advisers also should consider the numerous cybersecurity initiatives being undertaken by the regulators. See e.g., OCIE’s 2015 CyberSecurity Exam Initiative, National Exam Program Risk Alert, Vol. IV, Issue 8 (Sept. 15, 2015).
30. Investment advisers that are not required to register with the SEC must comply with the Federal Trade Commission’s (“FTC’s”) Privacy Rules. The rules issued by the FTC are substantially similar to those issued by the SEC and CFTC.
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third parties unless certain conditions imposed by the regulations have been satisfied, with certain limited exceptions. In addition, the regulations include a “Safeguard Rule” that requires advisers to adopt written policies and procedures to safeguard nonpublic personal infor-mation.31 The SEC’s regulation further contains a “Disposal Rule” that requires advisers to take reasonable measures to protect such information when disposing of customer records and information. Each of these components of the regulations are discussed below.
An adviser must adhere to the regulations with respect to non-public personal information about its consumers and customers. A “consumer” is defined as an individual who obtains or has obtained a financial product or service from a financial institution primarily for personal, family, or household purposes, or that individual’s legal representative. A “customer” is defined as a consumer who has an ongoing relationship with the financial institution. As a result, an entity such as a pension plan or a fund that solicits advisory services would not be a consumer or a customer of the adviser and its non-public personal information would not be protected under the regulations.32
When onboarding new clients, advisers should be aware that certain categories of clients with whom they form advisory rela-tionships are subject to federal privacy rules as well. In particular, the SEC’s privacy rules apply to investment companies, as defined in Section 3 of the Company Act, and, although the SEC’s rules do not extend to private funds that are excluded from the definition of an investment company, such funds are subject to privacy rules imposed by the FTC. Depending upon the nature of the relationship between
31. Over the past two years, the SEC and FINRA have both performed examinations focused on cybersecurity issues, including the security of customer data. In recent guidance on cybersecurity, the Staff of the Division of Investment Management cited Regulation S-P when suggesting that advisers’ compliance programs address cybersecurity risk as it relates to identity theft, data protection and fraud, among other issues. IM Guidance Update No. 2015-02 (April 2015).
32. This could change should the SEC adopt certain amendments to Regulation S-P as proposed several years ago. See generally Part 248 – Regulation S-P: Privacy of Consumer Financial Information and Safeguarding Personal Information, Invest-ment Advisers Act Release No. 2712 (March 4, 2008) (proposing to amend the safeguard and disposal rules to cover “personal information,” which would be defined as information that is handled by the adviser that is identified with any consumer, or with any employee, investor, or security holder who is a natural person).
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the adviser and a fund client, the adviser may need to ensure the reg-istered investment company or private fund client satisfies its regu-latory obligations under SEC or FTC privacy rules.
Advisers must understand when they have a customer rela-tionship with an individual because the regulations apply different protections to the information of consumers that are customers than to those who are not customers. Both SEC and CFTC regulations require advisers to adopt written policies and procedures to safeguard customer records and information. The procedures must address administrative, technical, and physical safeguards. In addition, under SEC regulations, an investment adviser’s procedures must be “rea-sonably designed” to safeguard the confidentiality of customer records and information, to protect against anticipated threats to their security or integrity, and to protect against unauthorized access to or use that could result in substantial harm or inconvenience to any customer.33 Both SEC and CFTC regulations impose different privacy policy notice requirements with respect to consumers and customers, as described more fully below.
Rule 10 of SEC Regulation S-P and Part 160.10 of CFTC Regulations make it unlawful for an adviser to disclose any nonpublic personal information about a consumer to a nonaffiliated third party unless four conditions are satisfied: the adviser provides the consumer an initial privacy policy notice; the notice describes the consumer’s right to opt out of the adviser’s information disclosure practices; the adviser provides a reasonable opportunity for the consumer to opt out; and the consumer does not opt out. Rules 4 through 6 of SEC Regulation S-P, and Parts 160.4 through 160.6 of CFTC Regulations, prescribe when a privacy policy notice must be provided to a consumer or customer and identify what must be included in the content of such notices. Rule 8 of SEC Regulation S-P and Part 160.8 of CFTC Regulations further provide that if an adviser alters its disclosure practices, it must provide a revised privacy policy notice to a con-sumer before disclosing that consumer’s nonpublic personal information, either directly or through an affiliate, to any nonaffiliated third party.
33. When developing its policies and procedures, an adviser should clearly define its expectations of how advisory personnel and representatives handle nonpublic personal information and make sure such expectations are disclosed in its privacy notices as necessary.
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While the regulations require advisers to provide a privacy policy notice to both consumers that are not customers and those that are customers, the timing of delivery differs. An adviser must provide an initial privacy policy notice to a customer no later than the time at which they establish the customer relationship.34 In addition to the initial notice, an adviser must provide customers with an annual pri-vacy policy notice that accurately reflects its privacy policies and practices. Advisers generally may define their own twelve-month period that forms the basis of their annual notification but must apply the period on a consistent basis.
In contrast, an adviser only must provide an initial privacy policy notice to a consumer that is not a customer before disclosing non-public personal information about the consumer to a nonaffiliated third party. If the adviser does not share such consumer information (except as otherwise permitted by law), it does not need to provide a privacy policy notice to consumers that do not establish a customer relationship with the adviser. Advisers do not have to provide an annual privacy policy notice to consumers that are not customers.
All privacy policy notices must describe the categories of non-public personal information collected by the adviser, the categories of nonpublic personal information disclosed to nonaffiliated third parties (which may be a sub-set of the information collected), the categories of nonaffiliated third parties with which the adviser shares such information (e.g., financial institutions, non-financial companies, or others), and a description of the adviser’s policies and procedures with respect to protecting the confidentiality and securities of such information, along with certain other disclosures. The notices must also advise consumers and customers of their right to “opt out” of such disclosure of their nonpublic personal information to nonaffili-ated third parties. The SEC, in conjunction with the federal bank regulators, adopted a Model Privacy Form to assist financial institu-tions in providing disclosures clearly and conspicuously as required by the various privacy regulations in 2010. Use of the Model Privacy Form constitutes compliance with the notice content requirements under Regulation S-P. As a result, although use of the Model Privacy
34. The SEC has stated that an adviser may provide the initial privacy policy notice at the same time it satisfies its brochure delivery obligation, and an investment company may provide its initial privacy notice to investors with the prospectus, no later than the trade date.
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Form is not required, it is strongly advised in order to qualify for the safe harbor.
Under both SEC and CFTC regulations, an adviser may provide its written privacy policy notices electronically if it can reasonably expect the consumer or customer to actually receive the notice via the particular electronic delivery mechanism used. However, an SEC-regulated adviser must take care in posting its privacy policy notice to its website as the sole method of delivery. The SEC has stated that “an institution cannot reasonably expect that all of its customers will receive actual notice in writing of a privacy notice that is posted at a particular location, whether that location is an advertising site, the institution’s premises, or the institution’s web site.”35 Whether an adviser can reasonably expect a website posting of its notice to pro-vide actual notice to a consumer or customer will depend on the particular facts and circumstances.
B. Enforcement Actions
Recent enforcement actions have focused on violations of the safeguard rule and notice and opt-out rules. In R.T. Jones, the SEC asserted that the adviser stored sensitive personally identifiable information (“PII”) of clients and other persons on its third party-hosted web server without adopting written policies and procedures regarding the security and confidentiality of that information and the protection of that information from anticipated threats as required by Regulation S-P.36 When the web server was attacked by an unau-thorized, unknown intruder, that intruder gained access rights and copy rights to the PII of more than 100,000 individuals, including thousands of R.T. Jones’s clients. In Gisclair, the SEC alleged, among other things, that the co-founder, co- owner, and then-COO of two investment advisers “willfully aided and abetted and caused violations by [the investment advisers] of Rule 10 of Regulation S-P” by “improperly remov[ing] and retain[ing] nonpublic personal infor-mation about both firms’ clients” without providing advance notice
35. Staff Responses to Questions about Regulation S-P, at Question 10. 36. In the Matter of R.T. Jones Capital Equities Management, Investment Advisers
Act Release No. 4204 (Sept. 22, 2015).
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or the opportunity for the clients to opt-out when he left the invest-ment advisers and found a new firm.37
Dual registrants should take notice that in the context of broker-dealers, the SEC has penalized firms and their executives for failures to provide customers with proper notice and a reasonable opportunity to opt-out before disclosing their nonpublic personal information. For example, in Maximillian Santos, a registered representative shared confidential information, including certain customers’ account holdings, cash balances and reports of trade activity, with a nonaffiliated third party without the customers’ knowledge or consent, and without those customers having been given notice of and an opportunity to opt out of the disclosures pursuant to Regulation S-P.38 Similar con-duct took place in Kraus and Levine, two enforcement actions against two executives of the same brokerage firm, where the SEC alleged that a notice letter advising customers of their right to opt-out sent after the customers’ information had been disclosed did not provide customers with a reasonable opportunity to opt-out.39 In these and other enforcement actions against broker- dealers, the SEC also alleged that the firms violated Rule 30 of Regulation S-P for failures to adopt adequate written policies or procedures complying with Regulation S-P’s requirements.40 The SEC also charged a broker in a civil action for gaining illegal profits by selling the names and other confidential personal information of more than 500 customers to insurance agents.41 The case was settled with a final judgment entered by consent against the broker, permanently barring the broker from future violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and from aiding and abetting future violations of Regulation S-P.
37. In the Matter of Gisclair, Securities Exchange Act Release No. 70742 (Oct. 23, 2013).
38. In the Matter of Maximillian Santos, Securities Exchange Act Release No. 77253 (February 29, 2016).
39. In the Matters of Kraus, Securities Exchange Act Release No. 64221 (April 7, 2011); In the Matters of Levine, Securities Exchange Act Release No. 64222 (April 7, 2011). See also In the Matter of Merriman Curham Ford & Co. et. al, Securities Exchange Act Release No. 60976 (Nov. 10, 2009) ; In the Matter of Next Financial Gp., Inc., Securities Exchange Act Release No. 56316 (August 24, 2007) .
40. In the Matters of Ellis, Securities Exchange Act Release No. 64220 (April 7, 2011); In the Matters of J.P Turner & Co., LLC, Initial Decision Release No. 395 (May 19, 2010)
41. SEC v. Sidney Mondschein, No. cv-07-6178-SI (N.D. Cal., Apr. 14, 2008); Litigation Release No. 20531 (Apr. 17, 2008).
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Questions to consider:
• Are your disclosures consistent with your actual practices?
• Do you evaluate your disclosures periodically to identify infor-mation that may have become inaccurate?
• Have you adequately tracked privacy notices and opt-outs?
• Do you always check privacy notices and opt-outs to make sure that they are clear and conspicuous, accurately reflect your firm’s practices, and comply with the content requirements under the rules?
• Do you restrict departing employees’ ability to retain, remove, or transfer customer information prior to sending out privacy notices?
• Have you evaluated your written policies and procedures to ensure proper safeguarding of nonpublic information based on the particular activities in which your firm engages (for example, electronic access to account statements or other information maintained by the firm)?
• Do you provide training for employees on your privacy policies and on regulatory requirements?
C. Regulation S-AM
To the extent that a potential client is solicited for onboarding via affiliate marketing, such affiliate marketing must comply with Regu-lation S-AM.42 In contrast to Regulation S-P, Regulation S-AM does not prohibit advisers from sharing customer information. Rather, Regulation S-AM prohibits an adviser from using eligibility infor-mation received from an affiliate to make a marketing solicitation to consumers unless: (1) the adviser clearly and conspicuously discloses the potential marketing use of eligibility information to the consumer in writing; (2) the consumer is provided with a reasonable method and opportunity to opt-out; and the consumer does not opt-out. The opt-out notice must be provided to the consumer either by an affiliate that has or previously had a pre-existing business relationship with the consumer, or as part of a joint notice from two or more members of an affiliated group of companies, provided that at least one of the
42. Investment Advisers Act Release No. 2911 (Aug. 4, 2009).
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affiliates has or previously had a business relationship with the consumer.
The Regulation S-AM notice and opt-out requirements and exceptions are similar to those in Regulation S-P. Several examples are provided in the rules to illustrate these requirements. In addition, the Appendix to Regulation S-AM contains model forms, which may be used to satisfy Regulation’s S-AM requirement that an affiliate marketing notice must be clear, conspicuous, and concise.
D. Regulation S-ID
Advisers must consider whether they become subject to the SEC’s Regulation S-ID or the CFTC’s identity theft red flags rules (the “red flags rules”) when establishing new client relationships. Generally, the red flags rules require financial institutions and creditors to develop and implement a written identity-theft prevention program designed to detect, prevent, and mitigate identity theft in connection with certain existing accounts or the opening of new accounts. The red flags rules also include guidelines to assist entities in the formulation and maintenance of their identify-theft prevention programs.
1. Generally
The red flags rules apply to any entity registered with the SEC or subject to the CFTC’s jurisdiction. Such advisers must first determine whether they are a “financial institution” or “creditor” within the meaning of the red flags rules. Financial institutions are defined to include certain banks, and credit unions, and any other person that, directly or indirectly, holds a “transaction account” belonging to a “consumer.” A “transaction account” includes an account on which the account holder is permitted to make with-drawals by negotiable or transferable instrument, payment orders or withdrawal, telephone transfers, or other similar items for the purpose of making payments or transfers to third persons or others. Because “consumer” is defined as an individual, to qualify as a financial institution, an entity must hold a transaction account belonging to a natural person.
The SEC considers an investment adviser that directly or indirectly holds transactions accounts for an individual and who is permitted to direct payments or transfers out of those accounts to third parties to be a “financial institution” under the rule. The SEC also provides that even if an investor’s assets are physically held
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with a qualified custodian, an adviser with such authority, by power of attorney or otherwise, would hold a transaction account. An adviser with authority to withdraw money from an investor’s account solely to deduct the adviser’s own advisory fees, however, would not hold a transaction account because the adviser would not be making the payments to third parties.
Similarly, the red flags rules apply to private fund advisers whether the advisers directly or indirectly hold transaction accounts. For example, an adviser would be deemed to maintain a transac-tion account if an individual invests money in a private fund managed by the adviser and the adviser has the authority, pursuant to an arrangement with the private fund or the individual, to direct such individual’s investment proceeds to third parties (e.g., redemp-tions, distributions, dividends, interest, or other proceeds related to the individual’s account). On the other hand, the SEC commented that a private fund adviser may not hold a transaction account if such adviser has a narrowly drafted power of attorney with an investor under which the adviser has no authority to redirect the investor’s investment proceeds to third parties or others upon instructions from the investor. In addition a private fund adviser whose fund clients regularly borrow money from third-party credit facilities until investor contributions have been received would not necessarily be a financial institution.
The red flags rules also apply to entities if they are “creditors.” A “creditor” is defined as a person that regularly extends, renews, or continues credit, or makes such arrangements. Moreover, a creditor is a person that regularly and in the course of business advances funds to or on behalf of a person, based on an obligation of the person to repay the funds or to make them repayable from specific property pledged by or on behalf of the person. The SEC con-firmed that registered investment advisers could be “creditors” under the rules. For example, a private fund adviser could be subject to the red flags rule as a “creditor” if it regularly, and in the ordinary course of business, lends money, short-term or otherwise, to permit investors to make an investment in the fund, pending the receipt or clearance of an investor’s check or wire transfer or extends loans to portfolio companies. However, a private fund adviser would not qualify as a creditor and be subject to the red flags rules solely because its private funds regularly borrow money from third-party creditors pending receipt of investor contributions.
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If an adviser determines that it is a “financial institution” or “creditor” subject to the red flags rules, it must periodically assess whether it offers or maintains one or more “covered accounts” to or on behalf of “customers.” A “covered account” is defined as either (1) an account that a financial institution or creditor offers or maintains, primarily for personal, family, or household purposes, that involves or is designed to permit wire transfers or other pay-ment to third parties, or (2) any other account that the financial institution or creditor offers or maintains for which there is a reasonably foreseeable risk to customers or to the safety and soundness of the financial institution or creditor from identity theft, including financial, operations, compliance, reputation, or litigation risks. To determine whether “covered accounts” are offered, the investment adviser must conduct a risk assessment that includes a review of the red flags determined to be relevant to the adviser’s business and considers the methods the adviser provides to open its accounts, the methods it provides to access its accounts, and its previous experiences with identity theft.
2. Compliance Obligations
After the investment adviser determines that it is a financial institution or creditor that offers covered accounts, the investment adviser must establish and administer a customized, written identity-theft prevention program (the “Program”) that is designed to detect, prevent, and mitigate identity theft in connection with the opening of, or any existing, covered account. The Program must include certain elements and administrative procedures in order to comply with the rules. In its adopting release, the SEC emphasized that the rules are intended to provide financial institutions and creditors with flexibility in determining which red flags are relevant to their businesses and the covered accounts they manage over time.
The investment adviser’s Program must include reasonable policies and procedures to:
• identify relevant “red flags” for its covered accounts and incor-porate those red flags into the Program;
• detect such red flags;
• respond appropriately, based on the degree of risk of identity theft, to any detected red flags; and
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• periodically update the Program to reflect changes in risks to customers and to the safety and soundness of the adviser from identity theft. The red flags rules also mandate continued administration of
the Program, which includes the following requirements:
• the adviser must obtain approval of the initial written Program from either its board of directors, an appropriate committee of the board of directors, or, if the adviser does not have a board, from a designated senior management employee (collectively, the “Oversight Persons”);
• the adviser must involve the Oversight Persons in the over-sight, development, implementation, and administration of the Program;
• the adviser must train staff to effectively implement the Program; and
• the adviser must exercise appropriate and effective oversight of service-provider arrangements through which detection, prevention, or mitigation operations have been outsourced. Advisers should also consult the Interagency Guidelines on
Identity Theft Detection, Prevention, and Mitigation that were issued together with the red flags rules. The Guidelines are meant to assist financial institutions and creditors in the formulation and maintenance of a Program that satisfies the requirements of the rules. The Guidelines also include Supplement A, which provides illustrative examples of red flags that financial institutions and creditors are required to consider incorporating into their Programs, as appropriate depending on their specific business operations.
Questions to consider:
• Have you analyzed the possible risks of identity theft associated with your business?
• Have you developed and implemented policies and procedures tailored to the unique risks you have identified? Do such pro-cedures establish processes to help identify and detect relevant suspicious activity and to respond appropriately to threats?
• Do you regularly train your employees to identify emerging risks and vulnerabilities and red flags?
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V. INVESTMENT ADVISORY CONTRACTS
There are numerous regulations and rules that apply to advisers when forming new client relationships. Among those most critical for con-sideration are regulations and rules in connection with investment advisory contracts (“advisory contracts”), many of which are set forth pursuant to Section 205 of the Advisers Act. Advisers should be aware of what generally needs to be in an advisory contract, as well as provisions applicable to particular clients. An adviser must carefully monitor its advisory contracts to stay on top of each client’s rights, and the various legal obligations associated with those rights, and its client base as a whole. Although not statutorily required by the Advisers Act, many of the Advisers Act’s rules are premised on advisory contracts being in writing.43 The framework of an advisory contract may be found in Appendix A of this article.
A. Legal Requirements
Section 205 of the Advisers Act dictates a number of contractual provisions related to an advisory contract. First, pursuant to Section 205 (a)(2) of the Advisers Act, an advisory contract must include a provision prohibiting the investment adviser from assigning the advi-sory contract without the client’s consent.44 The term “assignment” is interpreted broadly, meaning any direct or indirect transfer of an advisory contract or of a controlling block of the adviser’s outstand-ing voting securities by a security holder of the adviser. To address the breadth of the definition, Rule 202(a)(1)-1 under the Advisers Act provides that certain transactions that do not involve a transfer of actual control or management of the adviser, despite falling within the scope of the definition of assignment, are not an assignment. The SEC staff has provided some guidance through no-action letters on the meaning of “control” and “controlling influence” and the types of transfers and transactions that would not qualify as an assignment. In the case of an assignment, however, an adviser should seek client consent by providing clients with written notice a reasonable amount
43. The Company Act, in contrast, requires an advisory contract with a registered investment company must be in writing, among other enumerated requirements.
44. This rule does not apply to investment advisory contracts with registered invest-ment companies.
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of time before the assignment.45 Second, if the adviser is organized as a partnership, the advisory contract must require the adviser to notify the client of any change in the membership of such partnership within a reasonable time after any such change.46
Third, an advisory contract cannot provide for compensation to an adviser based on a share of capital gains or the appreciation of a client’s funds or any portion of such funds (i.e., performance fees), except in certain limited circumstances.47 Such limited circumstances include those in which the client is a “qualified client.” The definition of “qualified client” includes a “qualified purchaser,” (as defined in the Company Act), “knowledgeable employee,” and persons meeting certain net worth and assets under management tests. Additionally, there are exceptions to the limitations on performance fees related to business development companies, 48 non-U.S. residents, private invest-ment companies excepted from the definition of “investment company” under Section 3(c)(7) of the Company Act, certain sophisticated clients, and fulcrum fees for registered investment companies, among others. Significantly, Rule 205-3 under the Advisers Act requires an adviser to “look through” certain clients to the equity owners to ensure that each owner satisfies the definition of qualified client before assessing a performance fee.49 This requirement applies to registered investment
45. The Advisers Act does not address the method of obtaining consent but SEC staff have granted no-action relief for negative consent letters provided written notifica-tion (paper or electronic) was given to clients in a reasonable timeframe, such as 60 days.
46. The SEC has not required such a notification when a limited partnership has changed its limited partners, to the extent the change was not an assignment.
47. The SEC staff recently granted no-action relief from the prohibitions in Section 205, permitting a fee rebate contingent on negative performance. Amerivest Investment Management, LLC, SEC No-Action Letter (Aug. 19, 2014).
48. In April of this year, a federal court permanently enjoined Charles Kokesh, the CEO of Kokesh Advisers, and imposed disgorgement and penalties for a number of securities law violations. Among the violations, the CEO was found to have aided and abetted violations of Section 205(b)(3), by exceeding the permissible threshold for performance-based compensation when entering into an advisory contract with a business development company. SEC v. Charles R. Kokesh, SEC Litigation Release No. 23228 (April 2, 2015).
49. An owner does not have to be a qualified client if it is not charged a performance fee, but it must be notified by the adviser if other owners have performance fee arrangements. See generally Exemption to Allow Registered Investment Advisers to Charge Fees Based upon a Share of Capital Gains upon or Capital Appreciation of a Client’s Account, Investment Advisers Act Release No. 996 (Nov. 14, 1985);
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companies, business development companies and private investment companies excepted from the definition of “investment company” under Section 3(c)(1) of the Company Act. The requirement does not apply to the adviser entering into the contract or to owners that obtain their interest through certain transfers by, for example, gift or bequest. Finally, with respect to fees, advisers should be aware of client con-sent and written disclosure obligations related to recommendations that clients invest part of their assets in a mutual fund managed by the adviser or an affiliate.
The Advisers Act also regulates certain indemnification provi-sions in an advisory contract. For example, under Section 215(a), any provision binding any person to waive compliance with the Advisers Act or its rules is void. Section 215(b) further limits an adviser’s ability to enforce an advisory contract that violates the Advisers Act. However, in Transamerica Mortgage Advisors, Inc., et. al. v. Lewis, the Supreme Court ruled that clients have “a limited private remedy under [Section 215 of] the Investment Advisers Act of 1940 to void an investment advisers contract, but that the Act confers no other private causes of action, legal or equitable,” with monetary damages reduced to solely fees paid to the adviser.50
More recent no-action relief from the SEC staff provides that a clause in an advisory contract that purports to limit liability, but that also contains a non-waiver clause, would not per se violate the anti-fraud provisions in Section 206 of the Advisers Act if the contract is with sophisticated clients, the terms accurately and clearly state the adviser’s intent and an intermediary explains the provision to the client.51 Staff further commented that whether a hedge or indemni-fication clause would violate Section 206 turns on “the form and content of the particular hedge clause (e.g., its accuracy), any oral or written communications between the investment adviser and the client about the hedge clause, and the particular circumstances of the client” (e.g., the client’s sophistication level).52
see also Investment Adviser Performance Compensation, Release No. IA-3372 (Feb. 15, 2012).
50. Transamerica Mortg. Advisors, Inc. et. al., v. Lewis, 444 U.S. 11, (1979). 51. Heitman Capital Management, LLC, SEC No-Action Letter (Feb. 12, 2007). 52. The SEC staff has said that an advisory contract cannot have any provision,
including a mandatory arbitration clause, which would lead a client to believe it had waived any available right of action against the adviser because such a provision may violate the antifraud rules of the Advisers Act.
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B. Suggested Provisions
Similar to having advisory contracts in writing, many advisers typically include provisions that, while not required by law, are matters of best business practice in light of the adviser’s business operations. Such suggested provisions address: the scope of the adviser’s authority; brokerage matters; delivery of documents; whether the adviser is also a broker-dealer; confidentiality of information; standard of care; use of sub-advisers; indemnification; proxy voting responsibility; custody; fees, charges and expenses; aggregation and allocation issues; exclu-sivity; termination or assignment of contracts; severability; governing law; and representations, warranties, waivers of breaches and dispute resolution.
Many advisory contracts also include investment guidelines and restrictions, as well as instructions for how the adviser will manage the client’s account. If an adviser includes investment guidelines in its advisory contracts with clients, such guidelines should be clear and include a process for amending.
Questions to consider:
• If you charge a performance fee, do you have a process in place to determine if each client charged the fee satisfies the definition of “qualified client” and, if necessary, that each beneficial owner of the client also satisfies the definition?
• Do you have written policies and procedures in place to ensure adherence to any investment guidelines and restrictions?
VI. SIDE LETTERS
Side letters are agreements that fund advisers enter into with certain new investors to accommodate their tax status (e.g., a tax-exempt investor), regulatory needs (e.g., a benefit plan investor), and/or legal status (e.g., a state administered fund). Side letters are also used to provide receiving investors with more favorable rights and privileges than other investors, as well as more favorable economic terms like lower management fees. Such partisan treatment, like liquidity preferences or more access to portfolio information, has spurred scrutiny by the SEC.53 Accordingly,
53. The SEC staff continues to review circumstances in which different or preferential treatment of investors is inadequately disclosed. See e.g., “Private Equity: A Look
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investment advisers should disclose in the fund’s marketing and dis-closure documents whether side letters will be utilized and create any conflicts of interest because of preferential treatment.
Conflicts of interest may also arise from the adviser’s internal compliance with side letters.54 One investor may request a side letter provision relating to its tax status that cannot be complied with when compared to a side letter provision previously given to another investor. Side letters also commonly include a most favored nations provision that gives the receiving investor the ability to review and elect provisions from side letters entered into with other investors. The administrative aspect of fulfilling such side letters may create compliance issues. Investment advisers should therefore develop and implement a record keeping and compliance procedure when entering into side letters.
Questions to consider:
• Have you adequately disclosed your use of side letters and the possible conflicts of interest created by such use?
• Do you have a process in place to fulfill most favored nations elections that reduces the risk of conflicts of interest?
• Have you implemented a system to track all side letter agreements and terms, and to monitor your practices to ensure they are con-sistent with such agreements?
VII. VOTING PROXIES
Investment advisers typically have the authority to vote proxies on behalf of their clients’ holdings. Unless the advisory contract explicitly reserves or assigns the proxy voting authority to the client, investment advisers will retain such proxy voting authority. With proxy voting authority, advisers have a fiduciary duty to vote such proxies in the best interests of clients. To effectuate this fiduciary duty, some investment advisers estab-lish proxy committees that manage the proxy voting process and engage third-party proxy voting services. Notwithstanding, rules under the Advisers Act require registered advisers that have proxy voting authority
Back and a Glimpse Ahead,” remarks by Marc Wyatt, Acting Director, Office of Compliance Inspections and Examinations (May 13, 2015).
54. When reviewing conflicts of interest in side letters, advisers should consider the cases discussed under VIII. Fiduciary Obligations.
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to meet four obligations with respect to such authority.55 Rule 206(4)-6, governing proxy voting, imposes three of these obligations and Rule 204-2 imposes the fourth.56
First, investment advisers with proxy authority must establish and maintain written policies and procedures for such proxy voting. The policies and procedures must be designed to ensure that proxy voting by the adviser will be conducted in the best interests of clients. The policies and procedures must also address how conflicts of interest are treated. Second, investment advisers must describe their written proxy policies and procedures to clients, indicate that a copy is available upon request, and provide a copy to the client if requested. Third, investment advisers must inform clients how they can obtain information on the advisers’ proxy voting history. Finally, pursuant to Rule 204-2(c)(2) under the Advisers Act, advisers must create and maintain five types of records in connection with proxy voting: (1) a copy of the proxy policies and pro-cedures; (2) copies of all proxy statements received for the securities owned by the fund;57 (3) copies of all votes cast on behalf of the fund; (4) records of all client requests for proxy voting information and responses thereto; and (5) any material records created in the course of the advisers’ proxy voting decision-making process.58
55. In adopting Rule 206(4)-6, the SEC noted that the rule did not alter or reduce any fiduciary duty applicable to any investment adviser or person associated with an investment adviser. Consequently, unregistered advisers should be mindful of their fiduciary obligations to clients if they have proxy voting authority. See generally Proxy Voting by Investment Advisers, Release No. IA-2106 (Jan. 31, 2003).
56. In 2015, the SEC staff included proxy rule compliance as an examination priority. Specifically, SEC staff determined to review policies and procedures that address any potential conflicts between clients and the adviser or third-party service pro-viders; disclosures on how clients can obtain a copy of proxy procedures and votes; and mechanisms to meet fiduciary obligations in voting proxies on behalf of clients. National Exam Program, Examination Priorities for 2015.
57. An adviser may rely on proxy statements filed in the SEC’s EDGAR system instead of maintaining its own copies. Rule 204-2(c)(2).
58. Investment advisers to registered investment companies should be aware of mutual funds’ proxy voting obligations to shareholders. In addition to having policies and procedures for proxy voting and disclosure of such procedures, mutual funds must publicly disclose their proxy voting history. See also Disclosure of Proxy voting Policies and Proxy Voting Records by Registered Management Investment Com-panies, Release No. 33-8188 (Jan. 31, 2003).
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Questions to consider:
• Do your written policies and procedures address the unique types of conflicts of interest that may arise with respect to proxy voting for your clients?
• Do your procedures assign responsibility for monitoring corporate actions and making voting decisions?
• Does your disclosure to clients accurately and concisely describe how you will handle the proxy voting process?
VIII. FIDUCIARY OBLIGATIONS
Although the Advisers Act does not specifically set forth fiduciary requirements for investment advisers, courts and the SEC have long rec-ognized that investment advisers owe fiduciary duties to their clients.59 As a fiduciary, an investment adviser has an affirmative obligation to discharge its duties solely in the best interests of its clients. This translates into putting clients’ interests first, acting with utmost good faith, provid-ing full and fair disclosure of all material facts, not misleading clients, and disclosing all conflicts of interest to clients.60 Additionally, the investment adviser must be sensitive not only to intentional wrongdoing, but also to unintentionally rendering investment advice that is less than impartial or less than disinterested.
Investments advisers’ fiduciary duties are made enforceable by the anti-fraud provisions in Section 206 of the Advisers Act.61 Areas in which advisers often fall short with respect to their fiduciary duties, as indicated by SEC enforcement cases and examination findings, include disclosure, portfolio management, employees’ personal trading, performance calculations, and brokerage arrangements and execution.62
59. SEC v. Capital Gains Research Bureau Inc., 375 U.S. 180 (1963). 60. Staff of the Investment Adviser Regulation Office, Division of Investment Manage-
ment, Regulation of Investment Advisers by the U.S. Securities and Exchange Commission, 22-24, (March 2013), available at https://www.sec.gov/about/offices/oia/ oia_investman/rplaze-042012.pdf.
61. Transamerica Mortg. Advisors, Inc.et. al., v. Lewis, 444 U.S. 11 (1979). 62. A September 2012 Internet article stated that breach of fiduciary duty was the number
one complaint in FINRA arbitrations. See “Breach of Fiduciary Duty No. 1 Complaint in FINRA Arbitration Cases,” available at http://www.thinkadvisor.com/2012/09/25/ breach-of-fiduciary-duty-no-1-complaint-in-finra-a.
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A. Conflicts of Interest
When establishing a new client relationship, the adviser needs to fully disclose to the client all material facts regarding a conflict and may have to seek client consent to engage in the activity or identify the steps, if any, taken to mitigate that conflict.63 For example, an investment adviser that manages assets of multiple clients and funds must adopt and disclose a policy that sets guidelines for the allocation of investments among the various clients and funds, although the policy can allow for fairly broad latitude in allocating the invest-ments.64 Registered advisers should make conflicts of interest dis-closures in their Form ADV brochures.65 Advisers should be mindful that the SEC staff continues to be highly focused on advisers and their actual or perceived conflicts of interest.66
B. Principal or Agency Transactions
Advisers must consider their fiduciary obligations when engaging in principal or agency transactions.67 Section 206(3) of the Advisers Act provides that an adviser may not (1) act as principal for its own account, knowingly sell any security to or purchase any security from a client, or (2) knowingly effect any sale or purchase of any security for the account of a client while acting as a broker for a third party (an agency cross transaction) without, in either case, disclosing to the client before the completion of such transaction, in writing, the
63. Amendments to Form ADV, Investment Advisers Act Release No. 3060 (July 28, 2010).
64. Compliance Programs for Investment Companies and Investment Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003).
65. Conflicts of interest remain a priority item for the SEC in 2015. The SEC staff has identified the topic within its priorities for its inspection program as well as its enforcement program. See e.g., Conflicts, Conflicts Everywhere – Remarks to the IA Watch 17th Annual IA Compliance Conference: The Full 360 View, Julie M. Riewe, Co-Chief, Asset Management Unit, Division of Enforcement (February 26, 2015).
66. See e.g., “Conflicts, Conflicts Everywhere – Remarks to the IA Watch 17th Annual IA Compliance Conference: the Full 360 View,” remarks by Julie Riewe, Co-Chief, Asset Management Unit, Division of Enforcement (Feb. 26, 2015).
67. In a principal transaction, an adviser, acting for its own account, buys a security from, or sells a security to, the account of a client. In an agency transaction, an adviser arranges a transaction between different advisory clients or between a brokerage customer and an advisory client. Interpretation of Section 206(3) of the Investment Advisers Act of 1940, Investment Advisers Act Release No. 1732 (July 17, 1998).
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capacity in which the investment adviser is acting and obtaining the client’s consent.68 The appropriate disclosure will depend upon the mate-riality of the facts in each circumstance and the nature of the particular client’s relationship with the adviser. In addition, the SEC has clarified that (1) advisers should obtain client consent to a principal or agency transaction before settlement of the transaction and (2) an adviser will not be “acting as a broker” within the meaning of Section 206(3) if the adviser receives no compensation (other than its advisory fee) for effecting a particular agency transaction between advisory clients.69
The SEC believes that both principal and agency transactions create the potential for advisers to engage in self-dealing and abusive activities such as price manipulation. As a result, Section 206(3)’s prohibition against acting in transactions in which the investment adviser has divided loyalties overrides any investment discretion con-ferred on the investment adviser by contract. Advisers should be aware of the availability in Rules 206(3)-1 through 206(3)-3T of limited exemptions from and safe harbors for compliance with Section 206(3),70 provided that certain conditions are fulfilled.71
68. Section 206(3) applies not only to transactions by advisers that are also broker-dealers, but also to transactions effected by a broker-dealer affiliated with an investment adviser.
69. Investment Advisers Act Release No. 1732 (July 17, 1998). 70. See generally, Adoption of Rule 206(3)-1 Under the Investment Advisers Act of
1940 and Termination of Temporary Rule 206(3)-1(T) Under that Act, Investment Advisers Act Release No. 470 (Aug. 20, 1975). See also, Rules Implementing Amend-ments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. 1633 (May 15, 1997), Temporary Rule Regarding Principal Trades with Certain Advisory Clients, Investment Advisers Act Release No. 2653 (Sept. 24, 2007), and Temporary Rule Regarding Principal Trades with Certain Advisory Clients, Investment Advisers Act Release No. 3984 (Dec. 17, 2014).
71. Conditions under Investment Advisers Act Rule 206(3)-3T include, among others, (1) providing written prospective disclosure regarding the conflicts arising from principal trades; (2) obtaining written, revocable consent from the client pro-spectively authorizing the adviser to enter into principal transactions; (3) making certain disclosures, either orally or in writing, and obtaining the client’s consent before each principal transaction; sending the client confirmation statements disclosing the capacity in which the adviser has acted and disclosing that the adviser informed the client that it may act in a principal capacity and that the client authorized the transaction; and (5) delivering to the client an annual report itemizing the principal transactions. Regulation of Investment Advisers by the U.S. Securities and Exchange Commission at 29-30 (March 2013).
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C. Directed Brokerage Arrangements
Directed brokerage arrangements are another area in which an adviser has a disclosure obligation because of the associated conflicts of interest. An adviser may have conflicts between the clients’ interest in obtaining best execution and the adviser’s interest in receiving future referrals or, when the executing broker under a directed brokerage arrangement is an affiliate of the adviser, the adviser’s and its affiliate’s interest in obtaining compensation from brokerage transactions. Conse-quently, the adviser must provide disclosure regarding any directed brokerage arrangements in its Form ADV brochure. The disclosure should include:
• the existence and terms of its practice regarding brokerage transactions;
• the effect of such practices on commission charges to its clients;
• the effect of directing brokerage on the adviser’s ability to negotiate commissions;
• the resulting inability to obtain volume discounts or best execu-tion for broker- directed accounts in some transactions;
• the resulting disparities in commission charges; and
• the potential conflicts of interest arising from referrals and directed brokerage practices.
D. Enforcement Actions
Recent enforcement actions in connection with fiduciary obli-gations have concentrated on conflicts of interest and lack of disclo-sure of such conflicts. For example, in a case against a private equity firm and four of its executives, the SEC settled charges that they failed to disclose conflicts of interest to a fund client and investors when fund and portfolio company assets were used for payments to former firm employees and an affiliated entity, particularly when the benefits of certain of the fees should have been provided to a fund client in the form of management fee offsets.72 The principles of Concord Equity Group Advisors, LLC, settled SEC charges that the
72. In the Matter of Fenway Partners, LLC, et al., Investment Advisers Act Release No. 4253 (November 3, 2015).
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principals of the firm breached their fiduciary duty to clients by failing to disclose a conflict of interest – namely, an undisclosed commission-sharing arrangement – and by failing to seek to obtain best execution for their clients.73 In another settled action, the SEC found that an adviser and its principal breached their fiduciary duties by allocating the majority of the principal’s compensation to funds managed by the adviser. The SEC found that the allocation of the expenses to the funds constituted a conflict of interest that was not expressly disclosed in the funds’ private placement memorandums or limited partnership agreements.74
In January 2015, the SEC alleged in Shelton Financial Group Inc. that an investment adviser failed to properly disclose com-pensation it received from a broker-dealer for investing client assets in certain no transaction fee mutual funds, thus creating a conflict because of the incentives for the adviser to recommend certain funds to its clients.75 And at the end of the year, in a settled action against two J.P. Morgan entities, the SEC alleged a failure to disclose conflicts of interest to clients arising from preferences for J.P. Morgan pro-prietary funds (mutual funds and hedge funds) and third party-managed private hedge funds that shared client fees with a J.P. Morgan affiliate.76 Not only were the funds proprietary but some client were being put into more expensive share classes as part of the placement in the proprietary funds.
In Alpha Titans LLC, a private fund adviser settled claims with the SEC that it breached its fiduciary duty under Section 206(2) by using fund assets to pay for operating expenses in a manner not clearly authorized under funds’ operating documents and by distrib-uting materially misleading financial statements that inadequately and incorrectly described expenses paid by its funds.77 In Kohlberg Kravis Robers & Co. (“KKR”), the SEC entered an order finding that
73. In the Matter of Alan Gavornik, Nicholas Mariniello and Lee Argush, Investment Advisers Act Release No. 3972 (Nov. 24, 2014).
74. In the Matter of Clean Energy Capital, LLC and Scott A. Brittenham, Investment Advisers Act Release No. 9667 (Oct. 17, 2014).
75. In the Matter of Shelton Financial Group, Inc. and Jeffrey Shelton, Investment Advisers Act Release No. 3993 (Jan. 13, 2015).
76. In the Matter of JPMorgan Chase Bank, N.A. and J.P. Morgan Securities, LLC, Investment Advisers Act Release No. 4295 (December 18, 2015).
77. In the Matter of Alpha Titans, LLC, Timothy P. McCormack, and Kelly D. Kaeser, Esq., Investment Advisers Act Release No. 4073 (April 29, 2015).
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KKR breached its fiduciary duty by misallocating broken-deal expenses and failing to implement a written compliance policy governing its fund expense allocation practices.78 In Equitas Capital Advisors, the SEC entered an order against an investment adviser and its officers for violating Sections 206(2), (4), and 207 by failing to adequately disclose certain fees and conflicts of interest to clients.79 Despite warnings by examination staff, the adviser never disclosed the con-flicts of interest the adviser had in recommending investments in a fund managed by the adviser’s principals. Because the firm’s prin-cipals had a financial incentive to recommend that clients buy and remain in that fund, the SEC found that a conflict of interest existed. Moreover, the adviser affirmatively stated in its Form ADV that there were no such conflicts, and denied that it had any such conflicts in its responses to requests for proposals from potential clients.
In a similar action, the SEC instituted administrative proceedings against an investment adviser for allegedly violating Sections 206(1), (2), and (4), and Section 207 by failing to disclose to its clients significant conflicts of interest from which the adviser profited at its clients’ expense.80 The SEC alleged that the adviser and its president obtained undisclosed compensation from inflated transaction charges charged to clients by the broker-dealer that it recommended. In addition, the adviser’s Forms ADV and brochures allegedly made false and misleading statements about the adviser’s compensation arrangement with the broker-dealer and omitted certain facts that were required to be disclosed. Moreover, the SEC alleged that the adviser and its president breached their fiduciary obligation to seek best execution for their clients by failing to seek to obtain the best price or lowest commission reasonably available for their clients.
Significantly, the SEC brought its first action charging violations of Rule 38a-1 of the Investment Company Act for failing to report a material compliance matter to a fund board.81 Specifically, the SEC alleged that the firm violated Rule 38a-1 of the Investment Company
78. In the Matter of Kohlberg Kravis Roberts & Co. L.P., Investment Advisers Act Release No. 4131 (June 29, 2015).
79. In the Matter of Equitas Capital Advisors, LLC et.al., Investment Advisers Act Release No. 3704 (Oct. 23, 2013).
80. In the Matter of Fry Hensley and Company and Nicholas L. Fry, II, Investment Advisers Act Release No. 3564 (Mar. 8, 2013).
81. In the Matter of BlackRock Advisors, LLC and Bartholomew A. Battista, Invest-ment Advisers Act Release No. 4065 (April 20, 2015).
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Act, Sections 206(2) and 206(4) of the Investment Advisers Act and Rule 206(4)-7, and breached its fiduciary duty by failing to either eliminate the conflict of interest created by the outside business activity of a top-performing portfolio manager, or to disclose the conflict to the relevant fund board or advisory clients. The adviser, BlackRock Advisors LLC, agreed to settle the matter for $12 million.82
Absent an exemption or safe harbor, the SEC has brought enforce-ment actions against advisers for unauthorized principal or agency transactions. The SEC, for example, obtained summary judgment against an advisory firm, its principal and affiliated broker-dealer for conducting thousands of cross-trades among clients, and principle transactions with client accounts, without notifying and obtaining consent from their clients in advance of each of those transactions that were cross-trades or principal transactions.83 In addition, last year, the SEC settled an action with Citigroup Global Markets (“CGMI”) where CMGI’s inadequate policies and procedures following an acquisition of a market maker led to execution of more than 467,000 orders on a principal basis.84
In 2014, the SEC obtained an initial decision against an invest-ment adviser for failing to provide adequate written disclosures and obtain client consent that the adviser was acting as a broker for the funds that were being recommended for investment.85 The SEC also charged an adviser and its managers with 206(3) violations in a case against VERO Capital Management, LLC (“VERO”).86 The SEC alleged that the adviser and managers caused the funds they managed to purchase notes from an affiliate of the firm, which constituted principal transactions, without providing the necessary notice or obtaining the required client consent.
In addition, the SEC instituted administrative proceedings against an adviser for violating Section 206(3) by causing private equity funds sold and managed by the adviser to borrow money from the
82. Id., April 20, 2015 83. SEC v. Warren D. Nadel et al., SEC Litigation Release No. 23235 (April 8, 2015). 84. In the Matter of Citigroup Global Markets, Inc., Investment Advisers Act Release
No. 4178 (August 19, 2015). 85. In the Matter of Larry C. Grossman and Gregory J. Adams, Initial Decision
Release No. 727, Administrative Proceeding File No. 3-15617 (Dec. 23, 2014). 86. In the Matter of VERO Capital Management, LLC, Robert Geiger, George Barbaresi
and Steven Downey, CPA, Investment Adviser Act Release No. 3991 (Dec. 29, 2014).
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adviser at unfavorable rates and pledging the funds’ assets as col-lateral, without providing written notice to or obtaining consent from the funds prior to each transaction.87 The SEC also charged the firm with violations of Sections 206(1), (2), and (4) of the Advisers Act for misappropriating more than $3 million from the funds by improp-erly allocating the adviser’s expenses to the funds without adequate disclosures to investors, among other fraudulent activities. In another enforcement action, the SEC charged an adviser with violating Section 206(3) by engaging in thousands of principal transactions through an affiliated broker-dealer without providing written disclosure to, or obtaining consent from, its clients.88 The adviser also allegedly failed to adopt and implement written compliance policies and pro-cedures reasonably designed to prevent violations of the Advisers Act, in violation of Section 206(4).89
The SEC also has brought violations in relation to failure to comply with obligations related to directed brokerage.90
Questions to consider:
• Have you fully disclosed to your clients the nature of any conflicts of interest?
• Have you developed and implemented written policies and procedures to mitigate any conflicts of interest?
• Do you have principal and personal trading policies and do you regularly train your employees on such policies?
IX. CUSTODY OF CLIENT ACCOUNTS
Rule 206(4)-2 of the Advisers Act requires registered investment advisers who have “custody” of client assets to take specific measures to protect
87. In the Matter of Clean Energy Capital, LLC and Scott A. Brittenham, Investment Advisers Act Release No. 3785 (Feb. 25, 2014).
88. In the Matter of Tri-Star Advisors, Inc., William T. Payne, and Jon C. Vaughan, Investment Advisers Act Release No. 3727 (Nov. 26, 2013).
89. See also, In the Matter of Belsen Getty, LLC, Terry M. Deru, and Andrew W. Limpert, Securities Act Release No. 9336 (Jul. 11, 2012).
90. See e.g., In the Matter of Mark Bailey & Co. and Mark Bailey, Investment Advisers Act Release No. 1105 (Feb. 24, 1988).
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those assets from loss.91 “Custody” is generally defined as holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. Under the rule, an adviser has custody if a related person has custody of securities or funds of the adviser’s clients in connection with advisory services provided to such clients by the adviser.
A. Generally
Rule 206(4)-2 provides three non-exhaustive examples of cir-cumstances that cause an investment adviser to have custody of client funds and securities. First, any arrangement (including general power of attorney) pursuant to which the adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian, including the right to deduct advisory fees, upon the adviser’s instruction to the custodian, would cause the adviser to have custody for pur-poses of the rule. Second, an adviser’s receipt and possession of client funds and securities triggers custody except where the adviser receives them inadvertently and returns them to the sender within three business days. Third, an adviser is deemed to have custody under the rule if it serves in any capacity that gives the adviser or a supervised person of the adviser legal ownership of or access to client funds or securities. As a result, an adviser is deemed to have custody of a private fund’s securities and assets if the adviser or a related person of the adviser serves as a general partner or managing member of the private fund.
If an adviser has custody over customer funds or securities, Rule 206 (4)-2 creates certain affirmative obligations at the onset of the custody relationship. The rule requires that an investment adviser maintain such funds or securities with a qualified custodian. A “qualified custodian” includes a bank, savings association, registered broker-dealer, and other institutions enumerated in the rule. The qualified custodian must maintain such funds or securities in either a separate account in the client’s name or in accounts containing only funds or securities of the adviser’s clients in the name of the adviser as agent/ trustee for the clients. Further, investment advisers that open an account
91. See generally Custody of Funds or Securities of Clients by Investment Advisers, Release No. IA-2968 (Dec. 30, 2009); See also Custody of Funds or Securities of Clients by Investment Advisers, Release No. IA-2176 (Sep. 25, 2003).
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on a client’s behalf must notify the client in writing of the custodian’s name, address, and the manner in which the funds or securities are maintained. This notice must be sent “promptly” after the account is opened, and must also be sent promptly after any changes in the infor-mation. In addition, advisers must ensure that they have a “reasonable basis” to believe that the custodian is sending account statements, at least quarterly, to each of the adviser’s clients for which it maintains funds or securities. The account statements should identify the amount of funds and/or securities in each account and set forth all trans-actions in the account during the relevant period.92
The rule also requires, subject to certain exceptions, that an investment adviser undergo a surprise examination on an annual basis with respect to client funds and securities for which the adviser has custody. Specifically, such client funds and securities must be verified at least once during each calendar year by an independent public account-ant, pursuant to a written agreement between the adviser and the accountant, and conducted without prior notice to the adviser of the timing of the examination and at times that are irregular from year to year.
Advisers should be aware that, in addition to the requirements described above, certain heightened requirements apply where the adviser or a related person of the adviser serves as the qualified cus-todian (as opposed to where the related person has “custody” under the rule) for the adviser’s clients in connection with advisory services the adviser provides to the clients. For example, the adviser or a related person may be registered with the SEC as a broker-dealer or may be a bank, and therefore able to serve as qualified custodian under the Rule. In such instances, the adviser must obtain, or its related
92. The SEC staff provided relief to the independent verification and account statement provisions of the rule for the limited circumstances where the only investors in the fund are (1) individuals who (a) have plenary access to infor-mation (either statutory, contractual or some combination of the two) concerning the management of the investment adviser, the pooled investment vehicle and the vehicle’s general partner or managing member (or equivalent), (b) are listed as “control persons” in Schedule A to Form ADV because of their status as the investment adviser’s officer or director with executive responsibility (or having a similar status or function) and (c) have a material ownership interest in the invest-ment adviser (“Principals”) and/or (2) any of the Principals’ spouses and minor children, as well as investment vehicles established solely for the individual or joint benefit of the Principals, their spouses or minor children. (Edwin C. Laurenson, McDermott Will & Emery, No-Action Letter (March 23, 2015).
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person must obtain and provide to the adviser, an internal control report within six months of the adviser or its related person com-mencing the role of qualified custodian and at least once each calendar year thereafter. The internal control report must be prepared by an independent public account registered with, and subject to inspection by, the Public Company Accounting Oversight Board (“PCAOB”) and must meet certain other requirements outlined in the Rule. Certain heightened requirements also apply in such circumstances to any surprise examination that the adviser must undergo.
The rule contains several exceptions that provide relief from one or more of its requirements. For example, none of the rule’s require-ments apply to accounts of registered investment companies managed by an adviser. Instead, an adviser must adhere to the custody require-ments in Section 17(f) of the Company Act with respect to registered investment companies managed by the adviser. Further, pooled investment vehicle assets for which an adviser has custody generally are exempt from all of the rule’s requirements except the qualified custodian requirement if: the pooled investment vehicle is subject to audit at least annually by an independent public accountant registered with, and subject to inspection by, the PCAOB (as of the date the engagement commences and as of the end of each calendar year); the adviser distributes the pool’s audited financial statements prepared in accordance with generally accepted accounting principles (“GAAP”) to all limited partners (or members or other beneficial owners) within 120 days of the end of the pool’s fiscal year; and the pool is subject to audit upon liquidation and distributes its audited financial statements prepared in accordance with GAAP to all limited partners (or members or beneficial owners) promptly upon completion of the audit.93
In addition, the rule includes an exemption from the qualified cus-todian requirements for certain privately offered securities. Securities
93. The Staff of the Division of Investment Management clarified the application of Rule 206(4)-2 to (i) special investment vehicles (“SPV”) used by a pooled invest-ment vehicle client when making investments and (ii) escrow accounts used by a pooled investment vehicle client when selling its interest in a portfolio company. Specifically, the guidance explained when an adviser relying on the audit provision may treat an SPV’s assets as assets of the pooled investment vehicle clients invested in it and when an adviser must treat the SPV as a separate client. The guidance also identified six set of circumstances in which a adviser may, in accordance with Rule 206(4)-2, maintain client funds in an escrow account with other client and non-client assets. IM Guidance Update No. 2014-07 (June 2014).
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that are acquired from the issuer in a private offering, that are uncertificated,94 and that are transferable only with the prior consent of the issuer or holders of the outstanding securities of the issuer are not subject to the custody rule.95 More recently, the SEC staff stated that, where a related person qualified custodian is the primary adviser, it will not recommend enforcement action against a subadviser that does not obtain a surprise examination provided that the subadviser does not: (1) hold client funds and securities itself; (2) have authority to obtain possession of clients’ funds or securities; or (3) have author-ity to deduct fees from clients’ accounts.96 Under this fact pattern, the subadviser will continue to be required to obtain from the primary adviser or qualified custodian annually a written internal control report prepared by an independent public accountant registered and subject to PCAOB inspection.
The Advisers Act imposes specific recordkeeping requirements on registered investment advisers that have custody or possession of client funds or securities. Specifically, these advisers must keep: (1) a journal or other record showing all purchases, sales, receipts, and deliveries of securities, and all other debits and credits to such accounts; (2) a separate ledger account for each client; (3) copies of con-firmations of all transactions effected by or for the account of any such client; (4) a record of each security in which any client has a position; and (5) a memorandum describing the basis upon which the adviser has determined that the presumption that any related person is
94. In guidance, the Staff of the Division of Investment Management have indicated that the Division would not object to advisers that keep client securities evidenced by private stock certificates, if: (1) the client is a pooled investment vehicle subject to a financial audit in accordance with paragraph (b)(4) of the rule; (2) the private stock certificate can only be used to effect a transfer or to otherwise facili-tate a change in beneficial ownership of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer; (3) ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client; (4) the private stock certificate contains a legend restricting transfer; and (5) the private stock certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction. IM Guidance Update No. 2013-04 (August 2013).
95. However, if the securities are held for the account of a limited partnership or other pooled investment vehicle, the exception is only available if the limited part-nership is audited and if the financial statements are distributed pursuant to paragraph (b)(4) of the rule.
96. Investment Adviser Association, No-Action Letter (April 25, 2016).
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not operationally independent has been overcome, if applicable. Advisers must also implement written policies and procedures designed to prevent, detect, and correct violations of the Advisers Act. In par-ticular, these policies and procedures must specifically address com-pliance with the custody rule, if applicable. The adopting release for the most recent amendments to the custody rule indicate certain suggested best practices for advisers with custody of client funds or securities: (1) conducting background checks on employees with access to client assets; (2) limiting the number of employees who interact with custodians, and periodically rotating those employees; (3) requiring authorization of more than one employee for the move-ment or withdrawal or assets from a client account; and (4) segregating the duties of advisory personnel from those of custodial personnel.
B. Enforcement Actions
When establishing a new client relationship, investment advisers should take care to evaluate whether they or an affiliate have custody over any client funds and securities. The SEC has focused significant attention on enforcement of violations of the custody rule in recent years.97 For example, in April 2015, the SEC settled charges again an adviser, its chief executive officer, and general counsel, for violations of the custody rule, among other violations.98 The adviser, which elected the audit exemption under the rule, was charged with dis-tributing financial statements that did not reflect certain related party relationships and material transactions such that the statements were not prepared in accordance with GAAP. In 2014, the SEC instituted administrative proceedings against Sands Brothers Asset Management LLC (“Sands Brothers”) for repeated violations of the custody rule.99 The SEC alleged failure to timely deliver to investors across ten private funds audited financial statements for three fiscal years. Noting
97. The SEC’s Office of Compliance and Examinations also has highlighted the importance of compliance with the custody rule in: National Exam Program Risk Alert: Significant Deficiencies Involving Adviser Custody and Safety of Client Assets, available at http://www.sec.gov/about/offices/ocie/custody-risk-alert.pdf.
98. In the Matter of Alpha Titans, LLC, Timothy P. McCormack and Kelly D. Kaeser, Esq., Investment Advisers Act Release No. 4073 (April 29, 2015).
99. In the Matter of Sands Brothers Asset Management, LLC, Steven Sands, Martin Sands, and Christopher Kelly, Investment Advisers Act Release No. 3960 (October 29, 2014).
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that the circumstances leading to the delays were predictable, the SEC alleged that Sands Brothers was at least 40 days late for fiscal year 2010, over six months late for fiscal year 2011 and approxi-mately three months late for fiscal year 2012. In 2010, the SEC had entered into a consent order involving Sands Brothers and similar violations of the custody rule for failing to distribute timely audited statements. The SEC also charged three fund managers and their advisory firm with failing to either have their funds audited by inde-pendent auditors or arranging for a surprise examination as part of their scheme to secretly divert investor money for their own benefit to prop up a fledgling side business.100 The SEC alleged that, in one instance, the managers lied to the funds’ custodial bank to withdraw $800,000 from the funds’ account to divert to the other company.
In July 2013, the SEC settled charges with a portfolio manager that misappropriated approximately $6 million in mutual fund shares after the manager made unauthorized transfers from client accounts.101 The manager routinely asked clients to sign blank transfer and wire authorization requests, which were then used to transfer client funds into his own trading account. The SEC also settled with the adviser entity for failing to take action to ensure that it complied with the requirements of the custody rule, including the surprise examination requirement, even after it learned of the manager’s illicit activities. Similarly, in April 2013, the SEC uncovered and settled violations of the custody rule and supervisory and compliance failures when an administrative and clerical employee of an adviser forged checks to misappropriate dividends owed to clients participating in pooled investment vehicles.102 The adviser had custody of the pooled invest-ment vehicle assets but failed to have the quarterly account statements or audited financial statements distributed to the clients investing in the vehicles. In addition, the adviser failed to perform an annual surprise examination, did not have policies and procedures in place that were reasonably designed to prevent violations of the custody rule,
100. In the Matter of VERO Capital Management, LLC, Robert Geiger, George Barbaresi and Steven Downey, CPA, Investment Adviser Act Release No. 3991 (Dec. 29, 2014).
101. In the Matter of Comprehensive Capital Management, Inc., Investment Advisers Act Release No. 3636 (Jul 20, 2013). See also In the Matter of GW & Wade, LLC, Investment Advisers Act Release No. 3706 (Oct. 28, 2013).
102. In the Matter of Vector Wealth Management, LLC, Investment Advisers Act Release No. 3587 (April 18, 2013).
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and did not conduct an annual review of the adequacy and effective-ness of its compliance policies and procedures. In September 2012, a hedge fund manager was charged with violations of the custody rule after diverting investor assets to an affiliated company, for failing to distribute audited financial statements, and for failing to undergo a surprise examination.103
The SEC has also brought actions for violating the custody requirements of the Investment Company Act. Last year, the SEC settled a matter with an investment adviser to several alternative mutual funds for violating the custody requirements of Section 17(f)(5) of the Investment Company Act of 1940 by maintaining $247 million in cash collateral at broker-dealer counterparties instead of the fund’s custodial bank.104
Questions to consider:
• Do you have procedures in place to protect client assets from loss or misappropriation? For example, have you designated the person(s) with authority to withdraw or transfer client assets from the custodial account? Do you require second-level approval to authorize any withdrawal or transfer?
• Have you provided adequate instructions to the custodian regard-ing the person(s) with authority to withdraw or transfer assets from each account?
• What steps do you take to form a reasonable belief that all clients receive periodic statements directly from any qualified custodian you select on behalf of a client? Do you receive a copy of the statements sent by the custodian to your clients? Do such state-ments adequately and accurately explain all account activity?
X. ERISA REQUIREMENTS
By having clients who are employee benefit plans, fund advisers are subject to the Employee Retirement Income Security Act of 1974 (“ERISA”). To establish whether new clients are employee benefit plans, fund advisers typically have ERISA-related representations in the funds’
103. In the Matter of Walter V. Gerasimowicz, et al., Investment Advisers Act Release No. 3464 (September 14, 2012).
104. In the Matter of Water Island Capital LLC, Investment Company Act Release No. 31455 (Feb. 12, 2015).
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subscription documents. Once advisers have determined the extent of employee benefit plan participation, fund advisers should determine whether to qualify for an exemption from ERISA or operate as an “ERISA fund.”
A. Exemptions
Pursuant to the Plan Asset Regulation promulgated by the Depart-ment of Labor, funds traditionally rely on what is commonly known as the “25% Test” for their exemption from ERISA. The 25% Test exemption limits investment by “benefit plan investors” (as such term is defined in ERISA) to less than 25%, so as to avoid the assets of the fund being treated as plan assets of benefit plan investors for pur-poses of ERISA. The 25% Test is calculated as of any date and with a couple of unique aspects. Equity interests in the fund held by the adviser and its affiliates do not count toward the 25% limit. If the fund structure is a master-feeder set up, the 25% test could apply to each feeder fund and separately to the master fund, but further analysis would be warranted in this scenario.
There are other exemptions available besides the 25% Test. A fund that operates as a venture capital operating company (“VCOC”) or a real estate operating company (“REOC”) may also be exempt from ERISA. A fund qualifies as a VCOC if (1) on the day on which it makes its first long-term investment and during a pre-established 90-day annual period, at least 50% of its assets are invested in “venture capital investments” or “derivative investments,” as defined by ERISA, and (2) on an annual basis, the fund exercises “management rights” (within the meaning of the Plan Asset Regulation) with respect to the management of the operating company. Advisers may satisfy the latter requirement by obtaining a board seat in conjunction with the fund’s first investment if it entails the right to substantially par-ticipate or influence the operating company’s management. A fund qualifies as a REOC if it (1) invests in real estate which is managed or developed with respect to which the fund has the right to sub-stantially participate directly in the management or development activities, and (2) on an annual basis is, in the ordinary course of its business, engaged directly in real estate management or development activities.
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B. Operating as an ERISA Fund
If the assets of the Fund are deemed to include benefit plan assets, or if the investment adviser chooses to operate as such, the fund will be considered an “ERISA fund” and be subject to ERISA’s reporting and disclosure requirements, as well as the bonding, the fiduciary responsibility, and the prohibited transaction provisions of ERISA and the IRS Code. The investment adviser must be registered with the SEC and acknowledge its status as a fiduciary (within the meaning of ERISA) with respect to each investor that is a benefit plan investor during all such times as the assets of the fund are treated as “plan assets” for purposes of ERISA.105 The investment adviser, for practical purposes, should qualify as a “qualified professional asset manager” (within the meaning of U.S. Department of Labor Exemp-tion 84-14) during all such times as the assets of the fund are treated as plan assets for purposes of ERISA. The investment adviser must also deliver available information to each benefit plan investor in order for such investors to make their annual filings of Form 5500 with the Department of Labor, as well as reasonable information held by the investment adviser to assist such investors’ compliance with Section 408(b)(2) of ERISA with respect to the fees charged by the investment adviser. The investment adviser must further acknowledge that it will use its best efforts to avoid any prohibited transactions under Section 406 of ERISA or Section 4975 of the IRS Code with respect to each benefit plan investor. For example, unless a statutory or class exemption is available, or an individual exemption is obtained from the Department of Labor, advisers are prohibited from cross trading with benefit plan assets, as the Department of Labor views such transactions as prohibited transactions under Section 406(b) of ERISA. In addition, ERISA fund advisers have specific obligations with respect to voting proxies and tendering shares (see below for a more general discussion on proxy voting). Finally, ERISA fund advisers
105. On April 14, 2015, the U.S. Department of Labor re-proposed rules addressing when a person providing investment advice with respect to an employee benefit plan or individual retirement account is considered to be a fiduciary under ERISA and the Internal Revenue Code. The re-proposal includes a general definition of fiduciary investment advice that would expand the group of people who would be considered fiduciaries, while also including a number of carve-outs for particular types of communications that would not be considered fiduciary in nature. Definition of the Term “Fiduciary”; Conflict of Interest Rule – Retirement Investment Advice, 80 Federal Register 21927 (Apr. 20, 2015).
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are subject to ERISA’s “prudent man” standard that requires such adviser to discharge its duties solely in the interests of the ERISA fund with the care, skill, prudence, and diligence under the circum-stances that a prudent man acting in a similar manner with appro-priate knowledge would use in a similar situation. To meet the prudent man standard, an ERISA fund adviser should give appropriate consid-eration to the surrounding facts and circumstances that such adviser should know are relevant to a particular investment decision.
C. Department of Labor Fiduciary Rule
On January 28 2016, the Department of Labor adopted rule changes re-defining the term “investment advice” and therefore the scope of persons who have a fiduciary obligation to pension and retirement plans.106 If a firm is deemed a fiduciary, it becomes subject to the prohibited transaction provisions of ERISA and the Internal Revenue Code, which may limit its ability to receive commissions, fees and other compensation.
Under the revised rule, a “fiduciary” is any individual receiving compensation for providing advice that is individualized or specifi-cally directed to a particular plan sponsor, plan participant, or IRA owner for consideration in making a retirement investment decision. Decisions within the scope of the rule include which assets to pur-chase or sell and whether to rollover from an employer-based plan to an IRA. Significantly, depending on the advice provided to a client, a fiduciary adviser can be a registered investment adviser, insurance agent, broker, or other type of adviser. The new rule includes exemp-tions for certain communications, business practices and activities. The rule has a phased implementation period beginning in April 2017 and ending January 1, 2018.107
Questions to consider:
• If operating as an “ERISA fund,” have you established proce-dures for providing information necessary for such investors’ annual filings of Form 5500 and compliance with Section 408(b)(2) of ERISA?
106. The final rule was published April 8, 2016. See 81 FR 20945. 107. At the time of publication, the rule was being challenged in both houses of Con-
gress. News reports claim that the President has said he will veto any challenge, leaving the rule to be implemented.
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• Do you have procedures in place to help prevent cross trading with benefit plan assets?
• Is the Department of Labor’s fiduciary rule applicable?
XI. ANTI-MONEY LAUNDERING
When establishing new client relationships, advisers should be aware of various monitoring and reporting obligations under federal anti-money laundering (“AML”) laws.108
A. Bank Secrecy Act
In general, advisers currently are not subject to rules imple-mented by the Financial Crimes Enforcement Network (“FinCEN”), a bureau of the U.S. Department of Treasury (“Treasury”), requiring financial institutions to establish AML programs pursuant to the Bank Secrecy Act (“BSA”) and the USA PATRIOT Act. Advisers are not subject to these rules because they are not considered “financial institutions” under the BSA. In 2003, FinCEN proposed an AML pro-gram rule for investment advisers, but subsequently withdrew its proposal. It then re-proposed a rule in September 2015 that would include advisers that are registered or required to be registered with the SEC within the scope of “financial institutions” under the BSA.109
Notwithstanding the proposed rule, certain investment advisers are subject to rules implemented by the Board of Governors of the Federal Reserve System that require non-bank subsidiaries of bank
108. Treasury’s Financial Crimes Enforcement Network recently adopted rule amend-ments to the AML laws, including a Customer Due Diligence rule, and proposed Beneficial Ownership legislation. The new rules are designed to strengthen require-ments for banks, broker-dealers, mutual funds, futures commission merchants, and commodities introducing brokers by requiring identification and verification of the beneficial owners or legal entity customers at the time a new account is opened. The rules also require AML programs to implement appropriate risk-based procedures for conducting ongoing customer due diligence. See Treasury Announces Key Regulations and Legislation to Counter Money Laundering and Corruption, Combat Tax Evasion (May 5, 2016).
109. 80 Federal Register 52680 (September 1, 2015). The proposed rule is similar to the prior rule iterations that had been withdrawn. By including advisers within the general definition of “financial institution” in the BSA regulations, the rule would require advisers to establish AML programs and to report suspicious activity as discussed in this section.
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holding companies to report suspicious activity by filing with FinCEN a Suspicious Activity Report (“SAR”). Such advisers must file a SAR in four categories of circumstances. The first category involves insider abuse involving any amount where the reporting entity has a substantial basis for identifying one of its directors, officers, employees, agents or other institution-affiliated parties as having committed or aided in the commission of a criminal act. The second category involves violations aggregating $5,000 or more where the reporting adviser has a basis for identifying a possible suspect or group of suspects. The third involves violations aggregating $25,000 or more even though there is no substantial basis for identifying a possible suspect or group of suspects.
The fourth category is similar to FinCEN’s bank SAR rule. It generally requires a SAR filing for any transaction conducted or attempted by, at or through the adviser and involving $5,000 or more in funds or other assets, if the adviser knows, suspects, or has reason to suspect that the transaction involves funds derived from illegal activities or is intended to disguise funds derived from such activities or has no business or apparent lawful purpose.
Advisers should careful review their affiliations to determine whether they have SAR reporting and recordkeeping obligations. Advisers that are dually registered as broker-dealers are subject to broker-dealer AML obligations, and all advisers must file Currency Transaction Reports with the Internal Revenue Service for cash trans-actions over $10,000. Further, advisers may voluntarily file SARs if they detect suspicious activity.
B. OFAC Sanctions
The Office of Foreign Assets Control (“OFAC”) of the Treasury administers economic and trade sanctions primarily against targeted countries and groups of individuals, such as terrorists and narcotics traffickers. All U.S. persons, including investment advisers, must comply with OFAC sanctions programs, which generally require U.S. persons to block accounts of targeted entities and prohibit or limit certain transactions involving such targeted entities.
When establishing a new client relationship, advisers should conduct due diligence to make sure their prospective client is not a targeted individual, entity, or company subject to OFAC sanctions. In addition, advisers should ensure their compliance programs incorporate procedures for compliance with OFAC rules.
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C. Criminal Money Laundering Laws
Sections 1956 and 1957 of the U.S. criminal code generally make it illegal to conduct or attempt to conduct a financial transaction knowing that the property involved in the transaction involves the proceeds of unlawful activity. Criminal penalties for AML violations include a maximum 20-year prison sentence and a $500,000 fine or twice the amount involved in the transaction, whichever is greater. As a result, an adviser could face criminal liability if, in the course of establishing a relationship with a new client, the adviser knows or suspects that the property involved in the transaction is criminally derived and does not respond appropriately.
D. Best Practices: Optional AML Programs
As a best practice, many investment advisers have implemented AML Programs as part of their overall compliance programs. Invest-ment advisers that want to comply voluntarily with FinCEN’s AML Program requirements to prevent money laundering and ensure com-pliance with OFAC should develop and implement AML policies, pro-cedures and controls, including policies and procedures for knowing their clients and the source of their clients’ funds – a Customer Identification Program (“CIP”). They should consider designation of an AML compliance officer, an employee training program, and audit procedures to test the implementation of their AML program.
An adviser’s CIP should include written risk-based procedures for verifying the identity of each client to the extent reasonable and practicable. The procedures should be tailored to the types of risks presented by the various accounts maintained by the adviser and the methods for opening such accounts. Overall, the adviser’s procedures should enable the adviser to form a reasonable basis for believing it knows the true identity of each client. In addition, the CIP procedures should address the following:
• what methods an adviser will take to verify the identity of the natural persons with authority or control over client accounts where the client is not a natural person;
• what steps the adviser will take if it is not able to form a rea-sonable belief that it knows the true identity of the client, including, among other considerations, when the advisor should not open an account or the terms under which the client may conduct
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transactions while the adviser continues to try to verify the client’s identification;
• the process by which an adviser will determine if a customer appears on any list of known or suspected terrorists or terrorist organizations issued by any federal government agency and the steps advisory personnel should take to follow any directives issued in connection with such lists; and
• the provision of notice to prospective clients regarding the adviser’s identity- verification process. Advisers to non-natural person clients should consider requiring
new clients to make representations in their client agreements relating to the source of such clients’ funds, including: (1) that the client has implemented a CIP as required under Section 326 of the USA PATRIOT Act and the regulations promulgated thereunder by the Treasury; (2) that the client has conducted the required internal due diligence; and (3) that the client and its customers or beneficial owners are not named on the List of Specially Designated Nationals and Blocked Persons maintained by OFAC.
An adviser that manages private funds should consider including certain information in a private fund’s subscription documents. For example, in the event of delay or failure by the subscriber or client to produce any information required for verification purposes, an adviser may want to refuse to accept a subscription or cause the withdrawal of any such investor from a fund. The investment adviser may also want the ability to suspend the payment of any distributions payable to such investor if the adviser reasonably deems it necessary to adhere to the adviser’s AML procedures and to satisfy any anti-money laun-dering regulations on a voluntary basis.
E. Reliance on Financial Institutions
Pursuant to FinCEN’s CIP rule, a broker-dealer may rely on another financial institution to perform any procedures of the broker-dealer’s CIP with respect to customers of the broker- dealer that are opening accounts or already have accounts with the other financial institution, provided certain conditions are satisfied. The Staff have provided no-action relief permitting broker-dealers to treat an invest-ment adviser as if it were subject to AML regulations and to rely on
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the investment adviser to perform the CIP procedures.110 Advisers therefore may want to consider their relationships with broker-dealers in determining whether or not to comply voluntarily with CIP rules.
Pursuant to SEC staff no-action relief, broker-dealers may rely on a US investment adviser that is registered as an adviser with the SEC to verify the identity of a shared customer for purposes of the CIP rule if such reliance is reasonable and the adviser contractually agrees to certain terms. Under the conditions of the relief, an adviser must contractually agree that:
• the adviser has implemented its own AML Program consistent with the specified requirements of the Bank Secrecy Act and will update its Program as necessary to comply with any changes to the law;
• the adviser will perform the specific requirements of the broker-dealer’s CIP consistent with relevant laws and rules;
• the adviser will promptly disclose to the broker-dealer potentially suspicious or unusual activity detected in carrying out the broker-dealer’s CIP in order to enable the broker-dealer to file a SAR as necessary;
• the adviser will certify annually to the broker-dealer that the rep-resentations in the reliance agreement remain accurate and that the adviser is in compliance with such representations; and
• the adviser will promptly provide its books and records relating to its performance of the CIP on behalf of the broker-dealer to the SEC, a self-regulatory organization with jurisdiction over the broker-dealer, or an authorized law enforcement agency, upon request. Additionally, a broker-dealer must engage in some due diligence
to assess the money- laundering risk presented by an investment adviser or the adviser’s customer base in order to determine if reliance on that investment adviser is reasonable under the circumstances. The foregoing requirements were promulgated by a no-action position taken by the Staff in 2004, and were recently reaffirmed and extended until the
110. Securities Industry and Financial Markets Association, SEC No-Action Letter (Jan. 9, 2015).
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earlier of either January 2017 or the date upon which an AML pro-gram rule for investment advisers becomes effective.111
F. Enforcement Actions
G. Enforcement Actions
Advisers dually registered as broker-dealers should be aware of recent FINRA and SEC enforcement actions for AML-related vio-lations.112 In a settled matter against Oppenheimer & Co, Inc. (“Oppenheimer”), the SEC claimed that the dually registered Oppen-heimer knew, suspected or had reason to suspect that a client was using its Oppenheimer account to faciliate unlawful activity.113 None-theless, Oppenheimer did not file any SARs with FinCEN as required by the BSA. In Department of Enforcement v. Highland Financial, Ltd. and Gordon D. Smith, FINRA fined the member firm and its managing principal, who served as the firm’s chief compliance officer (“CCO”) and AML compliance officer, for several AML violations.114 These included failing to timely file currency transaction reports, structuring deposits of customer’s cash,115 and failing to implement procedures designed to detect suspicious financial activities. Similarly, FINRA settled an enforcement action against a dually registered adviser and its CCO for failing to implement policies and procedures that could reasonably be expected to detect and cause the reporting of suspicious activity.116 The firm also was charged with failing to
111. Advisers should be mindful that AML Programs are an examination priority for the SEC in 2016. National Exam Program, Examination Priorities for 2016.
112. Reports indicate that the SEC staff may have conducted a sweep examination of the brokerage industry in 2014 for AML-related violations. “SEC probes Schwab, Merrill, for anti-money laundering violations – sources,” Emily Flitter and Jed Horowitz, Reuters (May 21, 2014).
113. In the Matter of Oppenheimer & Co. Inc., Securities Exchange Act Release No. 74141 (Jan. 27, 2015).
114. Department of Enforcement v. Highland Financial, Ltd. and Gordon D. Smith, FINRA Disciplinary Proceeding No. 2011025591601 (Sept. 27, 2013).
115. Structuring occurs when a person “conducts or attempts to conduct one or more transactions in currency, in any amount, at one or more financial institutions, on one or more days, in any manner, for the purpose of evading the reporting requirements under §1010.311.” 31 C.F.R. §1010.11(xx).
116. Department of Enforcement v. Thornes & Associates, Inc. Investment Securities and John Thomas Thornes, FINRA Disciplinary Proceeding No. 2012030567401 (July 18, 2013).
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implement policies, procedures, and internal controls reasonably designed to achieve compliance with the Bank Secrecy Act and regu-lations thereunder.
Questions to consider:
• Does your compliance program incorporate procedures for com-pliance with OFAC rules?
• Have you analyzed the types of risks presented by your various clients and tailored a CIP to address such risks?
• If you provide advisory services to pooled investment vehicles, have you drafted your subscription agreement to require investors to produce any information required for verification purposes?
• Do any broker-dealers with which you have a relationship rely on you to fulfill their CIP requirements? If so, have you established a process for ensuring you adhere to the requirements promulgated by the no-action position taken by the SEC?
• Do you have a training program for your employees regarding AML and, in particular, CIP, obligations?
XII. TAX CONSIDERATIONS
Investment advisers should consider the tax implications of any new client relationship as part of the client on-boarding process. Although the application of tax laws and regulations depend on the specific facts and circumstances surrounding each relationship and are beyond the scope of this paper, the client intake decisions discussed above can and often do have a significant tax impact on both the adviser and the client. Take for example, the tax-related obligations under the Foreign Account Tax Com-pliance Act provisions of the Hiring Incentives to Restore Employment Act of 2010 (commonly known as “FATCA”). Under FATCA, with-holding agents must withhold at a rate of 30% on certain payments to Foreign Financial Institutions, a classification that includes many advisers, unless they agree to report certain information to the IRS about their direct and indirect U.S. owners and accountholders.
Accordingly, advisers should consider including a consultation with appropriate tax counsel as part of their standard client on-boarding procedures.
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XIII. CONCLUSION
The above discussion provides only a broad overview of the obligations triggered with respect to onboarding new clients. Once educated on the various compliance obligations for new clients, investment advisers should develop and maintain policies and procedures addressing each such obligation. Advisers should also initiate annual internal evaluations and routinely update such policies and procedures to ensure that they are working, they are working in the manner described in the adviser’s disclosure, and they are current with developments in the law or industry practice. Investment advisers should consult their counsel as to the full array of compliance issues applicable to their specific business.
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Appendix A
Contributed by: Daniel Malooly and Debra Groisser For Illustrative Purposes
FRAMEWORK OF AN INVESTMENT MANAGEMENT AGREEMENT
This Investment Management Agreement (the “Agreement”) between [_______________ ____________] (the “Client”), as [______________] on behalf of the [_________________] and _______________________, a corporation organized under the laws of the State of ___________, U.S.A. (the “Investment Manager”), is made as of [_______], 20___.
WHEREAS, the Client desires to appoint the Investment Manager to furnish discretionary investment advisory services with respect to the investments of the account established by the Client (the “Account”); and
WHEREAS, the Investment Manager is willing to accept the duties and responsibilities of an investment manager with respect to the Account on the terms and conditions hereinafter contained;
NOW, THEREFORE, in consideration of the promises and mutual considerations provided herein, and intending to be legally bound hereby, the Client and the Investment Manager agree as follows: 1. Appointment. The Investment Manager will act as the investment
manager with respect to the Account. 2. Fees. The Client will pay the Investment Manager, as compensation
for its services under this Agreement, a fee determined in accord-ance with Schedule A to this Agreement. [IAA Section 205: Consider representations to establish “Qualified Client” status if there is a performance based fee]
3. Authority of Investment Manager. (a) Subject to Section 4 of this Agreement, the Investment Manager
shall have the discretionary authority to manage and control the assets of the Account, including the power to acquire and dispose of assets in the Account. In the exercise of that power, the Investment Manager may invest and reinvest the assets, without distinction between principal and income, in investments consistent with the investment guidelines of the Account attached hereto as Schedule B (the “Investment Guidelines”). [Specify any limitations on discretion] In no event shall the Investment Manager have the power or authority to take
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custody or possession of any assets in the Account. [Custody - IAA Section 223: Custody Rule – IAA Rule 206(4)-2]
(b) The assets initially segregated into the Account shall be [cash and/or securities as agreed upon by the parties hereto]. [Additional provisions relating to the addition and removal of assets (e.g. notice requirements)]
(c) In connection with transactions permitted hereunder, Client hereby grants to the Investment Manager, as its agent, the authority to negotiate and execute agreements and ancillary documents with appropriate counterparties (“Documentation”) that are binding on the Client, and to perform on the Client’s behalf, any and all of the obligations contemplated under such Documentation. [Necessary if signing trading or other agree-ments on behalf of client][Additional provisions relating to Investment Manager’s authority to act on behalf of the Client]
4. Investment Guidelines and Limitations. The Investment Manager shall manage the Account in accordance with the Investment Guide-lines contained in Schedule B to this Agreement; provided that, unless otherwise agreed by the parties, the Investment Manager shall have a [ ] period to bring the Account into compliance with the Investment Guidelines during initial funding and [additional pro-visions relating to non-compliance with guidelines, such as per-mitting non-compliance resulting from market movement and cash flows as long as non-compliance is cured within a reasonable time period (such as the next rebalancing of the portfolio)]. The Client represents and warrants that there are no restrictions on investments for the Account other than as provided in the Investment Guidelines, or on the Investment Manager’s selection of trading counterparties that may be used for the purchase or sale of investments in the Account.
5. Brokerage. The Investment Manager shall use its best efforts to obtain best execution of orders at the most favorable prices rea-sonably obtainable. When determining the most favorable prices reasonably obtainable, the Investment Manager may consider, in accordance with Section 28(e) of the Securities Exchange Act of 1934, as amended, the value of the receipt by the Investment Manager of services that affect securities transactions and incidental functions, such as clearance and settlement services, and advice as to the value of securities, the advisability of investing in securities, the
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availability of securities or purchasers or buyers of securities, and analyses and reports concerning issues, industries, securities, economic factors, trends, portfolio strategy and the performance of accounts. Commissions charged by or prices paid to brokers who provide these services may be somewhat higher than the commissions charged by or prices paid to brokers who do not provide these ser-vices. In accordance with Section 28(e), Investment Manager may pay a broker who provides these services commissions that are higher than the lowest available rate that another broker might have charged, if Investment Manager determines in good faith that the commissions are reasonable in relation to the value of the bro-kerage and research services provided, viewed in terms of either the particular transaction or the Investment Manager’s overall respon-sibilities with respect to all accounts as to which the Investment Manager exercises investment discretion. In selecting brokers, the Investment Manager may also consider various other factors, as described in the brochure (Part 2A of Form ADV) related to the Investment Manager. [Fiduciary Duty – IAA Section 206: Conflicts of Interest Disclosure - Best Execution – 1934 Act Section 28(e) safe harbor for Soft Dollar Arrangements]
With respect to the Account, the Investment Manager may cause securities transactions to be executed concurrently with authorizations to purchase or sell the same securities for other accounts managed by the Investment Manager. In these instances, the executions of purchases or sales shall be allocated among the various accounts (including the Account) in accordance with the allocation procedures of the Investment Manager, as described in the Investment Manager’s brochure, as amended from time to time. [Fiduciary Duty – IAA Section 206: Conflicts of Interest Disclosure – Allocation of Investment Opportunities]
6. Other Activities of the Investment Manager. In addition to the investment management services performed under this Agreement, the Investment Manager or any of its affiliates may engage in any other business and may render investment advisory services to any other person, even if the Investment Manager or other person has investment policies similar to those followed by the Investment Manager for the Account. The Investment Manager may, at any time, buy or sell, or may direct or recommend that another person buy or sell, securities of the same kind or class that are purchased or sold for the Account, at a price that may or may not differ from
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the price of the securities purchased or sold for the Account. In addition, the Investment Manager may, at any time, execute trades of securities of the same kind or class in one direction for an account and trade in the opposite direction or not trade for any other account, including the Account. As described in the Investment Manager’s brochure the Investment Manager is subject to various conflicts of interest arising out of [may add specifics relating to conflicts], and seeks to address such conflicts through elimination of the conflict, disclosure of the conflict, or management of the conflict through the adoption of appropriate policies and procedures. [Fiduciary Duty – IAA Section 206: Conflicts of Interest Disclosure – Other Activities of Investment Adviser]
7. Reports. [Provisions relating to reporting requirements] 8. Investment Manager Representation. The Investment Manager rep-
resents that it is a registered investment adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). The Investment Manager shall promptly notify the Client of any change in its status as such. [IAA Section 208]
9. Corporate Actions and Proxies; Other Actions. [Clearly state whether the Investment Manager is responsible for handling corporate actions, proxies, class actions, bankruptcies and other litigation related to investments and state which party is responsible for associated costs.]
10. Delegation. [Provisions relating to sub-advisers and other service providers]
11. Termination. [Provisions relating to termination] 12. Assignment of Agreement. The Investment Manager hereby agrees
in accordance with the Advisers Act that it shall not assign, as such term is defined in the Advisers Act, this Agreement without the prior written consent of the Client. [IAA Section 205(a)(2) ]
13. Notices. [Notice Provisions] 14. Disclosure Statement. The Client hereby acknowledges that it has
received from the Investment Manager a copy of the Investment Manager’s brochure (Form ADV, Part 2A) and applicable brochure supplements (Form ADV, Part 2B). [IAA Rule 204-3: Delivery requirements for IA Brochures and Brochure Supplements]
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15. Liability. The Investment Manager undertakes to manage the Account in accordance with the Investment Guidelines and in a professional and responsible manner. [Additional provisions relating to limitations on liability] This provision shall not constitute a waiver of any rights the Client may have under U.S. federal securities laws. [IAA Sections 206 and 215: IAA Release No. 58, 1951: Hedge Clauses]
16. Confidential Relationship. [Confidentiality obligations and appropriate carve outs including federal, state and global regulatory disclosures.]
17. Representations and Warranties. [Investment Manager representations relating to authority] [Client representations relating to authority, Commodity Exchange Act exemptions, QIB status, ERISA (if appli-cable), representations required under international laws (e.g. related to registration exemptions), representations to support execution of derivatives agreements by the Investment Manager on behalf of Client, etc.]
18. Entire Agreement; Amendments; Severability. 19. Governing Law[/Venue]. 20. Counterparts. 21. Consent to Electronic Delivery. Client hereby consents to electronic
delivery of all documents and information that the Investment Manager may be required to deliver to Client from time to time under the Advisers Act. [SEC Release No. IA - 1562 (May 9, 1996) – Guidance Relating to Electronic Delivery of Required Disclosures]
PURSUANT TO AN EXEMPTION FROM THE COMMODITY FUTURES TRADING COMMISSION IN CONNECTION WITH ACCOUNTS OF QUALIFIED ELIGIBLE PERSONS, THIS BROCHURE OR ACCOUNT DOCUMENT IS NOT REQUIRED TO BE, AND HAS NOT BEEN, FILED WITH THE COM-MISSION. THE COMMODITY FUTURES TRADING COMMIS-SION DOES NOT PASS UPON THE MERITS OF PARTICIPATING IN A TRADING PROGRAM OR UPON THE ADEQUACY OR ACCURACY OF COMMODITY TRADING ADVISOR DISCLO-SURE. CONSEQUENTLY, THE COMMODITY FUTURES TRADING COMMISSION HAS NOT REVIEWED OR APPROVED THIS TRADING PROGRAM OR THIS BROCHURE OR ACCOUNT DOCUMENT. [17 C.F.R. §4.7(c): Commodity Trading Advisory disclosure relief]
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IN WITNESS WHEREOF, the Client and the Investment Manager have executed this Agreement as of the day and year written above.
[CLIENT]
By: _______________________________ Name: Title:
[INVESTMENT MANAGER] By: _______________________________ Name: Title:
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SCHEDULE A
Fee Schedule Fees are payable quarterly in arrears and calculated by applying the annual rates specified below to the Average Market Value of the assets in the Account and dividing the resulting amount by four:
First $__ million 0.__% Next $__ million 0.__% Thereafter 0.__% For purposes of calculating the Investment Manager’s fee hereunder,
the Average Market Value of the assets under management shall be the average of the three month-end values of the assets in the Account during the applicable quarter, as determined by the Custodian pursuant to any reasonable methodology commonly used by custodians for such purposes. If funds or securities are contributed to or withdrawn from the Account by the Client, compensation shall be adjusted based on the amount of the funds so contributed or withdrawn or the market value of the securities, as determined by the Custodian, so contributed or withdrawn prorated for the actual number of days such assets were in the Account during the applicable quarter.
Bills will be rendered by the Investment Manager quarterly, and shall become payable by the Client upon receipt thereof.
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SCHEDULE B
Sample Investment Guidelines for Fixed Income Mandate 1. The objective of the Account is to outperform the [ ] Index (the
“Benchmark”) by [ ] basis points over a full market cycle. There is no assurance that such objective will be achieved.
2. The Account will be invested primarily in fixed income securities rated below investment grade by a Nationally Recognized Statistical Ratings Organization (“NRSRO”) or, if not rated, determined by the Investment Manager to be of comparable quality to securities so rated.
3. Under normal circumstances, eligible investments include, but are not limited to:
• U.S. Treasury and agency securities
• Obligations of issuers payable in any currency
• Issuers represented in the Benchmark
• Preferred securities
• Convertible debt obligations
• Securities subject to resale under Rule 144A of the Securities Act of 1933, as amended (“Rule 144A Securities”)
• Floating rate securities
• Payment-in-kind
• Common or related warrants, but only as the result of exer-cising an option related to an otherwise eligible security
• Forward foreign currency contracts, currency options, and currency futures
• Private placement securities (not including Rule 144A securi-ties) subject to a limit of []% of the market value of the Account
• Derivatives as specified below 4. The following chart sets forth the various quality, sector and issuer
limitations on Account investments (as a percentage of the Account’s market value):
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Quality Limits: BB- rated and higher No limit Below BB- Maximum of []% Minimum Rating (at time of purchase)
CCC-
Sector Limits: Per Industry +/- []% of index weights Foreign Issuers (Total) Limited to []% of the Account’s
market value Issuer Limits: U.S. government and agencies No limits BB- or better Maximum of []% of the
Account’s market value per issuer at time of purchase
B- to B+ Maximum of []% of the Account’s market value per issuer at time of purchase
Below B- Maximum of []% of the Account’s market value per issuer at time of purchase
In the case of split ratings, quality is based on the higher of ratings published by a NRSRO. Where no rating is available, quality will be based on the Investment Manager’s judgment as being equivalent to rated securities.
5. [permitted derivatives/limitations on derivative transactions] 6. In connection with the management of the Account’s cash position,
the Account may acquire and hold obligations of the U.S. Gov-ernment or any agency or instrumentality thereof, and [specify other cash investments].
7. [limitations on leverage]
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NOTES
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Compliance and Exams for Investment Adviser Lawyers (July 15, 2015)
Michael B. Koffler
Sutherland Asbill & Brennan LLP
Steven A. Yadegari
Cramer Rosenthal McGlynn, LLC
This outline was prepared by Issa Hanna, an Associate with Sutherland Asbill & Brennan, LLP.
Reprinted from the PLI Course Handbook, Fundamentals of Investment Adviser Regulation 2015 (Order #57123)
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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I. INTRODUCTION
A. Office of Compliance Inspections and Examinations (“OCIE”) – In creating OCIE, the Commission consolidated the inspection and examination programs authorized by the Securities Exchange Act of 1934 (the “Exchange Act”), the Investment Company Act of 1940 (the “Company Act”) and the Investment Advisers Act of 1940 (the “Advisers Act”).
OCIE describes its mandate as: to improve compliance; prevent fraud, monitor risk, and inform policy.
B. Securities and Exchange Commission (the “Commission” or the “SEC”) Authority to Examine 1. The Exchange Act – The Commission’s examination
program was established by the Exchange Act after the stock market crash of 1929 revealed shocking misconduct and mar-ketplace anarchy. Section 17 of the Exchange Act states in relevant part that the Commission is authorized to subject “such records…at any time, or from time to time, to such reasonable periodic, special or other examinations by repre-sentatives of the Commission…as the Commission…deems necessary or appropriate in the public interest, for the protec-tion of investors.”
2. The Company Act – Section 31 of the Company Act gives the Commission authority to mandate record keeping require-ments for investment companies and certain affiliates relating to the investment company’s financial statements. It also author-ized the Commission to conduct examinations. In 1996, Section 31 was amended to give the SEC greater authority to prescribe books and records for investment companies. Section 32 gives the Commission authority to require account-ants and auditors to keep records and provides for the inspection of audit reports and other documents relating to investment companies.
Section 32(c) specifically authorizes the Commission to require accountants and auditors to keep reports, work sheets, and other documents and papers relating to registered investment companies and to make them available for inspection by a representative of the Commission as the Commission may prescribe by rule, regulation, or order.
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3. The Advisers Act Amendments of 1960 – The Advisers Act did not originally authorize the Commission to mandate that advisers maintain specific books and records, nor did it authorize examinations. These gaps in the regulatory system were filled in 1960 when Congress amended section 204 of the Advisers Act to give the Commission authority to mandate the maintenance of specific books and records and to examine investment advisers.
II. BASICS OF ADVISER EXAMS –
In 1975, the Commission’s examination program was given its modern characteristics in the Securities Acts Amendments of 1975 (the “1975 Amendments”). Among other things, the 1975 Amendments established the framework for a national market system, expanded the Commission’s examination authority and authorized the agency to collect information outside of the formal examination process. A. Scope of Examinations – The 1975 Amendments provided the
Commission’s authorization to conduct reasonable periodic, special or other examinations at any time, or from time to time, as the Com-mission deemed necessary and appropriate in the public interest and for the protection of investors. Congress also authorized the SEC to examine “all records” maintained by the affected entities so that the agency’s examination authority was no longer limited to its books and records authority. As a result of this amendment to the Advisers Act, the Commission is authorized to inspect all of an adviser’s records.
B. Independent Authority to Obtain Copies of Records – The 1975 Amendments also gave the Commission the authority to require registrants to furnish copies of books and records independent of the examination process. This provided the agency with an entirely new power.
C. Entities Subject to Examinations – The books and records and examination provision of the Advisers Act applies to advisers, except those “specifically exempted from registration pursuant to section 203(b)” of the Act. Thus, even unregistered advisers are subject to examination, unless they are specifically identified in Section 203(b).
Section 203(b) exempts several types of entities, including: an intra-state adviser; an adviser whose only clients are insurance
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companies; an adviser that is a foreign private adviser; an adviser that is a charitable organization; a Section 414(e) plan; an adviser registered with the Commodity Futures Trading Commission, subject to certain restrictions; and an adviser to a Small Business Invest-ment Company, subject to certain restrictions.
Prior to the Dodd-Frank Act of 2010 (“Dodd Frank”), Section 203(b) included an exemption for private advisers with fewer than fifteen clients. Because that exemption was repealed by Dodd-Frank, advisers that were previously within the scope of that exemption are subject to examination.
D. Examination Characteristics – Given the diversity of investment advisers examinations vary considerably from firm to firm. However, the following characteristics are found in many examinations of advisers. 1. Preparation – Advance preparation includes research in
automated data libraries, review of the adviser’s filings with the Commission, review of any customer complaints received by the Commission, review of past inspection history and reports, and formulation of problem areas likely to be found.
2. Scope – Topics covered in an investment adviser inspection typically focus on how advisers comply with their fiduciary duties to their clients and often include, but are not limited to: (i) filings and reports, (ii) Form ADV brochure disclosure and delivery, (iii) contracts, (iv) custody, (v) books and records, (vi) financial condition, (vii) internal controls, (viii) advisory services, (ix) pay to play activity, (x) portfolio management, (xi) allocation of investment opportunities and expenses, (xii) privacy, (xiii) conflicts of interest, (xiv) brokerage and execution, (xv) wrap fee programs, (xvi) advertising and performance calculations, (xvii) compensation and client fees, (xviii) client referrals, (xix) valuation, (xx) cybersecurity, and (xx) litigation
3. Scheduling Fieldwork – Depending on the nature of the examination, the staff may contact an adviser to make an appointment before beginning fieldwork. Prior notice can range from a few days to a few weeks. However, generally no advance notice is given with respect to cause examinations and certain follow up examinations.
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4. Dealing with Refusals to Permit Access – In instances where the adviser attempts to deny access to its books and records, the Commission has two options. The Commission may (i) bring an enforcement action immediately to enjoin the adviser from further violations of the examination provisions, or (ii) initiate an enforcement investigation and gather the desired information by way of subpoena. Under the second option, the adviser may also be charged with failure to permit an examination in addition to any other violations discovered during the investigation.
5. Entry Interview – The substance of the entry interview will be determined by the nature of the examination. As a matter of policy, examiners will not disclose the type of examination they are conducting. Following the interview, the staff will frequently ask for a tour of the adviser’s offices and operations, to give the examiners some insight into how it conducts its business. An open and responsible attitude shows, often more clearly than any specific statement, that an adviser has nothing to hide.
6. Document Requests – The specific documents requested depend on the nature of the examination. Examiners may request records from areas that are not the primary focus of the examination. If certain records are not immediately availa-ble, the staff should be informed as to which records are not available and why, and be kept informed of the adviser’s process in making them available.
7. Questions – Examiners frequently have questions while reviewing the adviser’s books and records. Advisers often designate a liaison to the examination team, and in those circumstances, the staff will direct questions to the liaison. If a liaison is chosen, it should be a knowledgeable employee, and someone who has ready access to other employees with relevant knowledge. Examiners often wish to speak to and question the department heads at a firm in order to understand the firm’s control environment, policies and procedures, expec-tations, standards and processes and to gauge the firm’s culture of compliance. Sometimes, the SEC staff also questions more junior employees to gauge the consistency of their responses with what the staff is told by senior executives and to test employees’ perception of the “tone at the top.”
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8. Exit Interviews and Continuing Dialogue – The on-site portion of the exam may or may not conclude with a final meeting between the adviser and examination staff. Examiners may request a final interview with personnel who have personal knowledge about or responsibility for a particular aspect of the entity’s operations. At the conclusion of the examination, which could occur several weeks after the conclusion of the on-site portion of the review, the exam team will hold an exit interview or conference call with the adviser to discuss all matters that will be cited by the staff in any follow-up letter.
9. Analysis – One of the most important parts of the exam process is the staff’s analysis of their findings. The simplest type of analysis is one in which deficiencies can be identified on the basis of the adviser’s own records. The second type of analysis exists when examiners spot potential problems and follow-up with a more searching review of the area of risk. The third type of analysis involves the examiners’ judgment of the adviser’s operations and culture of compliance, and whether the adviser’s management and control structures work well and make sense in light of the firm’s operations. The fundamental purpose of an examination is not merely to determine whether the adviser maintains all required books and records, but also to determine whether investors have been or are being harmed, or face the prospect of future harm.
10. Results – Generally the examination will conclude with one of three results: (i) the examination is closed with no further action, (ii) the staff provides the adviser with a letter describ-ing any problems that were found (this was previously known as a “deficiency letter” but is now sometimes called an “exam results letter”), or (iii) the matter is referred to the Division of Enforcement for further investigation.
An exam that is closed with no further action by the staff is not a “clean bill of health” per se, but rather indicates that no violations were identified during the examination.
Where examiners identify compliance failures or defi-ciencies, they generally provide the adviser with a letter iden-tifying the problem and stating that they expect the adviser to take remedial action. These letters are issued to the adviser and generally are not made public.
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Where the adviser’s compliance failures are serious, the examination staff may refer the matter to the Division of Enforcement. The Division of Enforcement then determines whether to investigate the matter further and whether to recommend an enforcement action to the Commission.
11. Follow-up – This is the final step in an examination to ensure that deficiencies have been remedied. The staff frequently will ask advisers to document their actions, and it may conduct a surprise follow-up examination. The Commission can give considerable weight to an adviser’s failure to correct deficiencies when it determines whether an enforcement action is appro-priate in light of a follow-up surprise examination.
III. CURRENT ISSUES
A. Examinations – OCIE recently posted on the SEC website a list of its current areas of examination concern relating to different types of registrants, including investment advisers. In addition, in recent speeches members of the SEC staff have discussed the areas in which they anticipate focusing their attention during exams in the coming year. The focus areas of the investment adviser exam program are set out below: 1. Fee Selection and Reverse Churning – OCIE has observed
that financial professionals serving retail investors are increas-ingly choosing to provide advice in the retirement market-place under the auspices of an investment adviser or as a dual registrant, rather than solely a broker-dealer. Where such financial professionals offer a variety of fee arrangements (e.g., commissions or mark-ups for broker-dealer customers and fees based on assets under management, hourly fees, or wrap-fees for advisory clients), OCIE will focus on recommendations of account types and whether they are in the best interest of clients at the inception of the arrangement and thereafter, including fees charged, services provided, and disclosures made about such relationships. In the past, members of the SEC staff had noted that the staff would be reviewing how financial representatives determine whether to recommend brokerage or advisory accounts, the financial incentives for making such recommendations, and whether all conflicts of interest are fully and accurately disclosed. As part of this
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inquiry, the staff stated that it would be reviewing dually registered firms’ policies and procedures to understand if such policies and procedures provide guidelines for when a financial professional should make securities recommendations to a customer via a broker-dealer account versus an investment adviser account.
2. Sales Practices – OCIE will be assessing whether investment advisers are using improper or misleading practices when recom-mending the movement of retirement assets from employer-sponsored defined contribution plans into other investments and accounts, especially when they pose greater risks and/or charge higher fees.
3. Suitability. OCIE will evaluate investment advisers’ recom-mendations or determinations to invest retirement assets in complex or structured products and high yield securities, including the suitability of the advice, whether proper due diligence is conducted, and whether sufficient disclosures are made.
4. Cybersecurity – OCIE states in its exam priorities letter that it will continue its efforts to examine investment advisers’ cybersecurity compliance and controls. The exam priorities letter was followed by the SEC’s release of a Risk Alert summarizing the results of its 2014 Cybersecurity Exam Sweep, as well as the Division of Investment Management’s issuance of a Guidance Update on the topic. The Risk Alert noted that (i) many firms reported undertaking risk assessments to identify cybersecurity threats, vulnerabilities and potential business consequences, (ii) many firms are using external standards, such as those published by the National Institute of Standards and Technology (NIST) or the International Organ-ization for Standardization (ISO) to model their information security architecture and written policies, (iii) many firms have identified best practices through information-sharing networks with industry groups and associations, (iv) cyber-security risk policies relating to vendors and other business partners varied, and (v) only 21% of investment advisers exam-ined maintain insurance to cover losses and expenses related to cybersecurity incidents. The Guidance Update noted that advisers can mitigate the compliance risks associated with cyber threats by addressing the following in their compliance
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programs: (i) identity theft and data protection, (ii) fraudulent use of client information by firm employees, (iii) business continuity, (iv) disruptions in service that may prevent advisers from managing client assets, and (v) management and oversight of service providers to ensure protective cybersecurity measures are in place at such service providers. Furthermore, the Guidance Update suggested that advisers consider taking the following steps to address cybersecurity risks: (i) conduct periodic cybersecurity risk assessments, (ii) create a strategy designed to prevent, detect and respond to cybersecurity threats, and (iii) implement the strategy through written policies and procedures and training.
5. Alternative Investment Companies – OCIE will continue to assess funds offering alternative investments and using alter-native investment strategies, with a particular focus on: (i) leverage, liquidity, and valuation policies and practices; (ii) factors relevant to the adequacy of the funds’ internal controls, including staffing, funding, and empowerment of boards, compliance personnel, and back-offices; and (iii) the manner in which such funds are marketed to investors. This priority follows a 2014 speech at the Investment Adviser Asso-ciation Compliance Conference in which Andrew Bowden, the former Director of OCIE, highlighted the liquidity and redemp-tion-related risks associated with alternative mutual funds and the need for advisers to implement reasonable and effective controls in connection with such funds.
6. Fixed Income Investment Companies – The staff is monitoring the risks associated with a changing interest rate environment to ensure bond funds with significant exposure to interest rate increases have implemented policies and proce-dures and investment and trading controls to ensure that their funds’ disclosures are not misleading and that their invest-ments and liquidity profiles are consistent with those disclosures.
7. Large Firm Monitoring – OCIE will to monitor the largest asset managers for the purpose of assessing risks at individual firms and maintaining early awareness of developments industry-wide.
8. Fees and Expenses in Private Equity – Given the high rate of deficiencies OCIE has observed among advisers to private equity funds in connection with fees and expenses, OCIE will
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continue to conduct examinations in this area. This follows examinations of private equity firms in which the staff reported that about half of the private equity funds the SEC had been examining (approximately 400) were collecting fees from companies owned by the funds without disclosing the fees to investors or sharing them with investors. The SEC has focused on a lack of transparency associated with this practice and the level of fees charged to the portfolio companies. This also follows a May 2014 speech at the Private Equity Interna-tional Private Fund Compliance Forum in which Andrew Bowden cited a lack of transparency and disclosure regarding advisers’ collection of fees and allocation of expenses as the most common observation during OCIE examinations of private equity advisers that took place as part of the “Presence Exams” initiative. Mr. Bowden specifically pointed to pay-ments beyond management and performance fees made by the funds to “Operating Partners” (whom advisers promote as providing their portfolio companies with consulting services or other assistance that the portfolio companies could not inde-pendently afford) without sufficient disclosure to investors. Mr. Bowden also identified a trend of advisers shifting expenses (such as expenses for adviser employees and back-office functions) from themselves to their clients during the middle of a fund’s life — without disclosure to limited partners.
9. Issues in the Recent Past. Prior to OCIE’s publication of this year’s list of examination priorities, OCIE had announced that it would focus on the following areas:
• Safety of Assets;
• Conflicts of Interest Inherent to Business Model;
• Marketing/Performance;
• Never Before Examined Investment Advisers;
• Wrap-Fee Programs;
• Quantitative Trading Models;
• “Presence Exams” of recently registered private fund advisers; and
• Payments for Distribution in Guide.
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The staff continues to review these areas in examinations of investment advisers even though they are no longer the primary focus of the staff.
B. Related Enforcement Activities – Recently, the SEC announced that it brought 130 enforcement actions related to advisers and funds in the fiscal year ending September 30, 2014. Although this was a slight decrease in enforcement activity compared to the prior year, it was still one of the SEC’s most active years. 1. Types of Cases – The types of cases brought by the SEC have
included: (a) compliance failures, (b) aberrational performance issues, (c) fraudulent conduct, (d) violations of the custody rule, and (e) failures to comply with the adviser pay-to-play rule and (f) incidences of retaliation against whistleblowers. a. Compliance Sweep – On November 28, 2011, the SEC
announced the first results of an enforcement initiative directed at investment advisers’ compliance programs. In announcing the cases, SEC officials emphasized that the advisers should have responded when examiners pointed out deficiencies.
Enforcement officials have indicated that their sweep directed at compliance continues. Increasingly, compli-ance officials are personally on the line (see below).
b. Aberrational Performance Inquiry (API) – On December 1, 2011, the Division of Enforcement announced the initial results of its API. Using proprie-tary risk analytics, the SEC has been evaluating private fund returns and looking for “outlier returns” to achieve earlier detection of securities law violations and prevention.
Cases based on the API extend way beyond performance and include cases focusing on (i) valuation, (ii) strategy and (iii) liquidity. This method of securities law enforce-ment allows the SEC to find wrongdoing, even in the absence of a tip or complaint.
c. Fraudulent Conduct – The SEC announced its first action arising from a focus on fees and expenses charged by private equity firms. In the action, the SEC charged an adviser for fraud in the allocation of certain expenses
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to funds it managed without adequate disclosure to investors. The misallocated expenses included the majority of the portfolio manager’s own compensation. The SEC also found other violations including unauthorized loans to the funds collateralized by the funds’ own assets, changes to distribution calculations to investors without adequate disclosure, and misstatements to an investor about how much the portfolio manager and a co-founded had invested in one of the funds.
d. Custody Rule – The SEC brought three cases against investment advisers who failed to maintain client assets with a qualified custodian or engage an independent public accountant to conduct surprise exams as required by the custody rule.
e. Pay-to-Play Rule and Whistleblower Retaliation – In 2014 the SEC brought its first case enforcing the investment adviser pay-to-play rule, charging a private equity firm for providing advisory services for compen-sation within two years after an associate made contribu-tions to political candidates. The SEC also brought its first case under its new authority to bring anti-retaliation enforcement actions, charging a hedge fund adviser for retaliating against an employee who reported prohibited principal transactions to the SEC.
2. Chief Compliance Officer Liability – Compliance officials are increasingly the target of SEC enforcement actions, which is a change from past practice. For several years, compliance professionals were involved in enforcement actions only when they themselves engaged in serious misconduct. In several recent cases, however, the SEC has brought enforcement actions against compliance professionals based on concerns about how they carried out their professional duties (and not for affirmative misconduct).
In one such case (Tracy Wiswall, 2011), the CCO of a newly registered adviser was tasked with responsibility for establish-ing and administering the firm’s compliance program. The adviser bought an off-the-shelf Compliance Manual and retained a consultant who identified weaknesses and recom-mended a risk assessment to identify needs such as a Code of Ethics and compliance policies and procedures. Six months
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later, the recommendations were not implemented. The SEC brought an enforcement action ordering the CCO to pay a penalty of $50,000.
In another case (Gina M. Hornbogen, 2012), the SEC disciplined a CCO for allegedly failing to supervise an investment adviser representative who misappropriated funds from clients by forging client signatures on wire requests. Because the CCO had supervisory responsibility over the IAR but failed reasonably to investigate or otherwise respond to the numerous red flags indicating possible violations, she was barred from associating in a supervisory capacity and ordered to pay a civil penalty of $25,000.
In yet another case (Paul G. Dietrich, 2013), the SEC disciplined a CCO for his firm’s failure to conduct a timely annual review of the firm’s compliance policies and proce-dures and also for his firm’s failure to maintain complete and accurate trading records. The CCO was found to have aided and abetted his firm’s violations and was censured and ordered to pay a civil penalty of $25,000.
Finally, in one case (Mark M. Wayne, 2014), the SEC disciplined a CCO who also served in the roles of president and CEO for violations of the investment adviser custody rule. Although the firm had custody of client assets, it repeatedly failed to meet its obligations under the rule. In one year, the firm engaged an accounting firm to perform a required surprise examination but did not ensure that the accounting firm completed it. Furthermore, in the subsequent two years, the firm engaged another accounting firm to perform the surprise examinations, but the exams were insuf-ficient because the firm told the accountant that only a portion of the accounts over which it had custody were subject to the examination requirement.
3. Whistleblowers – Regulators have developed many mechanisms to obtain complaints about those they regulate. Recently, the SEC has adopted a new approach to obtaining complaints. Whistleblowers, even anonymous whistleblowers, are eligible for substantial monetary bounties under the SEC rules. If a whistleblower voluntarily provides original infor-mation that leads to a successful enforcement action in which the SEC obtains monetary sanctions of more than $1 million, the whistle blower may receive an award of between 10 and
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30 percent of the amount. In late 2014, the SEC published its Annual Report on the Dodd-Frank Whistleblower Program. According to this report, the SEC received 3,620 whistleblower tips, complaints and referrals in fiscal year 2014. During fiscal year 2014, the SEC made $2 million in award payments to whistleblowers under the SEC’s whistleblower program. This amount did not include a record award of $30 million to one whistleblower that was authorized during fiscal year 2014 but paid after the close of the year. Senior staff members of the SEC have repeatedly commented that the SEC’s whistleblower program is a key component of the agency’s efforts to detect and stop fraudulent activity and that the agency continues to investigate the tips that are received.
C. Never-Examined Advisers – In February 2014, OCIE launched an initiative directed at investment advisers that have never been examined, focusing on those that have been registered with the SEC for three or more years. In connection with this initiative, OCIE sent a form letter to never-examined advisers explaining that OCIE’s examination of never-examined advisers would focus on one or more of the following higher-risk areas: (i) compliance programs, including a review of an adviser’s books and records, to determine if an adviser has adequately identified conflicts of interest and compliance-related risks, adopted appropriate policies and procedures to mitigate and manage those risks, and empowered a competent CCO to administer the compliance program; (ii) filings/disclosures to ensure that all material facts regarding con-flicts of interest have been disclosed; (iii) marketing materials with a view to whether the adviser has made false or misleading statements about its business; (iv) portfolio management, including the allocation of investment opportunities and whether the adviser’s investment management practices are consistent with disclosures; and (v) compliance with the Custody Rule.
D. Compliance Issues for Private Fund Advisers – Title IV of Dodd-Frank eliminated the private adviser exemption from regis-tration. As a result, private fund advisers, including advisers to hedge funds and private equity funds, are now subject to registration and SEC oversight. The SEC’s NEP has focused in on these new registrants, highlighting a number of issues of particular relevance to them.
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1. Presence Exams – In 2012, the SEC’s NEP launched an initiative to conduct focused, risk-based examinations of investment advisers to private funds that recently registered with the SEC (“Presence Exams”). The Presence Exams initia-tive is nearing completion and has three primary phases: engagement, examination, and reporting. Each phase was described in a letter from the head of OCIE. a. As part of the engagement phase, the NEP engaged in
nationwide outreach to inform newly registered firms about their obligations under the Advisers Act and related rules, the Presence Exams initiative, and OCIE’s practice of engaging with firms’ senior management.
b. During the examination phase, which is nearing completion, NEP staff reviews one or more of the following higher-risk areas of the business and opera-tions of advisers selected for an examination: (i) marketing, including how investors are solicited and the use of placement agents; (ii) portfolio management; (iii) con-flicts of interest, (with a particular focus on allocation of investment opportunities, fees and expenses, sources of revenue, payments made by private funds to advisers and related persons, employees’ outside business activities and personal securities trading, and transactions by advis-ers with affiliated parties); (iv) compliance with the Custody Rule and safety of client assets; (v) valuation of client holdings and assessment of fees based on those valuations.
c. At the conclusion of the examination phase, the NEP intends to report its observations to the SEC and the public. These observations may include common practices identified in the higher-risk focus areas, industry trends, and significant issues. In sharing examiners’ observations from Presence Exams, the NEP staff will aim to encourage firms to review compliance in these areas and to promote improvements in adviser compliance programs.
2. Special Considerations for Hedge Fund Advisers – In a series of speeches, Norm Champ, the former Director of the SEC’s Division of Investment Management, highlighted a number of issues of particular importance to hedge fund advisers.
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a. In a 2012 speech to the New York City Bar, Mr. Champ reminded firms of the importance of allocating fees and expenses fairly, and making clear disclosure to clients of such fee and expense allocations. Particular caution should be exercised when deals are undertaken among funds under common management and affiliated entities. In cases where two funds managed by the same investment adviser co-invest in the same investment vehicle, expenses should be allocated fairly across both funds.
b. In his 2012 speech, Mr. Champ continued that firms should identify any conflicts presented by the type and structure of investments their funds typically make, and ensure that such conflicts are properly mitigated and disclosed. Fee structures are an example of an area that can lead to conflicts of interest – e.g., conflicts of interest may arise when an adviser has the incentive to allocate trades to a hedge fund at the expense of affiliated mutual funds, for instance, because of the opportunity for the investment adviser to earn greater profits from its manage-ment of hedge funds.
c. Mr. Champ’s 2012 speech also suggested that hedge fund advisers should evaluate their risk management structures and processes by asking themselves the follow-ing types of questions: (i) Do the business units manage risks effectively at the product and asset class levels in accordance with applicable tolerances and appetites of risk? (ii) Are the key control, compliance and risk man-agement functions effectively integrated into the structure of the organization while still having the necessary inde-pendence, standing and authority to effectively identify, manage and mitigate risk? (iii) Does the firm’s internal audit process independently verify the effectiveness of the firm’s compliance, control and risk management functions? (iv) Do senior managers effectively exercise oversight of enterprise risk management? (v) Does the organization have the proper staffing and structure to adequately set its risk parameters, foster a culture of effective risk management, and oversee risk-based compen-sation systems and the risk profile of the firm?
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d. Mr. Champ closed his 2012 speech by providing the following takeaways for hedge fund advisers: (i) review control and compliance policies and procedures annually with a view to identifying any gaps, and test them; (ii) assess Form PF requirements, with a particular focus on collecting the data required by the form; (iii) identify risks for clients and the firm; (iv) enhance the expertise of employees with training on procedures and products; (v) verify client assets; (vi) eliminate silos within the firm where legally permissible to open communication among divisions and offices; (vii) provide clear, com-plete, and accurate disclosure in performance data and advertising; (viii) verify portfolio management compli-ance (e.g., reviewing client account holdings for appropriateness and trades for unusual performance, and comparing trades against restricted lists to ensure absence of insider trading); (ix) address client complaints; and (x) check IT security to ensure clients’ assets and information are not at risk.
e. In a 2013 speech to the PLI Hedge Fund Management Conference, Mr. Champ discussed the general advertising that is now permitted with private offerings and warned private fund advisers of the applicability of the anti-fraud rules to their statements in connection with such offerings. Mr. Champ urged private fund advisers to care-fully review their policies and procedures to determine whether they are reasonably designed to prevent the use of fraudulent or misleading advertisements and update those policies where necessary, particularly if the hedge funds intend to engage in general solicitation activity.
f. In his 2013 speech Mr. Champ also discussed a number of insider trading cases that have been brought against private fund advisers and suggested that advisers should revisit their compliance policies and procedures and assess whether they provide an effective framework for the identification and prevention of the misuse of non-public information. In addition, Mr. Champ suggested that advisers should provide continuous training and guidance to ensure that employees know what to
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do—or, more importantly, what to refrain from doing—when they come into possession of inside information.
3. Risks for Private Equity Fund Advisers – Recently, the SEC staff has provided guidance with respect to its examination of private equity fund advisers. a. In a 2012 address at the Private Equity International
Private Fund Compliance Forum, Carlo V. diFlorio, former Director of OCIE, discussed the NEP’s risk-based approach and how it applies to private equity fund advis-ers. The risk-based approach is comprised of two parts – identification of certain risks that render an adviser more likely to be chosen for an examination, and a focus on certain risk areas during individual examinations. For purposes of the first step of the risk-based approach, Mr. diFlorio explained that the NEP tracks information from the SEC’s Tips, Complaints, and Referrals (TCR) Database, material changes in business activities such as lines of business or investment strategies, changes in key personnel, outside business activities of the firm or its personnel, the regulatory history of the firm or its personnel, anomalies in key metrics such as fees, perfor-mance, disclosures as compared to peers or to previous periods, and possible financial stress or weaknesses. The NEP then makes a top-down assessment of which firms appear to exhibit these risks and selects firms for examination based on this assessment.
b. In his 2012 speech, Mr. diFlorio explained that the particular risk areas that might be considered during an examination of a private equity fund adviser include the following: (i) whether the investment strategy makes sense and whether investments are in easily understandable companies; (ii) how clear investor disclosures are around ancillary fees (particularly those charged to portfolio companies), management fee offsets and allocation of expenses, and the efficacy of compliance with those disclosures; (iii) whether the firm has a complicated set of diverse products, and if so, how inter-product conflicts are managed; (iv) the risks imposed by the life cycles of the firm’s funds; (v) the sophistication and reliability of the processes used by the firm; and (vi) the overall
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attitude of management to the examination process, com-pliance obligations, and risk management, as compared to peers.
c. As noted above, in a May 2014 speech, Andrew Bowden, the former Director of OCIE, cited a lack of transparency and disclosure regarding advisers’ collection of fees and allocation of expenses as the most common observation during OCIE examinations of private equity advisers that took place as part of the Presence Exams initiative.
4. Asset Management Unit 2015 Priorities for Private Funds – In a February 2015 speech at the IA Watch Compliance Conference, Julie Riewe, Co-Chief of the Division of Enforcement’s Asset Management Unit (AMU), explained that the AMU’s enforcement priorities for private funds include conflicts of interest, valuation, and compliance and controls. On the hedge fund side, the AMU anticipates cases involving undisclosed fees, undisclosed conflicts including related-party transactions, and valuation issues including use of friendly broker marks. AMU continues to refine its API, which is discussed in detail above. On the private equity side, the AMU expects to see more undisclosed and misallocated fee and expense cases. Finally, and interestingly, Ms. Riewe stated in her speech that advisers can discharge their fiduciary obligation to put their clients’ and investors’ interests ahead of their own through complete and timely disclosure. Although Ms. Riewe encouraged advisers to eliminate or mitigate their conflicts, it appears that the AMU’s view is that so long as an adviser makes complete and timely disclosure of its conflicts, it satisfies its fiduciary obligations.
IV. RECORDKEEPING FOR ADVISERS
A. Basics of Adviser Recordkeeping – Section 204 of the Advisers Act requires advisers to make and keep certain records for prescribed periods. This section also makes books and records subject to reasonable examinations by the SEC. Rule 204-2 under the Advisers Act, adopted in 1962 and amended several times, prescribes the books and records an adviser must maintain. An adviser is required to maintain two general types of books and records: (1) the common business records that any enterprise would normally be expected to
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keep; and (2) certain additional records unique to the activities of investment advisers.
B. Required Books and Records – Rule 204-2(a) includes 18 categories of books and records that must be maintained by all advisers. Rule 204-2(b) provides additional recordkeeping require-ments for advisers that have custody. Rule 204-2(c) sets forth the books and records that must be maintained by advisers who render any investment supervisory or management services, and advisers who exercise voting authority with respect to client securities.
C. Retention Periods – Rule 204-2(e) prescribes the retention periods applicable to adviser books and records. Most books and records are required to be maintained in an easily accessible place for at least five years, the first two of which must be in an appropriate office of the adviser.
D. SEC Expectations – It is the SEC’s position that any record maintained by an adviser is “fair game for inspection” even if it is not the type of record required to be maintained by Rule 204-2. Thus, any e-mail or other record that is preserved and retained is subject to SEC inspection. The SEC staff’s operating assumption is that if an adviser has not documented an activity, then it has not been done. The SEC expects that advisers will maintain documen-tation of all testing and reviews that the adviser performs.
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Investment Advisers to Private Funds: A Short Outline of Key Concepts (May 16, 2016)
Peter M. Rosenblum
Foley Hoag LLP
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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I. PRIVATE FUND INVESTMENT ADVISERS REGISTRATION ACT OF 2010 (THE “PRIVATE FUND ADVISERS ACT”)
A. The Private Fund Advisers Act was part of the broad Dodd-Frank Wall Street Reform and Consumer Protection Act.
B. The Private Fund Advisers Act was a short titled section of the statute which left much of the substance of its concepts for rule-making. However, the Act established a number of basic philo-sophical changes in the approach to regulation of investment advisers to private funds under the Investment Advisers Act of 1940 (the “Advisers Act”).
II. THE CHANGES IN BASIC APPROACH WROUGHT BY THE PRIVATE FUND ADVISERS ACT
A. Greater reliance on state regulation. The new regulatory approach relies on states as the primary regulatory for U.S. advisers with less than $100 million under management and for advisers solely to private funds with less than $150 million under management. 1. Thus, each adviser in these categories will have to look to
state law for whether it must register. Needless to say, the laws vary from state to state.
2. There are exceptions to these basic rules. For example, an adviser to an investment company registered under the Invest-ment Company Act of 1940 (the “Investment Company Act”) must register no matter the amount of assets under its management.
The SEC remains the primary regulator for all advisers whose principal office and place of business is outside the United States. Unless an exemption is available, they must register if they have any U.S. persons who are clients.
B. Many advisers with only private funds as clients will have to regis-ter. Exemptions from registration have become quite limited. 1. The Private Fund Advisers Act amended the Advisers Act to
eliminate the exemption from registration in Section 203(b)(3) (often referred to as the private investment adviser exemption) which permitted advisers with fewer than fifteen clients in a twelve month period not to register under the Advisers Act.
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2. Section 203(b)(3) was the exemption from registration that had been relied upon by most advisers to private funds. Under this Section and rules under it, most funds were treated as a single client. The primary trap under the Section was that an adviser could not be “holding itself out generally” to the pub-lic as an investment adviser.
3. The Private Fund Advisers Act effectively embodies the different approach to registration taken by the Securities and Exchange Commission (“SEC”) in the rules that were invali-dated in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
C. Even many investment advisers to private funds that are exempt from registration under the Advisers Act will nevertheless have to make annual filings and provide information to the SEC and the public. These “exempt reporting advisers” will have to complete and file selected portions of Form ADV. Under the new regulatory approach, only smaller advisers do not have to make federal filings – and they may be required to register, or to make other filings, at the state level.
D. Investment advisers to private funds operating solely within one state must register with the SEC if they are above the minimum size thresholds. The Private Fund Advisers Act eliminated the intrastate exemption for advisers to private funds that had been in Section 203(b)(1) of the Advisers Act.
E. Investment advisers that could claim exemption from registration under the Advisers Act may nevertheless choose to register if they have assets under management of $100 million or more.
III. RULES DEFINE AND ESTABLISH THE CURRENT SYSTEM
Following extensive rule-making process, the SEC adopted necessary rules to require registration and define exemptions from registration in accordance with the Private Fund Advisers Act.
IV. DEFINITIONS
A number of definitions are fundamental to the new approach under the Advisers Act.
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A. A “private fund” is an issuer that would be an investment company under the Investment Company Act but for Section 3(c)(1) or 3(c)(7) of that Act. See Section 202(a)(29) of the Advisers Act.
B. Other definitions such as those of “foreign private adviser,” “venture capital fund” and “qualifying portfolio company” are addressed below in connection with relevant substantive discussions.
V. BASIC THRESHOLDS
The Private Fund Advisers Act established $25 million of assets under management and $100 million of assets under management as thresholds for determining when registration under the Advisers Act is required. A. It continues to be the case that, subject to exceptions to the basic
rule, an adviser must have at least $25 million of assets under man-agement before it is permitted to register under the Advisers Act. 1. The old “buffer” permitting state registration between $25
million and $30 million has been eliminated. 2. If the state of the adviser’s principal office and place of
business does not regulate investment advisers, registration of a smaller adviser will be required.
3. Investment advisers to investment companies registered under the Investment Company Act will be required to register without regard to assets under management.
B. The Private Fund Advisers Act established a new category of “mid-sized investment advisers” which may not register with the SEC and whose regulation is largely intended to be managed by state authorities. 1. For these purposes, Section 203A(a)(2)(B) of the Advisers
Act defines a covered mid-sized investment adviser as an adviser (a) That is required to be registered as an investment adviser
with the securities commissioner (or similar agency) of the state in which it maintains its principal office and place of business and, if registered, would be subject to examination as an investment adviser by a relevant state agency; and
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(b) That has assets under management between $25 million and $100 million.
2. Advisers that are investment advisers to an investment company registered under the Investment Company Act or a company that has elected to be a business development com-pany under that Act (and has not withdrawn the election) must still register with the SEC under the Advisers Act. An invest-ment adviser that would be required to register with 15 or more states also may register under the Advisers Act and benefit from its preemption of state law.
3. For this purpose, assets under management are deemed to be in “securities portfolios” for which the adviser provides “con-tinuous and regular supervisory or management services.” Assets under management will be determined in accordance with the definition of regulatory assets under management under Item 5.F of Form ADV.
4. Rule 203A-1 establishes transitional rules for mid-sized advis-ers and investment advisers who have ceased to be advisers permitted to register with the SEC because of the amendments to the Advisers Act. (a) An SEC-registered adviser must withdraw from regis-
tration with the SEC only when it has less than $90 million of assets under management.
(b) Mid-sized investment advisers must register with the SEC only when assets under management equal at least $110 million.
5. According to information on the SEC’s website, only two states do not both require registration of advisers and make registered advisers subject to examination by the state secu-rities authority. In those states, mid-sized investment advisers would have to register under the Advisers Act unless an exemp-tion under the Advisers Act applied.
6. Under the Advisers Act, the SEC has authority to adjust the $25 million and $100 million thresholds. However, it has not yet used that regulatory authority.
7. The rules under Section 222 of the Advisers Act, the national de minimis standard, have been amended to conform to these changes and the new definition of “client” described below.
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VI. THE PRIVATE FUND ADVISER EXEMPTION
Section 203(m) of the Advisers Act establishes an exemption from the registration requirements under the Advisers Act for advisers solely to private funds which have assets under management in the United States of less than $150 million. Rule 203(m)-1 contains relevant definitions and conditions for this exemption. A. United States Investment Advisers. An investment adviser with its
principal office and place of business in the United States is exempt if such adviser acts solely as an investment adviser to one or more qualifying private funds and it manages private fund assets of less than $150 million.
B. Non-United States Investment Advisers. An investment adviser with its principal office and place of business outside the United States is exempt from the registration requirement of the Advisers Act if it has no client that is a United States person except one or more qualifying private funds and all assets managed by the invest-ment adviser at a place of business in the United States are solely attributable to private fund assets, the total value of which is less than $150 million.
C. Place of business for this purpose is defined in Rule 222-1(a). D. Assets under management are the regulatory assets under manage-
ment as determined under Item 5.F of Form ADV. E. Calculations of assets under management are to be made annually
and reported in annual updating amendments to filings. Investment advisers that no longer qualify for this exemption will have 90 days after filing the updating amendment to apply for registration with the SEC. However, the transition period is only available to advisers that have complied with all reporting requirements as exempt report-ing advisers, and that have not accepted a client that is not a private fund. See General Instruction 15 to Form ADV. Investment Advisers Act Rel. No. 3222 (the “Amendment Release”) at 92 and nn. 377-378.
F. In accordance with the instructions to Form ADV, investment advisers must include in their calculations proprietary assets and assets managed without compensation as well as uncalled capital commitments and assets of non-U.S. clients. Amendment Release at 82 and n. 334. Assets are to be valued at market value or fair value on a gross basis and without deduction for liabilities. Id. at nn. 335-336.
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G. The SEC has cautioned that it may view two or more separately formed entities as a single entity for purposes of calculations under this exemption. Amendment Release at nn. 314, 322 and 506.
H. The SEC has also indicated that other exemptions cannot be com-bined with this exemption: an investment adviser cannot manage on an exempt basis venture capital funds with assets in excess of $150 million and other funds with less than $150 million. The SEC’s analysis focuses on the word “solely” in Sections 203(l) and 203(m) of the Advisers Act. Amendment Release at 77-78.
I. It is not clear that a single-investor fund would be a private fund for purposes of this exemption. The analysis would depend on the facts and circumstances. See Amendment Release at 78-79. See also Section 208(d) of the Advisers Act.
J. Investment advisers that are exempt from federal registration under Section 203(m) of the Advisers Act are not necessarily exempt from state registration. Applicable state law should be considered in each case. Many state regulatory regimes have been significantly enhanced to reflect the expanded state role in regulation of advisers following the adoption of the Private Fund Advisers Act.
VII. EXEMPTION OF VENTURE CAPITAL FUND ADVISERS
Section 203(l) of the Advisers Act provides an exemption from registra-tion for an investment adviser that advises solely one or more venture capital funds. As noted above, this exemption cannot be combined with the exemption provided by Section 203(m). Much of the substance of the venture capital exemption is embodied in relevant definitions set forth in Rule 203 (l)-1. A. According to the SEC, the “proposed definition of venture capital
fund was designed to distinguish venture capital funds from other types of private funds, such as hedge funds and private equity funds and to address concerns expressed by Congress regarding the poten-tial for systemic risk.” Amendment Release at 10. Under Rule 203 (l)-1(a), a venture capital fund is a private fund that: 1. Represents to investors and potential investors that it pursues
a venture capital strategy; 2. Immediately after the acquisition of any asset (other than
qualifying assets or short-term holdings) holds no more than 20 percent of the private fund’s aggregate capital contributions
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and uncalled committed capital (collectively “capital commit-ments”) in non-qualifying assets;
3. Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15 percent of the pri-vate fund’s capital commitments and, subject to an exception for certain guarantees, any such borrowing, debt obligation or leverage is for a non-renewable term of no longer than 120 days;.
4. Issues securities which do not provide redemption, withdrawal or other similar liquidity rights except in “extraordinary circum-stances”; and
5. Is not registered under the Investment Company Act and has not elected to be treated as a business development company under that Act.
B. A “qualifying investment” is an equity security issued by a “qualifying portfolio company” that has been acquired by the fund directly from the qualifying portfolio company. “Qualifying investments” also include equity securities issued by a qualifying portfolio company in exchange for directly issued equity securities or issued by a company of which the qualifying portfolio company is a majority-owned subsidiary or predecessor and acquired by the fund in exchange for directly acquired securities. “Equity security” has the same meaning as in Section 3(a)(11) of the Securities Exchange Act of 1934 and Rule 3a11-1 thereunder, a very broad definition.
C. A “qualifying portfolio company” is a company that 1. At the time of any investment by a private fund is not reporting
or foreign traded and is not affiliated (as defined) with a com-pany that is reporting or foreign traded;
2. Does not borrow or issue debt obligations in connection with the private fund’s investment in the company and distribute to the private fund the proceeds of such borrowing or issuance in exchange for the private fund’s investment; and
3. Is not an investment company, a private fund, an issuer that would be an investment company but for Section 3a-7 of the Investment Company Act or a commodity pool.
D. The basket of 20 percent of capital commitments that may be invested in non-qualifying investments (other than short-term hold-ings) is a key concept. The calculation for purposes of this basket
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limitation is made at the time of acquisition of the non-qualifying investment and, after the acquisition, a change in value of the investment will not require disposition of the asset. However, the change in value will affect the fund’s calculation of the 20 percent limitation for future investments unless valuation is done using historical cost methodology. In the calculation of the basket, either historical cost or fair value may be used as long as the same method is used for all investments of a qualifying fund in a consistent manner over the life of the fund. See Rule 203 (1)-1(a)(2) under the Advisers Act; Amendment Release at 27-32.
E. A fund of funds that invests in venture capital funds will not qualify as a venture capital fund. Amendment Release at 49-52.
F. A non-U.S. adviser may only rely on the venture capital exemption if all of its clients, wherever located, are venture capital funds. A note to Rule 203(l)-1 indicates that an investment adviser may treat as a private fund a non-U.S. fund that has not offered or sold its securities in the United States or to U.S. persons in a manner “incon-sistent with being a private fund” provided that the adviser treats the fund as a private fund for all purposes under the Investment Advisers Act. Amendment Release at 68-72.
G. The SEC recognized that many venture capitalists would have funds that were formed before passage of the Private Fund Advisers Act and related rules and would not qualify as venture capital funds under the new Rule. Accordingly, in the Rule, there is an explicit grandfathering provision. The definition of venture capital fund “grandfathers” private funds that 1. represented to investors and potential investors at the time the
fund offered its securities that it pursues a venture capital strategy; 2. sold securities to one or more investors (that are not related
to any investment adviser to the private fund) prior to December 31, 2010; and
3. did not sell any securities to (including accepting any committed capital from) any person after July 21, 2011. Rule 203(1)-1(b). Amendment Release at 72-75. These grandfathered funds are included within the group of “venture capital funds” to which the exemption applies. Because private funds that accepted com-mitted capital after July 21, 2011 will not be grandfathered, the grandfathering provision of the Rate will likely have limited applicability.
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VIII. FOREIGN PRIVATE ADVISERS
The Private Fund Advisers Act identified a new class of investment advisers that are exempt from registration under the Advisers Act: foreign private advisers. The exemption was inserted in the Advisers Act as a new Section 203(b)(3), and the fundamental definition of foreign private advisers was added as Section 202(a)(30) of the Advisers Act. The new exemption resembles the “private investment adviser” exemption it replaced, but applies only to foreign private advisers with relatively few assets under management in the United States. An SEC staff memorandum indicates that many of the definitions and interpretations under the private investment adviser exemption will be applied by the SEC staff in its approach to the new foreign private adviser exemption and that the SEC “incorporated many of the rules from the ‘old’ section 203 (b)(3) under the new section.” A. Under the definition, a “foreign private adviser” is an investment
adviser which 1. has no place of business in the United States; 2. has fewer than 15 clients and investors in the United States in
private funds advised by the investment adviser; 3. has aggregate assets under management attributable to clients
in the United States and investors in the United States in private funds advised by the investment adviser of less than $25 million; and
4. Neither (a) holds itself out generally to the public in the United
States as an investment adviser; nor (b) acts as an investment adviser to any investment company
registered under the Investment Company Act or a com-pany that has elected to be a business development com-pany under that Act and has not withdrawn its election.
B. The SEC may by rule increase the $25 million threshold, but has not done so. Assets under management are defined to be regulatory assets under management as determined in accordance with Item 5.F of Form ADV. Rule 202(a)(30)-1(c)(1).
C. The definition of foreign private adviser treats private funds as transparent for purposes of counting “investors” and clients. An investor is defined under Rule 203(a)(30)-1(c)(2) as any person
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who would be included in the determination of the number of beneficial owners of the outstanding securities of a private fund under Section 3(c)(1) of the Investment Company Act or the determination whether the outstanding securities of a private fund are exclusively owned by qualified purchasers for purposes of Section 3(c)(7) of that Act. “Investor” also includes beneficial owners of short-term paper issued by the private fund, but, as a result of these definitions, does not include “knowledgeable employ-ees” as defined under the Investment Company Act. Amendment Release at 107.
D. Place of business is used in the foreign private adviser definition as in Rule 222-1(a) under the Advisers Act.
E. As used in the definition, “in the United States” carries the meaning (with stated exceptions) given the phrase in Rules 902(k) and (l) under the Securities Act of 1933. A person may be treated as not being in the United States if such person was not in the United States at the time of becoming a client or, in the case of an investor in a private fund, each time the investor acquires securities issued by the fund. Note to paragraph (c)(3)(i) of Rule 202(a)(30)-1 under the Advisers Act.
F. A key provision of the foreign private adviser definition, which was carried over from the predecessor private investment adviser exemp-tion in repealed Section 203(b)(3) of the Advisers Act, indicates that, to be a foreign private adviser, the adviser cannot be an entity that “holds [itself] out generally to the public as an investment adviser.” Under the old private investment adviser exemption, the SEC Staff took a very restrictive view of what constitutes “holding out to the public.” One would expect that the Staff will continue this approach to “holding out” under the foreign private adviser exemption.
G. An investment adviser will not be deemed to be holding itself out generally to the public in the United States as an investment adviser solely because it participates in a non-public offering in the United States of securities issued by a private fund under the Securities Act of 1933. Rule 202(a)(30)-1(d) under the Advisers Act.
H. Rules 202(a)(30)-1(a) and (b) contain methodology for counting clients and investors under the foreign private adviser definition. Among other things, a limited partnership or limited liability company is a client of any general partner, managing member or other person
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acting as an investment adviser to the partnership or limited lia-bility company, but a private fund need not be counted as a client if any investor in the private fund is counted as an investor in the United States in that private fund for purposes of the definition of foreign private adviser.
IX. REPORTING AND CONTINUED FEDERAL REGULATION
Although venture capital fund advisers and private fund advisers (“exempt reporting advisers”) may be exempt from registration under the Advisers Act, Sections 203(l) and 203(m) of the Advisers Act nevertheless state that the SEC shall require such advisers “to maintain such records and provide to the Commission such annual or other reports as the Com-mission determines necessary or appropriate in the public interest or for protection of investors.” The SEC has adopted Rule 204-4 under the Advisers Act to provide a basic reporting requirement for exempt report-ing advisers. A. Under Rule 204-4, each exempt reporting adviser must complete
and file annual and updating reports on Form ADV in accordance with the instructions to the Form. The instructions specify the items in the Form that must be answered by each exempt reporting adviser. Exempt reporting advisers that are registering with any state secu-rities authority must complete all of Form ADV.
B. Form ADV is to be filed electronically by exempt reporting advisers with the Investment Adviser Registration Depository, and the exempt reporting adviser must pay the required fee to FINRA (the operator of the Depository).
C. Some state regulators require exempt reporting advisers that are not registered in their states to file the Form ADV with them.
D. Exempt reporting advisers will be subject to the antifraud provi-sions of Section 206 of the Advisers Act and the rule under Section 206 restricting certain political contributions (the “pay-to-play rule”). Certain states impose substantive regulation on exempt reporting advisers operating within their states.
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May 16, 2016
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Registration by Investment Advisers to Private Funds and Multiple Entities: SPVs and Relying Advisers (May 16, 2016)
Peter M. Rosenblum
Foley Hoag LLP
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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1. THE SEC STAFF LETTERS
A. Successive regulatory and legislative efforts to expand registration requirements have swept private equity, hedge fund and other advisers into the registration net of the Investment Advisers Act of 1940 (the “Advisers Act”). Under both the so-called “Goldstein rules” and later the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), advisers to private funds, who had formerly been exempt from registration under Section 203(b)(3) of the Advisers Act, could no longer rely on that exemption even though their “advisees” were a limited number of funds. The Goldstein rules looked through each fund to its investors in counting the num-ber of clients, and the Advisers Act after Dodd-Frank no longer contained the version of Section 203(b)(3) on which private fund advisers had relied.
B. As a consequence, certain investment advisers to private funds with multiple entities in their investment organization were forced to contemplate the possibility of multiple registrations under the Advisers Act and possible overlapping registration.
C. Initially, a particular concern arose among private equity fund advisers and some advisers to hedge funds: it is customary in the private equity industry to have a general partner for each fund that is separate from the basic sponsor / investment manager which employs most personnel and is the operating business. Before the Goldstein rules and later Dodd-Frank, each general partner was clearly exempt from registration. Thereafter, in many cases, it appeared they might not be exempt.
D. In the wake of the Goldstein rules, the Subcommittee on Private Investment Entities of the American Bar Association addressed a letter (the “2005 Request”) to the SEC’s staff requesting interpretive guidance concerning a range of issues under those rules and the Advisers Act. Among other things, in the 2005 Request, the Sub-committee requested guidance to the effect that registration under the Advisers Act of special purpose vehicles (“SPVs”) which, among other things, act as general partners or managing members of pri-vate funds would not be required in addition to the registration of the principal investment adviser to the funds. In its response (the “2005 Staff Letter”), the SEC’s staff confirmed that, subject to stated conditions, the staff would not recommend enforcement
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action under the Advisers Act if the SPVs were not separately registered.
E. Following the voiding of the Goldstein rules by the United States Court of Appeals for the District of Columbia Circuit, the issue of SPVs and other potential multiple registrants was of less industry concern. Normally, each general partner had only a single client (the private fund), and was therefore comfortably exempt under Section 203(b)(3).
F. The adoption of Dodd-Frank and issuance of related new rules and rule amendments under the Advisers Act raised these registration issues again. In 2012, the American Bar Association, Business Law Section submitted a new request for interpretive guidance from the SEC’s staff on various issues related to the changes made by Dodd-Frank and the rules. In its response, among other things, the SEC’s staff confirmed the continued applicability of the SPV section of the 2005 Staff Letter and described the circumstances in which an investment adviser could file a single Form ADV on behalf of itself and certain other advisers that collectively conduct a single advisory business.
2. SPVs AND THE 2005 STAFF LETTER
A. In the 2005 Staff Letter, the SEC’s staff stated that it would not recommend enforcement action to the SEC if an SPV established by a registered investment adviser to be the general partner or managing member of a private fund does not separately register under the Advisers Act as long as it satisfied specific assumptions and conditions.
B. The assumptions and conditions set forth in the 2005 Staff Letter (the “2005 Conditions”) were: (i) The investment adviser to the private fund establishes the
SPV to act as the private fund’s general partner or managing member.
(ii) The SPV’s formation documents designate the investment adviser to manage the private fund’s assets.
(iii) All investment advisory activities of the SPV are subject to the Advisers Act and the rules thereunder, and the SPV is subject to examination by the SEC.
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(iv) The registered adviser subjects the SPV, its employees and persons acting on its behalf to the registered adviser’s supervision and control; they would be “persons associated with” the registered adviser.
In these circumstances, the SPV would look to and rely upon the registered adviser’s registration with the SEC and would not submit a separate Form ADV.
3. THE 2012 STAFF LETTER: REITERATING THE 2005 STAFF LETTER AND EXPANDING UPON IT; RELYING ADVISERS
A. In the 2012 Staff Letter, the SEC’s staff revisited the 2005 Staff Letter’s approach to SPVs in light of the repeal of the 203(b)(3) exemption by Dodd-Frank. The 2012 Staff Letter indicated that the 2005 Staff Letter’s guidance concerning SPVs continued to be the SEC staff’s position. The 2012 Staff Letter specifically referenced the 2005 Conditions, and articulated more directly the assumptions and conditions described above (which it referred to as “representa-tions and undertakings”). It stated that each covered SPV is an investment adviser registered with the SEC and is required to comply with all provisions of the Advisers Act and the rules there-under that apply to registered advisers.
B. The 2012 Staff Letter contained additional guidance concerning SPVs. It confirmed that the staff’s position was not limited to a registered adviser with a single SPV and that, under this guidance from the staff, a registered adviser would not be limited to a single SPV. It also indicated that the fact that directors of an SPV who are independent of the registered adviser were not under the supervision and control of the registered advisers (and thus were not “persons associated with” the registered adviser) would not affect the staff’s basic position concerning the need to register separately the SPV.
C. The 2012 Staff Letter also addressed the situation in which certain related advisers to private funds that are not SPVs may satisfy their obligations to register through the registration of a single adviser. The 2012 Staff Letter stated that the SEC’s staff would not recom-mend enforcement action under the Advisers Act against an invest-ment adviser that files (or amends) a single Form ADV on behalf of itself and each other adviser that is controlled by or under common control with the filing adviser that is registering through a single registration with the filing adviser (each, a “relying adviser”) where
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the filing adviser and each relying adviser collectively conduct a single advisory business. The SEC’s staff identified the following “circumstances” as indicating that, “absent other facts suggesting that they conduct different businesses,” a filing adviser and one or more relying advisers collectively conduct a single advisory business (and thus a single registration would be appropriate): (i) They advise only private funds and separate account clients
(a) that are “qualified clients” and otherwise eligible to invest in the private funds advised by the filing adviser or relying adviser and (b) whose accounts pursue investment objectives and strategies that are substantially similar or otherwise related to those of the private funds.
(ii) Each relying adviser, its employees and persons acting on its behalf are subject to the filing adviser’s supervision and con-trol and, therefore, are “persons associated with” the filing adviser.
(iii) The filing adviser has its principal office and place of busi-ness in the United States. Therefore, all of the substantive provisions of the Advisers Act and the rules thereunder apply to the filing adviser’s and each relying adviser’s dealings with each of its clients.
(iv) The advisory activities of each relying adviser are subject to the Advisers Act and the rules thereunder and each relying adviser is subject to examination by the SEC.
(v) The filing adviser and each relying adviser operate under a single code of ethics and a single set of written policies and procedures administered by a single chief compliance officer.
(vi) The filing advisor discloses in its Form ADV that it and its relying advisers are together filing a single Form ADV in reliance on the positions in the 2012 Staff Letter and identifies each relying adviser appropriately in a separate Section 1.B., Schedule D.
In addition, each relying adviser must not be prohibited from regis-tering with the SEC by Section 203A of the Advisers Act.
Under the 2012 Staff Letter, each relying adviser is an investment adviser registered with the SEC and, as such, is required to comply with all of the provisions of the Advisers Act and the rules thereunder that apply to registered advisers.
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4. THE PROPOSED “UMBRELLA” CHANGES TO FORM ADV AND THE RELATED RELEASE
A. In May 2015, the SEC issued a release (SEC Release IA-4091) (the “Umbrella Release”) in which it proposed for comment, among other things, changes to Form ADV that would permit private fund adviser entities operating a single advisory business to register using a single Form ADV. In the Umbrella Release, the SEC said that it believes that its staff’s guidance concerning what the SEC termed “umbrella registration” of a filing adviser and one or more relying advisers had been successful in addressing the registration concerns that can arise from the legal structures of private fund advisers. However, in the SEC’s view, the approach provided in the staff’s guidance had been “limited” by the fact that Form ADV was designed for a single legal entity.
The Umbrella Release proposed changes to Form ADV to facilitate umbrella registration. Under this approach, umbrella registration would only be available when a private fund adviser is operating a single business through multiple legal entities. The conditions pro-posed for assessing whether umbrella registration is available are the same as the conditions in the 2012 Staff Letter (other than disclosure conditions for Form ADV which are addressed in the proposed amendments to Form ADV). In the Umbrella Release, they are treated by the SEC as “indicia” of a single advisory business.
The Umbrella Release proposed a new schedule to Part 1A - Schedule R - that would have to be filed for each relying adviser. The proposal expands information that would be required in Form ADV for each relying adviser.
B. Under the proposed changes to Form ADV, umbrella registration would not be available for exempt reporting advisers. It seems clear that the SEC staff’s guidance in the 2012 Staff Letter did not extend to exempt reporting advisers.
C. The Umbrella Release notes the SEC staff’s guidance in the 2005 Staff Letter concerning SPVs but does not address that guidance substantively.
**********
May 16, 2016
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The National Society of Compliance Professionals: Currents—Doing More With Less: The New Compliance Paradigm (April 2016)
Alan K. Halfenger
ACA Compliance Group
Submitted by: Jeffrey C. Morton
ACA Compliance Group
This article was originally published in the April 2016 issue of NSCP Currents, a professional journal published by the National Society of Compliance Professionals. It is reprinted here with permission from the National Society of Compliance Professionals. This article may not be further re-published without permission from the National Society of Compliance Professionals.
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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APRIL 2016 SPECIAL REPRINT
Doing More With Less: The New Compliance ParadigmBY ALAN K. HALFENGER
Recently, I had dinner with a good friend, who is the Chief Compliance Officer (CCO) and General Counsel of a mid-size financial services firm. As we waited for our table, he told
me how frustrated he was over an internal meeting in which the discussion focused on the fact that market downturn would force his firm to look for opportunities to reduce headcount and optimize and reallocate costs. Specifically, the two new compliance positions that had been budgeted for 2016 (one a replacement and one for an additional person to cover AML and international issues) were on the chopping block.
However, what really bothered the CCO was not the headcount reduction, but the commentary on his firm’s legal and compliance functions. During the meeting, it was said several times that compliance was critical to the firm and that the firm wanted to take on no regulatory risk. However, the necessity of the additional compliance positions was doubted because they appeared to be redundant. The conversation concluded with a “rah-rah” speech about “doing more with less.” Although I have frequently heard stories like this, it is just as common (if not more common) to sit with COOs and Managing Partners, and hear them complain about the ever-upward spiral of compliance costs.
The purpose of this article is to suggest a new paradigm for thinking about compliance costs which, if implemented wisely, will drive how firms spend money protecting themselves on regulatory matters and, more importantly, will stop many of the budget battles being waged.
In order to make these real changes, CCOs will need to implement three key steps in order to adopt this paradigm:
1. Change your approach to staffing and costs;
2. Work harder on educating management about the true cost of compliance and, more importantly, non-compliance; and
3. Act as a true steward of the firm’s balance sheet by implementing cost-saving strategies.
Step 1: Change how you approach your budget
The first step is to change the process around the almost constant increases in headcount and firm compliance costs. Despite all of our lobbying and industry-to-regulator conversations, new regulations are issued and the demands on compliance continue to grow. All too often this triggers an immediate knee-jerk reaction that results in adding staff, even though the full impact of the new rule is not yet fully understood. These requests are often off budget cycle and ad hoc in nature. While it is important to meet these regulations, the solution cannot always be to add headcount, and CCOs must find creative ways to comply.
CCOs should slow down, wait and see if and when the rule is implemented, see what consulting and law firms are saying about the rule and, most importantly, see what everyone else is doing. All too often CCOs run up large professional services bills trying to identify the impact of a pending regulatory change and immediately hire an expert in that particular subject area, just as the market is hitting its peak for that skill set. CCOs often come to realize that after the initial impact of the rule change, they do not need a full-time dedicated resource. Then they are forced to deal with a highly compensated professional who is not really needed. The CCO is often forced to use this resource for other tasks and projects that could be performed by a less expensive resource. When you consider this scenario, it is no surprise that management often feels compliance staffing is reactionary and not well thought out.
Whether or not it is required by senior management, you should have a budget and a compliance plan, neither of which are difficult to implement. For example, consider establishing an annual first quarter process that begins with the completion of the firm’s annual compliance program review. At the conclusion of the annual review, update your risk and conflicts matrix to include all major new business initiatives (conduct meetings with key firm personnel and review the new product committees’ forward docket) and regulatory changes (sift through industry newsletters on what to expect in the coming year). Weigh and prioritize the issues, and categorize the various projects into “new projects” or “business as usual.” Then, determine the expected budget for each project. In particular, technology spending should have a detailed proposal, and task and volume budgets should be developed for day-to-day tasks.
For example, say a firm knows that it wants to review approximately 1% of the emails in its system, and that task currently requires two analysts. However, growing the firm’s overall headcount by 20% will increase email volume. If the compliance team models the capacity of a surveillance analyst, using this budgeting approach will help firms predict when they need to add staff, and where someone has slack and can absorb the incremental work. All of this is built into an overall budget that is then presented to management and the oversight committee. Barring a crisis, headcount should never need to be added off-cycle.
As a result of this process and the ongoing dialog with management, compliance managers develop a supportive relationship with management and encounter fewer headcount battles. CCOs of
About the Author
Alan K. Halfenger is a Partner at ACA Compliance Group. www.acacompliancegroup.com. He can be reached at [email protected].
This article was originally published in the April 2016 issue of NSCP Currents, a professional journal published by the National Society of Compliance Professionals. It is reprinted here with permission from the National Society of Compliance Professionals. This article may not be further re-published without permission from the National Society of Compliance Professionals.
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small firms may not be able to complete this detailed process, but there is no reason that a simplified model cannot be implemented with the help of the firm’s corporate finance staff. Adding headcount is not always the silver bullet, and decisions based on solid planning are always easier to defend.
Step 2: Educate senior management
When you eliminate the ad hoc headcount requests and develop a budget and a plan, you now have to support and explain it to management. If you have sought their input throughout the budgeting process, this step is easy. You need to “sell” or educate management on the risks, costs and need for mitigation. One of the key roles of a CCO is to advise senior management on the risks of their business and the key regulatory expectations. The most successful CCOs always present extensive benchmarking information as part of their presentations. This benchmarking may be done on narrow issues, such as when CCOs are urging senior management to implement a more restrictive personal trading policy (it always helps when you can say your peers have already migrated to the more restrictive rule you are proposing.) More importantly, it is critical for management to understand where the industry is on broader issues, such as the size and budget of other compliance programs in not only peer firms, but firms larger and smaller.
Step 3: Be the steward
The next step in this process is for management to fully understand the costs and risks related to non-compliance. As part of their compliance training, many firms talk about what enforcement actions have incurred. The CCO must present this to management as part of the planning and education process. But it should not stop at the headlines, because the costs of negative regulatory actions have a deeper and broader impact. As a CCO, one of my biggest allies in this area was our head of sales and marketing. His concerns were always straightforward, as in, “How do I explain this issue and crisis to clients and investors?”.
When these reputational risks are combined with out-of-pocket legal expenses and management time is often dedicated to enforcement actions, the case for proactive compliance spending and testing gets easier. It is critical to remember that the selling of fear almost always backfires in the long term because the scary event does not always occur, and therefore not only can headcounts be reduced, but your credibility as a trusted advisor protecting the firm suffers.
CCOs not only have to think like a regulator (or, as I have been described, a cop), but they must start thinking like a business partner. As mentioned above, the credibility of the CCO as a trusted advisor is critical to the overall success of the program. No place is this more clearly demonstrated than when a new issue rule or expectation is raised and the CCO can say, “We have thought about this and we can absorb this into our existing program,” or, “We have identified several ways to address this issue and we have found an efficient (cheaper) way to get it done.”
Tools of the trade
I have talked to dozens of CCOs in the last couple of months, and I have heard one consistent message: “I need more resources.” Since this solution is often not possible, the conversation quickly turns to, “How do I get it done?” I have found that there are three primary drivers that we can focus on:
1. Implement technology to support day-to-day operations Deploy technology solutions in key processing areas. Examples of this include personal trading, regulatory reporting, marketing materials tracking, and trade surveillance. These solutions, when integrated into a holistic compliance solution, allow a CCO to track risks, publish compliance rules, and automate testing and issue tracking. This can have a game-changing impact on the development of a compliance program. While the process of selecting and implementing these technology solutions can actually add stress and increase workloads in the short term, the long-term impact is huge. It should be noted that technology solutions have often been packaged and decreased in cost in recent years, allowing smaller firms to take advantage of the benefits.
2. Find a third-party partner to help The second major trend is outsourcing and partnering with consulting firms and other service providers to reduce the costs of certain processes. There are a large number of compliance tasks that are operational in nature or small enough that they can be done more cheaply, and often better by a third-party provider. Many CCOs are looking for help in in a number of areas, such as: reviewing emails; monitoring data security and data loss prevention programs; processing OFAC and KYC information; social media monitoring; personal trading and the review of advertising. While these are all critical to the success of the firm and its compliance program, many CCOs are stretched too thin to sweat the small stuff. There are many new solutions for this to be accomplished in a high-quality, cost-effective manner. Anywhere a CCO can get additional help, support, and leverage is a good thing for the compliance program.
3. Invest in highly-trained compliance professionals The final trend is in the area of staffing. The market for experienced compliance officers and staff has gone through the roof. Although this relentless upward spiral has benefited many of us personally, not to mention many recruiters, it has not always served our firms and their clients well. Many compliance programs have been forced to look to alternative sources for smart, well-trained staff. In recent years, there have been a number of universities and law schools that have developed certificates and programs in regulatory compliance. Larger firms have joined with these programs to invest in the training program to create pipelines of new and junior compliance staff. Many of the programs I have managed have benefited from close partnerships with finance and operations. Not only was I able to shift some testing and control work to them, but these departments often have larger staffs and are a good source of smart, hard-working analysts. We have also identified other alternative sources for high-quality staff, but it is critical that money is reinvested into training and development for these newly minted compliance officers.
Like high-quality health insurance, a world-class compliance program does not come cheap, but it does not have to be bloated and inefficient. CCOs must continue to mitigate regulatory risk in addition to identifying opportunities to spend money wisely and develop the business and budgeting skills necessary to fulfill their duties as officers of their firms. Many of the processes identified in this article can be tailored to any size firm and can significantly improve its performance. CCOs should realize they are not alone in this struggle and start the conversations needed to develop efficient and cost-effective compliance programs at their firms.
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The Final Rule: DOL’s Expanded Definition of Investment Advice Fiduciary Under ERISA and Revised Complex of Exemptions—Analysis and Critical Issues
Submitted by: Vanessa A. Scott
Sutherland Asbill & Brennan LLP
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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THE FINAL RULE:
DOL’s Expanded Definition of Investment Advice Fiduciary Under ERISA and Revised Complex of Exemptions
Analysis and Critical Issues
SUTHERLAND ASBILL & BRENNAN LLP / SUTHERLAND (EUROPE) LLP / WWW.SUTHERLAND.COM
ATLANTA / AUSTIN / GENEVA / HOUSTON / LONDON / NEW YORK / SACRAMENTO / WASHINGTON DC
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PAGE i
INTRODUCTION
DID YOU KNOW?
SUTHERLAND’S INTERDISCIPLINARY DOL FIDUCIARY
RULE COMPLIANCE TEAM
WHY SUTHERLAND?
Public comment letters filed with the DOL regarding the 2015 proposed rule.
Sutherland’s unique team of ERISA, insurance, securities, banking, investment management and litigation attorneys are working collaboratively to share industry knowledge and insight regarding DOL fiduciary rule compliance best practices.
For resources and commentary regarding the Final Rule, visit Sutherland’s www.dolfiduciaryrule.com.
STRENGTH in representing the country’s and the world’s leading organizations impacted by the Final Rule.
INSIGHT into the legal and business drivers impacting our clients’ compliance decisions.
EXPERIENCE advising our clients on fiduciary compliance issues in the ERISA, FINRA, insurance, securities and investment management space for more than 35 years.
DEPTH as trial attorneys in efficiently and zealously representing our clients in individual and class actions filed in state and federal courts across the country.
Working days between the close of the DOL public comment period and the date that the final rule was delivered to the Office of Management and Budget for final review.
Assets in the U.S. retirement plan system that could be impacted by the Final Rule.
The Department of Labor’s (DOL’s) final rule expanding ERISA’s definition of investment advice fiduciary (the “Final Rule”) will permanently restructure long-standing business practices in the banking, insurance, securities, and financial services industries.
3,134 86$18.9
TRILLION
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WHEN IS A PERSON ACTING AS AN INVESTMENT ADVICE FIDUCIARY UNDER ERISA?
ERISA § 3(21) (A) (ii) : “… [A] person is a fiduciary with respect to a plan to the extent … he renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan…”
1975 – “5 PART TEST”2015 – PROPOSED
“4 X 2 DEFINITION”2016 – FINAL “3 X 3 DEFINITION”
FOR A DIRECT OR INDIRECT FEE, A
PERSON:
PERSON MEETS AT LEAST ONE IN EACH COLUMN, FOR A DIRECT/INDIRECT FEE (INCLUDING TO
AN AFFILIATE)
PERSON MEETS AT LEAST ONE IN EACH COLUMN, FOR A DIRECT/ INDIRECT FEE (INCLUDING TO
AN AFFILIATE)
1. Renders advice as to the value of securities/property, or makes recommendations as to the advisability of investing in, purchasing or selling securities/property
2. On a regular basis
3. Pursuant to a mutual agreement, with fiduciary, that
4. Advice will serve as a primary basis for investment of plan assets, and
5. Advice will be individualized to particular needs of the plan.
SERVICE STATUS SERVICE STATUS
1. Investment recommendation, including to take a distribution, or as to the investment of a rollover or distribution
2. Asset or investment property management recommendation, including any recommendations regarding rollovers, transfers or distributions
3. Valuation of an asset in a specific transaction
4. Paid adviser recommendation
1. Admitted fiduciary
2. Provides advice pursuant to a written or verbal agreement, arrangement or understanding that the advice is individualized or specifically directed to recipient for consideration in making investment or management decision
Makes a recommendation regarding:
1. Acquiring, holding, disposing of or exchanging investment in a plan /IRA
2. How investment should be invested after rollover, transfer or distribution from plan/IRA
3. Management of investment in a plan/IRA
1. Admitted fiduciary
2. Provides advice pursuant to written or verbal agreement, arrangement, or understanding that advice is based on the needs of the recipient, or
3. Directs advice to recipient regarding a particular management investment decision
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CONTENTS
HEADLINES FOR PLAN SPONSORS ............................................................................................................................................................................... 1
HEADLINES FOR RETIREMENT PRODUCT AND SERVICE PROVIDERS ..................................................................................................... 1
KEY DATES ....................................................................................................................................................................................................................................2
ARRANGEMENTS IN SCOPE OF THE FINAL RULE ................................................................................................................................................2
THE FINAL REVISED FIDUCIARY DEFINITION ..........................................................................................................................................................4
INVESTMENT EDUCATION VS. FIDUCIARY ADVICE ............................................................................................................................................ 7
THE RESTRUCTURED COMPLEX OF EXEMPTIONS ...............................................................................................................................................9
BEST INTEREST CONTRACT EXEMPTION (BICE) .....................................................................................................................................................9
REVISED PTE 84-24 ...............................................................................................................................................................................................................20
OTHER REVISIONS TO THE COMPLEX OF EXEMPTIONS ................................................................................................................................22
PTE 75-1, PART II(2) ......................................................................................................................................................................................22
PTE 75-1, PARTS III, IV ..................................................................................................................................................................................22
PTE 75-1, PART V ...........................................................................................................................................................................................22
NEW PTE .......................................................................................................................................................................................................... 22
PTE 77-4 ...........................................................................................................................................................................................................23
PTE 80-83 ........................................................................................................................................................................................................23
PTE 83-1 ............................................................................................................................................................................................................23
PTE 86-128 .......................................................................................................................................................................................................23
NEW COMPLIANCE STRATEGY? ................................................................................................................................................................................... 24
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As it signaled during the August 2015 hearing and in subsequent public comments, DOL has also incorporated a number of revisions into the complex of related exemptions issued in connection with the Final Rule, including the Best Interest Contract Exemption (“BICE”; also “BIC Exemption”).
HEADLINES FOR RETIREMENT PRODUCT AND SERVICE PROVIDERS
• The Final Rule elaborates on the definition of an investment “recommendation” in an effort to highlight DOL’s standard for determining when advice communications rise to the level of being covered under the Final Rule.
• Marketing one’s own services (or the services of an affiliate) will not trigger fiduciary status, so long as no investment recommendation is provided.
• The counterparty carve-out was refashioned to provide instead that a person will not be deemed to provide “fiduciary investment advice” if the advice is provided to an independent fiduciary of a plan or an IRA who is either a licensed and regulated provider of financial services or a plan fiduciary with responsibility for the management of $50M or more in plan assets. The carve-out for plans with 100 or more participants was dropped.
THE FINAL RULE: DOL’S EXPANDED DEFINITION OF INVESTMENT ADVICE FIDUCIARY UNDER ERISA AND REVISED COMPLEX OF EXEMPTIONS
Just less than a year since its proposal, and just more than six months after receiving thousands of pages of commentary, petitions and hearing testimony, the Department of Labor (DOL) finalized its redefinition of “investment advice fiduciary” for ERISA purposes (the “Final Rule”)and its modification of the complex of exemptions corollary to that definition. This remains the most substantial and consequential regulatory undertaking by DOL since the enactment of ERISA in 1974. The DOL seeks nothing less than to reorganize many financial services companies in respect of the services they provide to ERISA plans and IRAs.
HEADLINES FOR PLAN SPONSORS
• Model asset allocations and interactive tools will not be considered fiduciary “recommendations” even if the materials identify specific plan investments.
• Communications between employees, such as human resource staff communicating information about plan distribution options, will generally be excluded from the definition of “fiduciary investment advice.”
• Recommendations regarding term life, health, and disability plans will not be considered fiduciary advice.
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KEY DATES
The “official” effective date of the revised definition of “fiduciary investment advice” and the date the exemptions are considered “issued” is June 7, 2016, which is 60 days after the Federal Register publication date of April 8.
As of April 10, 2017, the revised definition of “fiduciary investment advice” will apply. With noted exceptions, the prohibited transaction exemptions (PTEs) also will be available on April 10, 2017.
Exceptions—For financial institutions and advisers, implementation of the BICE and the Principal Transactions Exemption will occur in phases—
• A Transition Period runs from the April 10, 2017, applicability date to January 1, 2018.
• During the Transition Period, a reduced number of the conditions of the exemptions apply.
• Also, the BICE includes an improved grandfathering rule.
The entire package goes into full effect as of January 1, 2018. As of that time, full compliance with the exemptions will be required.
ARRANGEMENTS IN SCOPE OF THE FINAL RULE
Like the proposal, the final revised definition of investment advice fiduciary applies not only to ERISA plans (including those §403(b) programs and employer-sponsored IRAs subject to ERISA), but also, by reason of Internal Revenue Code (IRC) §4975(e)(1), to the following non-ERISA arrangements:
a. Traditional IRA accounts and annuities;
b. Roth IRAs;
c. Archer medical savings accounts;
d. Health savings accounts; and
e. Coverdell education savings accounts.
Section 403(b) and 457(b) plans generally are outside the legal scope of the Final Rule.
• Private sector 403(b) arrangements are in scope if they are subject to ERISA.
• There is the possibility of a “knock on” effect for arrangements outside the legal scope of the Final Rule, however.
Transition Period - BICE, Principal Transactions Exemption relief fully available subject to limited conditions
Effective Date – Final Rule officially becomes law; no longer
subject to amendment
Applicability Date – Final Rule fully applicable; PTE
relief fully available
Final Rule and complex of exemptions fully applicable,
PTE relief subject to all conditions
Final Rule Issuance Date
April 8, 2016 June 7, 2016 April 10, 2017 January 1, 2018
60 Days
1 Year
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Sutherland Commentary As a conceptual matter, the Final Rule substantially follows the 2015 proposal:
• It greatly expands the circumstances in which interactions between, on the one hand, retirement product and service providers and, on the other, ERISA plans, participants and IRA owners are fiduciary activity subject to ERISA standards of prudence and loyalty; and
• It creates for IRA owners, through the BICE, a private right of action for enforcing those standards that does not exist in the statute.
And because, unlike under any other body of fiduciary law of which we are aware, conflicts of interest under ERISA standards cannot be cured by disclosure to and waiver by the party to whom those fiduciary duties are owed, DOL becomes the arbiter of those conflicts, through its prohibited transaction exemption process.
In commentary on the 2015 proposal, plan sponsors and the financial services industries generally (albeit not universally) supported the policy objective that investment intermediaries should be responsible for putting the interest of retirement investors before their own interest, as a matter of legal accountability as well as business accountability. Criticisms of the proposal were largely directed at the execution of that objective, and the consequences of that execution for investors and the retirement system.
DOL plainly made an effort to be responsive to at least some of that commentary. The circumstances in which valuation becomes fiduciary activity, which had proven difficult to articulate, were deferred to a future guidance project. More detail was provided about the types of communications that will be treated as fiduciary recommendations, although meaningful ambiguities inevitably remain. Elements of the proposal most obviously in conflict with other bodies of law to which retirement product and service providers are subject were eliminated. Operational requirements of the proposed BICE, intended by DOL as the flagship exemption for interactions with retail retirement investors, were improved in ways that make it a more viable compliance alternative.
That having been said, the most fundamental objections to this particular rulemaking are inherent in DOL’s undertaking, including that:
• The investment systems DOL seeks to change are in fact the product of the governance of financial services industries by their primary regulators—Congress, state legislatures, and federal and state banking, insurance and securities regulators;
• DOL exceeds its competence when it undertakes to reorganize those financial services industries in these respects and, for example, is not entitled to the deference normally accorded an expert regulator;
• Even remedial statutes are to be interpreted in accordance with their plain meaning absent specific direction from Congress, but the Final Rule rewrites the statute in a number of respects;
• The private right of action created by the BIC Exemption exceeds the authority of a regulatory agency;
• The cost-benefit record is insufficient to and does not support a rulemaking of this magnitude. There are real costs to the Final Rule, which will be borne directly or indirectly by plan participants and IRA owners, and the piecemeal manner in which various regulators are addressing the same ultimate consumer protection objective will only maximize those costs. It is entirely speculative whether any gains that inure to retirement investors collectively will be commensurate with those costs; and
• The greater chance is that the Final Rule will be counterproductive to the most important issue facing the U.S. retirement system—the pressing need to expand retirement plan coverage among working Americans.
Accordingly, the burden now shifts to the regulated community to implement the Final Rule in a manner that protects the important interests of plan sponsors, participants, IRA owners, financial services providers and the retirement system as a whole that have been put in play.
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THE FINAL REVISED FIDUCIARY DEFINITION
Under the final revised fiduciary definition, both the 1975 “five-part” investment advice fiduciary test and the 2015 proposed “4 x 2” fiduciary investment advice definition are replaced by a revised “3 x 3” definition that still focuses on services and status of the adviser, but clarifies certain key aspects of the 2015 proposal. Appraisal activity has been removed from the DOL’s fiduciary interpretation entirely, and reserved for future rulemaking:
ACCORDING TO THE PREAMBLE, NORMAL MARKETING OF ONESELF OR AN AFFILIATE AS A POTENTIAL FIDUCIARY SHOULD NOT TRIGGER FIDUCIARY STATUS (THE "HIRE ME" RULE), UP TO THE POINT THAT AN INVESTMENT RECOMMENDATION IS MADE.
INVESTMENT PROPERTY DOES NOT INCLUDE HEALTH OR DISABILITY POLICIES, TERM LIFE POLICIES, OR OTHER ASSETS THAT DO NOT INCLUDE AN INVESTMENT COMPONENT.
THE MORE INDIVIDUALLY TAILORED THE COMMUNICATION IS TO A SPECIFIC RECIPIENT ABOUT A SPECIFIC INVESTMENT, THE MORE LIKELY IT WILL BE VIEWED AS A “RECOMMENDATION.”
A PERSON IS A FIDUCIARY IF, FOR A FEE:
SE
RV
ICE
S
That person provides to a plan, plan fiduciary, plan participant or beneficiary, IRA or IRA owner:
1. A “recommendation”—a communication that, based on its content, context and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from a particular course of action—as to the advisability of acquiring, holding, disposing of, exchanging securities or other investment property; or
2. A recommendation as to how securities or other investment property should be invested; or
3. A recommendation as to the management of securities or other investment property, including recommendations regarding the selection of other persons to provide investment advice or investment management services; selection of investment account arrangements; or recommendations with respect to rollovers, transfers or distributions from a plan or IRA.
AND
STA
TU
S
Such person directly or indirectly (e.g., through or together with any affiliate):
1. Represents or acknowledges that it is acting as a fiduciary; or
2. Renders the advice pursuant to a written or verbal agreement, arrangement or understanding that the advice is based on the particular needs of the advice recipient, or
3. Directs the advice to a specific recipient regarding the advisability of a particular investment or management decision with respect to plan or IRA securities or other investment property.
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Note that these definitional exceptions would not apply to an adviser of “admitted” fiduciary status.
GENERALLY, COMMUNICATIONS THAT REQUIRE THE ADVISER TO COMPLY WITH SUITABILITY REQUIREMENTS UNDER SECURITIES OR INSURANCE LAWS WILL BE TREATED AS A “RECOMMENDATION” FOR PURPOSES OF THE FINAL RULE.
> THE FINAL REVISED FIDUCIARY DEFINITION
Unlike the 2010 and 2015 proposals, the final definition does not include “carve-outs” from the fiduciary definition; instead, most of the previous carve-outs have been repurposed as exclusions from the definitions of “recommendation” (for purposes of 29 CFR § 2510.3-21(b)(1)) or “fiduciary investment advice” (for purposes of ERISA § 3(21)(A)(ii)) and are therefore not fiduciary activity under the Final Rule. The carve-out for appraisals made part of the 2015 proposal has been removed in light of the DOL’s decision to reserve appraisals for future rulemaking. The DOL has created a new exclusion from the definition of “recommendation” for general marketing communications.
THE FOLLOWING SERVICES AND INFORMATION WILL NOT BE DEEMED A “RECOMMENDATION” (AND, THUS, NOT FIDUCIARY ADVICE)
Platform Marketing: Marketing and making available investment platforms to plans without regard to individualized plan/participant needs, with appropriate disclosures; not available in the IRA market.
Selection and Monitoring Assistance: Identifying options meeting the plan fiduciary’s specifications in connection with developing an investment platform, or responding to a plan RFP on a limited basis with respect to investments available on a platform, with appropriate disclosures; not available in the IRA market.
General Marketing Communications: Furnishing information (to a plan or IRA owner) that a reasonable person would not view as an investment recommendation (i.e., general circulation newsletters, broadcast commentary, widely attended speeches, general marketing data performance reports, etc.).
Providing Investment Education: Making investment-related education available to a plan, plan fiduciary, participant, beneficiary, or IRA owner if the information does not include specific investment recommendations except as discussed below under “Investment Education vs. Fiduciary Advice.”
IN ADDITION, THE FOLLOWING ACTIVITIES WILL NOT BE TREATED AS “FIDUCIARY INVESTMENT ADVICE”:
“Seller” Transactions: Transactions with fiduciaries with financial expertise or who manage $50M in assets.
Swap Transactions: Specified swap or securities-based swap transactions with an ERISA plan.
Employee Communications: Advice provided by an employee of a plan sponsor to a plan fiduciary or employee advice provided the employee receives only normal compensation for the work performed.
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Sutherland Commentary• Given the concerns expressed in the public comment regarding the expansiveness of the definition of “recommendation”
in the 2015 proposal, the DOL has drawn much clearer distinctions between fiduciary and non-fiduciary activities both in the preamble and in the text of the Final Rule. For instance, plan information that describes product features, investor rights and obligations, fee and expense information, and trading restrictions will not be considered fiduciary communications. A particularly welcome change relates to the treatment of RFP responses, which may now identify a limited or sample set of investment alternatives based on the size of the plan, the plan’s current designated investment alternatives, or both, without triggering fiduciary duty for the responding adviser.
• In addition, the Final Rule now provides that general communications that a reasonable person would not view as an investment recommendation—such as newsletters, commentary made part of publicly broadcast talk shows, remarks made during speeches or at conferences, performance reports, or prospectuses—will not be considered “recommendations” and will therefore not trigger fiduciary status. With the elimination of the “mutual agreement” and “primary basis” prongs of the five-part test, this addition to the Final Rule was critical in order to distinguish general public communications from actual fiduciary advice.
• Furthermore, the Final Rule makes clear that even if a particular communication does not fall within any of the examples and exclusions set forth in the text of the rule, it will be treated as a fiduciary communication only if it is truly an investment “recommendation” as defined under the regulation.
• The DOL was quite eloquent in the Final Rule in describing the fees that are sufficient to make a recommendation fiduciary advice, “including, though not limited to, commissions, loads, finder’s fees, revenue sharing payments, shareholder servicing fees, marketing or distribution fees, underwriting compensation, payments to brokerage firms in return for shelf space, recruitment compensation paid in connection with transfers of accounts to a registered representative’s new broker-dealer firm, gifts and gratuities, and expense reimbursements,” and specified a “but for” test to determine whether those fees are received in connection with the recommendation.
• The Final Rule not only treats advice as to whether to take a rollover or distribution as fiduciary advice, but also advice about any investment in which that distribution might be placed, arguably even if that investment is outside any retirement arrangement subject to the Final Rule. If that is intended, it would constitute an extraordinary assertion of jurisdiction by DOL.
• Along with all the other compliance undertakings required by the Final Rule, service providers not previously subject to the ERISA § 408(b)(2) disclosure rules will be required to develop those disclosures by April 10, 2017, if their services have been recharacterized as fiduciary activity.
• DOL declined to create a platform exception for IRAs, putting added pressure on the other compliance solutions available in that setting.
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INVESTMENT EDUCATION VS. FIDUCIARY ADVICE
The 2015 proposed regulation would have upended long-standing investment education practices by superseding Interpretive Bulletin (IB) 96-1, and replacing it with a carve-out from the fiduciary definition for investment education that would have prohibited advisers from incorporating information on specific investment products in education models or materials.
In light of comments received on the 2015 proposal, the Final Rule was modified to replace the education carve-out with an exception from the definition of “recommendation” that allows asset allocation models and interactive investment materials to identify specific investment products or specific investment alternatives under certain circumstances.
CATEGORY OF
INVESTMENT
EDUCATION
SIGNIFICANT CHANGES
IN FINAL RULEOBSERVATIONS
PLAN INFORMATION
Definition modified slightly to include descriptions of product features; investor rights and obligations; fee and expense information; and applicable trading restrictions.
As in the 2015 proposal, may not include reference to appropriateness of individual benefit distribution options for the plan or an IRA but may include descriptions of varying forms of distributions and other forms of lifetime payment options (e.g., immediate annuity, deferred annuity, or incremental purchase of deferred annuity), advantages, disadvantages and risks of different forms of distribution.
GENERAL INVESTMENT
INFORMATION
Modified slightly to include information on the effects of fees and expenses on the rate of return.
Still may not include information on specific investment products, plan alternatives, or distribution options, or specific alternatives or services outside of the plan.
However, may provide information about retirement-related risks (longevity, market/interest rates, inflation, health care, etc.), and general methods and strategies for managing assets in retirement, including outside the plan.
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> INVESTMENT EDUCATION VS. FIDUCIARY ADVICE
Sutherland Commentary The Final Rule retained the characterization of certain decumulation communications as education, which was largely understood under IB 96-1 but helpfully confirmed. It also clarified that information about specific investments can be provided in a neutral manner and, as noted above, reversed course to allow asset allocation models and interactive materials to reference specific designated investment alternatives in the ERISA plan setting. Both are important improvements over the 2015 proposal.
DOL did not take up the suggestion to clarify that communications related to improvident distribution elections—“you will never be able to replace that in-service distribution in your retirement savings, and you should think again about taking it”—are education rather than advice. If that communication is provided by a plan sponsor, it would not be “fiduciary investment advice” under the Final Rule. If instead it is provided by a retirement product or service provider, the “recommendation” definition would have to be parsed to determine if the line between education and advice has been crossed. In these circumstances, this difference in outcome seems a needless distinction and complication.
CATEGORY OF INVESTMENT EDUCATION
SIGNIFICANT CHANGES
IN FINAL RULEOBSERVATIONS
ASSET ALLOCATION
MODELS
Models may identify specific investment alternatives under a plan (not an IRA) if the investment is a designated investment alterative under a plan subject to oversight by a plan fiduciary and the person who develops or markets the model:
(a) identifies all of the other designated investment alternatives with similar risk/return characteristics; and
(b) the model is accompanied by a statement that identifies where information on those investment alternatives can be obtained, including general plan information and participant-level fee information.
Preamble suggests an ongoing duty to monitor plan service providers and to evaluate whether information is unbiased. Asset allocation models that describe a hypothetical portfolio could fit into this category.
INTERACTIVE INVESTMENT MATERIALS
Materials may identify specific investment alternatives if the alternative is specified by the plan participant, beneficiary, or IRA owner, or if the investment is a designated investment alternative under a plan subject to oversight by a plan fiduciary and the materials:
(a) identify all the other designated investment alternatives available under the plan that have similar risk/return characteristics; and
(b) are accompanied by a statement identifying where information in the alternatives may be obtained, including general plan information and participant-level fee information.
Still permissible to evaluate distribution options, products or vehicles (based on plan information supplied by participant and general financial, investment, and retirement information).
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THE RESTRUCTURED COMPLEX OF EXEMPTIONS
The Final Rule is accompanied by the most substantial reworking of PTEs ever undertaken by DOL. Except as otherwise noted below, the changes to the PTEs take effect on April 10, 2017. There is no clear guidance with respect to the recurring consequences on or after April 10, 2017, of advice provided before that date in accordance with the existing terms of a PTE, but in principle those arrangements should still enjoy the relief provided by the existing exemption.
BEST INTEREST CONTRACT EXEMPTION (BICE)The proposed BICE was the centerpiece of the restructured complex of exemptions. It was and is intended to be the generally applicable exemption for certain “retail” advice. The final BICE was amended in a number of substantial respects, including:
• Certain operational details of the contract and disclosure requirements have been modified, including the timing of and required parties to the contract, and the requirement of an executed contract has been eliminated for ERISA plans.
• While not providing a true “grandfather” rule, a transition rule has been added and existing contracts may become compliant through negative consent.
• The proposed BICE “approved asset” list has been dropped, meaning that the exemption will now be available regardless of the type of asset, subject to certain caveats described below.
• As a result of amendments to PTE 84-24, prohibited transactions involving variable annuities and fixed index annuities will have to rely upon BICE if no other exemption is available.
COVERED TRANSACTIONS
THE FINAL VERSION OF THE BICE PERMITS:
THE RECEIPT OF COMPENSATION
Permitted compensation includes “many forms of compensation that would otherwise be prohibited, including, inter alia, commissions, trailing commissions, sales loads, 12b-1 fees, and revenue-sharing payments from investment providers or other third parties.” Differential compensation is permitted to the extent that the conditions of the exemption are met with respect to such compensation
BY AN “ADVISER,” “FINANCIAL
INSTITUTION,” AFFILIATE OR
RELATED ENTITY
“Adviser” is defined as an individual who is:
• A fiduciary solely by reason of providing investment advice;
• An employee, independent contractor, agent or registered representative of a “Financial Institution”; and
• Appropriately licensed under applicable law for the advice to be given.
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> THE RESTRUCTURED COMPLEX OF EXEMPTIONS
COVERED TRANSACTIONS
THE FINAL VERSION OF THE BICE PERMITS:
BY AN “ADVISER,” “FINANCIAL
INSTITUTION,” AFFILIATE OR
RELATED ENTITY CONT'D
A “Financial Institution” is an entity that “employs or otherwise retains” the Adviser and is:
• An investment adviser registered under federal or state law;
• A bank or similar institution supervised by the United States or a state that is subject to periodic federal or state examination and review;
• An insurance company qualified to do business by a state with an active certificate of authority from its domiciliary jurisdiction (which must require annual actuarial review and reporting of reserves) and that undergoes either annual CPA examinations or a triennial financial examination by the state’s insurance commissioner;
• A broker or dealer registered with the SEC; or
• An entity that is described in the definition of Financial Institution in an individual prohibited transaction exemption.
“Affiliate” includes:
• Any person directly or indirectly through one or more intermediaries, controlling, controlled by, or under common control with the Adviser or Financial Institution;
• Any officer, director, partner, employee, or relative of the Adviser or Financial Institution; or
• Any corporation or partnership of which the Adviser or Financial Institution is an officer, director, or partner.
A “Related Entity” is any entity other than an Affiliate in which the Adviser or Financial Institution has an interest that may affect the exercise of its best judgment as a fiduciary.
FOR INVESTMENT ADVICE PROVIDED TO A “RETIREMENT
INVESTOR”
A Retirement Investor includes:
• An ERISA plan participant or beneficiary in a participant-directed plan;
• The beneficial owner of an IRA; and
• A “Retail Fiduciary” of an ERISA Plan or IRA (an independent fiduciary with financial expertise, as described in the Final Rule).
UNLESS SPECIFICALLY
EXCLUDED
The exemption does not apply with regard to plans sponsored by the Adviser, Financial Institution or an Affiliate, or for which it is a named fiduciary or plan administrator, most “robo-advice,” Principal Transactions other than “Riskless Principal Transactions,” or situations where the Adviser has discretionary authority or control with regard to the recommended transaction.
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> THE RESTRUCTURED COMPLEX OF EXEMPTIONS
BICE Conditions
While many of the more onerous conditions of the proposed exemption have been modified, the final BICE remains a highly conditioned exemption for which compliance certainty may prove difficult, if not impossible, in practice.
BICE CONDITION TERMS
CONTRACT
REQUIREMENT (IRAs AND
NON-ERISA PLANS)
• New Contracts:
Before or at the same time as the execution of a recommended transaction Financial Institution enters into an enforceable written contract with the Retirement Investor that includes all of the terms specified below.
• Existing Contracts:
Existing contracts may be amended by negative consent before January 1, 2018, subject to certain conditions.
• No Contract:
A narrow exception is provided for circumstances in which the Retirement Investor fails to open an account but somehow manages to generate additional income for the Financial Institution or Adviser.
CONTRACT TERMS
The Contract must contain the following terms:
• The Financial Institution and its Adviser(s) are fiduciaries under ERISA, the IRC or both;
• The Financial Institution and its Advisers comply with and will adhere to Impartial Conduct Standards:
• They will provide advice that is in the Best Interest of the Retirement Investor (discussed below) at the time of the recommendation.
• They will not cause the Adviser, Financial Institution, Affiliates or Related Entities to receive compensation for their services that would exceed reasonable compensation within the meaning of ERISA.
• Statements about the recommended transaction, fees and compensation, Material Conflicts of Interest, and any other matters related to the Retirement Investor’s investment decisions will not be misleading at the time they are made.
THE FINAL RULE ELIMINATES THE EXECUTED WRITTEN CONTRACT REQUIREMENT FOR ERISA PLANS.
A MATERIAL CONFLICT OF INTEREST EXISTS WHEN AN ADVISER OR FINANCIAL INSTITUTION HAS A FINANCIAL INTEREST THAT A REASONABLE PERSON WOULD CONCLUDE COULD AFFECT THE EXERCISE OF ITS BEST JUDGMENT AS A FIDUCIARY IN PROVIDING ADVICE TO THE RETIREMENT INVESTOR.
ACCORDING TO THE PREAMBLE, “REASONABLE COMPENSATION” IS TO BE MEASURED BY REFERENCE TO THE MARKET, AS UNDER THE ERISA § 408(B)(2) SERVICE PROVIDER EXEMPTION.
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> THE RESTRUCTURED COMPLEX OF EXEMPTIONS
BICE CONDITION TERMS
CONTRACT TERMS CONT’D
The Financial Institution complies with and warrants:
• The Financial Institution has adopted and will comply with written policies and procedures reasonably and prudently designed to ensure that Advisers adhere to Impartial Conduct Standards;
• In formulating the policies and procedures, the Financial Institution identified and documented any Material Conflicts of Interest and adopted measures to prevent the Material Conflicts of Interest from causing violations of the Impartial Conduct Standards, with a designated person responsible for addressing and monitoring these issues;
• The Financial Institution’s policies and procedures require that neither the Financial Institution nor (to the best of its knowledge) Affiliates use or rely upon quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation or other actions or incentives that are intended or would reasonably be expected to cause Advisers to make recommendations not in the Best Interest of the Retirement Investor (although differential compensation that is not counter to the Retirement Investor’s Best Interest is allowable).
The contract may not contain:
• Exculpatory provisions disclaiming or otherwise limiting liability for a violation of contract terms, provided that the parties may knowingly waive the right to punitive damages or rescission to the extent permissible under state or federal law; or
• Any waiver or qualification of the Retirement Investor’s right to bring or participate in a class action against the Adviser or Financial Institution or to agree to liquidated damages. The contract may not provide for arbitration of individual claims in distant venues or that otherwise unreasonably limit the ability of the Retirement Investor to pursue claims.
TRANSACTION DISCLOSURE
Before or at the same time as execution of the recommended investment, the Financial Institution must provide disclosure in a single written document:
• Stating the Best Interest Standard and describing any Material Conflicts of Interest;
• Informing the Retirement Investor of the right to obtain copies of the Financial Institution’s written description of its policies and procedures, as well as specific disclosure of costs, fees and other compensation including Third Party Payments regarding recommended transactions.
• Containing a link to the Financial Institution’s public website disclosure and explaining that certain information can be found on the website.
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BICE CONDITION TERMS
WEBPAGE DISCLOSURE
The Financial Institution must maintain a webpage, open to the general public and updated at least quarterly, that contains:
• A description of its business model and the Material Conflicts of Interest associated with that business model;
• A schedule of typical account or contract fees and service charges;
• A model contract or other model notice of the contractual terms (if applicable) and the required disclosures, which are reviewed for accuracy no less frequently than quarterly and updated within 30 days if necessary;
• A written description of the Financial Institution’s policies and procedures that accurately describes or summarizes key components of the policies and procedures relating to conflict-mitigation and incentive practices in a manner that permits Retirement Investors to make an informed judgment about the stringency of the Financial Institution’s protections against conflicts of interest;
• To the extent applicable, a list of all product manufacturers and other parties with whom the Financial Institution maintains arrangements that provide Third Party Payments to either the Adviser or the Financial Institution with respect to specific investment products or classes of investments recommended to Retirement Investors; a description of the arrangements, including a statement on whether and how these arrangements impact Adviser compensation, and a statement on any benefits the Financial Institution provides to the product manufacturers or other parties in exchange for the Third Party Payments;
• Disclosure of the Financial Institution’s compensation and incentive arrangements with Advisers including, if applicable, any incentives (including both cash and non-cash compensation or awards) to Advisers for recommending particular product manufacturers, investments or categories of investments to Retirement Investors, or for Advisers to move to the Financial Institution from another firm or to stay at the Financial Institution, and a full and fair description of any payout or compensation grids, but not including information that is specific to any individual Adviser’s compensation or compensation arrangement.
DISCLOSURE TO DOL
Before receiving compensation in reliance on the BICE, the Financial Institution must provide a one time notification to DOL of its intent to rely on the exemption.
RECORDKEEPING AND ACCESS
The Financial Institution must maintain certain records for six years and, subject to certain limitations, provide reasonable access during normal business hours to designated persons, including: (a) DOL or IRS; and (b) participants or IRA owners (or their representatives).
> THE RESTRUCTURED COMPLEX OF EXEMPTIONS
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> THE RESTRUCTURED COMPLEX OF EXEMPTIONS
BICE CONDITION TERMS
BEST INTEREST STANDARD:
PROPRIETARY PRODUCTS AND
THIRD PARTY PAYMENTS
The Best Interest Standard will be deemed to be satisfied with respect to proprietary products and Third Party Payments if:
• Before or at the same time as the execution of the recommended transaction, the Retirement Investor is clearly and prominently informed in writing:
• That the Financial Institution offers Proprietary Products or receives Third Party Payments with respect to the purchase, sale, exchange, or holding of recommended investments;
• Of the limitations placed on the universe of investments that the Adviser may recommend to the Retirement Investor, including specific disclosure of the extent to which recommendations are, in fact, limited on that basis and;
• Of any Material Conflicts of Interest that the Financial Institution or Adviser have with respect to the recommended transaction.
• The Financial Institution documents in writing its limitations on the universe of recommended investments; the Material Conflicts of Interest; any services it will provide to Retirement Investors in exchange for Third Party Payments, as well as any services or consideration it will furnish to any other party, including the Payor, in exchange for the Third Party Payments; reasonably concludes that the limitations on the universe of recommended investments and Material Conflicts of Interest will not cause the Financial Institution or its Advisers to receive compensation in excess of reasonable compensation for Retirement Investors; reasonably determines, after consideration of the policies and procedures that these limitations and Material Conflicts of Interest will not cause the Financial Institution or its Advisers to recommend imprudent investments; and documents in writing the bases for its conclusions.
• The Financial Institution adopts, monitors, implements, and adheres to policies and procedures and incentive practices that meet the requirements of the BICE.
• At the time of the recommendation, the amount of compensation and other consideration reasonably anticipated to be paid, directly or indirectly, to the Adviser, Financial Institution, or their Affiliates or Related Entities for their services in connection with the recommended transaction is not in excess of reasonable compensation.
• The Adviser’s recommendation reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor; and the Adviser’s recommendation is not based on the financial or other interests of the Adviser or on the Adviser’s consideration of any factors or interests other than the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor.
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> THE RESTRUCTURED COMPLEX OF EXEMPTIONS
BICE CONDITION TERMS
LEVEL FEE FIDUCIARY
The final BIC Exemption contains streamlined conditions for “Level Fee Fiduciaries.” To qualify, the only fee received by the Financial Institution, Adviser and any Affiliate in connection with advisory or investment management services to a Plan or Investment Adviser assets is a Level Fee.
• “Level Fee” is a fee or compensation provided on the basis of a fixed percentage of the value of the assets or a set fee that does not vary with the particular investment recommended, and does not include a commission or other transaction-based fee.
• Need not enter into a contract with the Retirement Investor or make BIC warranties or disclosures; provide web- and transaction-based disclosures; or comply with DOL reporting and recordkeeping requirements.
• But must provide a written statement of fiduciary status no later than when a recommended transaction is effected, and must comply with impartial conduct standards.
• Also, in the case of a rollover recommendation, the fiduciary must document the specific reason why the recommendation was considered to be in the Best Interest of the Retirement Investor, including consideration of the alternatives, such as leaving money in the plan, whether the employer pays for some of the plan’s expenses, and the different levels of services and investments available.
• And in the case of a recommendation to switch to a Level Fee arrangement, the Level Fee Fiduciary must document the reason the arrangement is considered to be in the Best Interest of the Retirement Investor, including consideration of the services to be provided for the fee.
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> THE RESTRUCTURED COMPLEX OF EXEMPTIONS
BICE CONDITION TERMS
EXEMPTION FOR PURCHASE OF INVESTMENT
PRODUCT
This exemption covers the purchase of an investment product by a Plan, participant or beneficiary account, or IRA, from a Financial Institution that is a party in interest or disqualified person if:
• The transaction is effected by the Financial Institution in the ordinary course of its business;
• The compensation for any services rendered by the Financial Institution and its Affiliates and Related Entities is not in excess of reasonable compensation; and
• The terms of the transaction are at least as favorable to the Plan, participant or beneficiary account, or IRA as in an arm’s length transaction with an unrelated party.
The exemption does not apply if:
• The Plan is covered by ERISA, and: (a) the Adviser, Financial Institution or any Affiliate is the employer of employees covered by the Plan; or (b) the Adviser and Financial Institution is a named fiduciary or plan administrator with respect to the Plan, or an Affiliate thereof, that was selected to provide advice to the plan by a fiduciary who is not Independent.
• The compensation is received as a result of a Principal Transaction;
• The compensation is the result of robo-advice unless the robo-advice provider is a Level Fee Fiduciary that complies with the conditions applicable to Level Fee Fiduciaries; or
• The Adviser has or exercises any discretionary authority or discretionary control with respect to the recommended transaction.
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Sutherland Commentary While the DOL has made broad statements about how it has carefully considered commentary and made revisions to the proposed BICE in that regard, a careful reading of the final exemption and preamble reveals a number of details and considerations that will require close attention.
Terms of ExemptionIn effect, the final form of the BICE is a compendium of related exemptions for:
• Advice regarding ERISA plans;
• Advice regarding IRAs and IRA rollovers;
• Advice regarding propriety products, or nonproprietary products providing Third Party Payments;
• Advice in a “Level Fee” setting;
• Advice provided in a Bank Networking Arrangement (for which more limited conditions are specified);
> THE RESTRUCTURED COMPLEX OF EXEMPTIONS
Transitional Rule
BICE CONDITION TERMS
GRANDFATHER/ PRE-EXISTING
ACCOUNTS
Includes a “grandfather” for retirement accounts in existence on the Applicability Date.
• Can provide limited advice. Advisers and Financial Institutions can provide advice after the Applicability Date on investments that were acquired for a retirement account before the Applicability Date.
• Prudence Standard. Any investment recommendations made after the Applicability Date must meet the prudence component of the Best Interest Standard—including the “without regard to” proviso.
• No new investments. But the grandfather does not cover any advice relating to new investments for, or any additional investment in, a grandfathered account after the Applicability Date except in the case of systematic investment programs and exchanges among funds or variable annuity options pursuant to an exchange privilege or rebalancing program, but only if, in either case, the program was set up before the Applicability Date.
• Reasonable compensation condition. A few conditions apply for a retirement account to qualify for the grandfather, including that the compensation paid to the Adviser, Financial Institution and their Affiliates or Related Entities after the Applicability Date not be in excess of reasonable compensation.
• No asset restriction. Given that the BIC Exemption no longer restricts investments in retirement accounts to a specified list of assets, the grandfather relief is not conditioned on a pre-existing retirement account holding only assets on the list.
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• Advice during the transition period from April 10, 2017, to December 31, 2017; and
• Advice in connection with arrangements existing on April 10, 2017.
The differences in the terms and conditions applicable in each of those circumstances will need to be carefully observed in implementation.
Scope of ExemptionThe operative terms of the exemption were broadened in a manner that should make the relief more generally available for recommendations treated as fiduciary activity under the Final Rule.
• For example, referrals or Investment Adviser “solicitations” are more clearly within the scope of the BICE.
• Plan-level advice is now generally within the scope of BICE. Indeed, BICE appears to be the only PTE available for plan-level advice with respect to nonproprietary mutual funds; DOL did not extend PTE 84-24 to or otherwise provide a product-specific PTE for that entirely commonplace activity.
• The circumstances in which the fiduciary definition itself was expanded in the Final Rule may necessitate reliance on the BICE in a broader range of circumstances.
The BICE remains unavailable for, e.g., discretionary advice or robo-advice arrangements.
AssetsThe types of investments that can be recommended within the relief provided by the BICE are no longer expressly limited, but the preamble suggests that there may be “Tier 1” (original 13 asset classes) and “Tier 2” investments (anything not on original list), and outlines additional standards (“special care,” training, etc.) and concerns (e.g., ongoing monitoring arrangements) for recommendations of Tier 2 investments to Retirement Investors.
BIC ContractIn the final exemption, the BIC contract is required only in the IRA setting, does not include the individual Adviser as a party, and can be executed along with other account-opening documentation rather than before the time a recommendation is first made.
• Because the BIC contract is the vehicle for the “ERISAfication” of IRAs and the source of a private right of action for IRA owners, it was unnecessary in the ERISA plan setting to DOL’s purposes and created discontinuities with the statute that were difficult to explain.
• Nonetheless, it may be sound business practice to make use of binding contracts clarifying the scope of fiduciary responsibilities and other pertinent matters when Financial Institutions rely on BICE in their work with ERISA plans.
The warranties that must be included in the BIC contract were narrowed in constructive ways. For example, a warranty of compliance with all applicable laws, which would have had a number of pernicious effects, was eliminated. Similar language was also eliminated from a number of other PTEs that were finalized. (See “Other Revisions to the Complex of Exemptions” below.) But at the same time, DOL still noted its view that significant violations of applicable laws could amount to violations of the Impartial Conduct Standard. Also, to the extent permissible under applicable state or federal law, punitive damages and rescission may be contractually waived as remedies for breach of a BIC contract.
Best Interest StandardAdvice is in the Best Interest of the Retirement Investor if it meets a prudent investor standard “without regard” to the financial or other interest of the Adviser or Financial Institution or certain Affiliates or Related Entities or any other party. The preamble presents mixed messages regarding the extent to which this standard is the same as the ERISA § 404 standard; the PTE language itself is very close to the statute with respect to the duty of prudence but inexplicably persists with the proposed “without regard” formulation with respect to the duty of loyalty. And the preamble suggests at certain points that “conflicted” revenue is not allowable, when the weight of the preamble discussion would permit such revenue. It is entirely predictable that these aspects of the BICE will create difficulties in implementation and potentially in litigation.
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AnnuitiesRecommendations of variable annuities and, in a change from the proposal, fixed indexed annuities to Retirement Investors will no longer qualify for reliance on PTE 84-24, as amended, and therefore will need to comply with BICE if a prohibited transaction exemption is needed. DOL relied in part on SEC and FINRA investor alerts regarding fixed index annuities (FIAs) to support its determination that FIAs are “appropriately subject to the protective conditions” of the BICE, rather than PTE 84-24, given their “risks and complexities.”
FIAs face unique challenges under BICE. DOL did not directly address which entity should be considered the “Financial Institution” for Advisers recommending FIAs to Retirement Investors. But the preamble notes that, if a product manufacturer is the only entity satisfying the “Financial Institution” definition with respect to a particular transaction, the product manufacturer must acknowledge fiduciary status and exercise the required supervisory authority over the Advisers to ensure compliance with BICE, including entering into a contract in the case of IRAs and non-ERISA plans. In this regard, DOL did not address the situation where an Adviser might be authorized to act on behalf of several otherwise unrelated product manufacturers.
DOL declined to add other types of insurance distribution intermediaries to the BICE’s list of Financial Institutions, as industry commenters had suggested, but made provision to consider an individual exemption for additional types of entities based on a showing of the regulatory oversight of those entities and their ability to effectively supervise individual Advisers’ compliance with BICE.
DOL helpfully determined in the preamble that incremental compensation to fiduciaries in connection with annuity transactions is permissible under the Final Rule.
Level Fee FiduciaryThe Level Fee Fiduciary provisions appear to have been included in the BICE to cover conflicts arising when an Adviser recommends that a participant roll money out of a Plan into a fee-based account. It would also cover recommendations to switch from a “low activity commission-based account” to an account charging an asset-based fee.
DisclosuresWhile much of the detailed disclosure information has, at first glance, been dropped from the disclosure conditions, specific disclosure of costs, fees and other compensation must nevertheless be provided upon the request of the Retirement Investor. The costs, fees, and other compensation may be described in dollar amounts, percentages, formulas, or other means reasonably designed to present materially accurate disclosure of their scope, magnitude, and nature in sufficient detail to permit the Retirement Investor to make an informed judgment about the costs of the transaction and about the significance and severity of the Material Conflicts of Interest. The information required under this section must be provided to the Retirement Investor before the transaction, if requested before the transaction, and, if the request is made after the transaction, the information must be provided within 30 business days after the request. The preamble admits that the public website disclosure “is intended as much for intermediaries, consumer watchdogs, and other third parties as for plan parties or IRA owners.” The extent to which the webpage disclosure can be developed and administered from existing resources will require company-by-company attention.
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REVISED PTE 84-24
As granted in 1977, in its original form PTE 84-24 allowed certain parties to receive commissions when plans and IRAs purchased insurance and annuity contracts and mutual funds. In the absence of the exemption, the receipt of such payments would be treated as a prohibited transaction.
The amended exemption limits that relief to the purchase of Fixed Rate Annuity Contracts, insurance contracts (by plans and IRAs), and mutual fund shares (by plans only) and narrows the definition of permissible “commissions.”
COVERED ACTIVITY CHANGES FROM THE 2015 PROPOSAL
PT
E 8
4-2
4
Commissioned sales of insurance/annuity products and proprietary mutual funds
Indexed Annuities. Relief revoked for indexed annuities and similar annuities (as well as variable annuities); for both plans and IRAs, previous relief for variable annuities sold to plans under 2015 proposal revoked.
Best Interest Standard. Consistent with other exemptions, Best Interest standard amended to align with ERISA § 404(a) language: retains “without regard” to standard but equated to “solely in the interest of” under ERISA § 404 (in the preamble).
Rollover Distributions. Clarifies that relief applies to rollover or distribution transactions.
Group Fixed Annuities. Group fixed annuities must guarantee return of principal net of “reasonable compensation” and provide a guaranteed declared minimum interest rate to qualify for relief.
Employee Benefits. Expands net permissible compensation for insurance and annuities to include certain employee benefits, and would include payments made through third parties.
Insurance Company Compensation. Clarifies that relief extends to receipt of compensation by insurance company.
Gross Dealer Concessions. Preamble suggests that gross dealer concession and overrides will be considered “commissions.”
The exemption is “issued” as of June 7, 2016, and is intended to take effect on that date. The amended PTE can be relied upon as of the Final Rule’s Applicability Date, April 10, 2017.
AS REVISED, PTE 84-24 IS INTENDED TO PROVIDE A MORE STREAMLINED EXEMPTION THAN THE BICE FOR LESS COMPLEX ANNUITY PRODUCTS THAT PROVIDE GUARANTEED LIFETIME INCOME.
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Sutherland Commentary As amended, the relief provided by PTE 84-24 is available for:
• Proprietary mutual funds, but only in the ERISA plan setting;
• “Fixed Rate Annuity Contracts” in either the ERISA plan or IRA setting, by which DOL means “immediate annuities, traditional annuities, declared rate annuities or fixed rate annuities (including deferred income annuities)”; that is, contracts that “provide payments that are the subject of insurance companies’ contractual guarantees and that are predictable.” Stable value contracts often would also seem to be within the intended scope (although the seller’s exception may generally be available for stable value contracts and obviate the need for a PTE). The language used in the PTE itself to define these annuities is imperfect in certain technical respects and will need to be interpreted appropriately to effectuate DOL’s stated intentions; and
• Insurance contracts in either the ERISA plan or IRA setting. Existing guidance provides that this category includes life insurance (which is unavailable in IRAs under the tax law), insurance contracts used to provide other welfare benefits, surety bonds, and recordkeeping/administrative services contracts.
DOL clarified that employee benefits provided to full-time life insurance salespersons and gross dealer concessions, along with traditional forms of insurance and mutual fund commissions including trail commissions, are forms of compensation permitted under PTE 84-24, but otherwise narrowed the exemption to exclude 12b-1 fees, revenue sharing payments, administrative fees/payments or marketing fees/payments.
• That distinction—wholly unnecessary in our judgment, since there is no qualitative difference in the nature of the conflict presented by any of these forms of payment, and the reasonable compensation condition sufficiently polices any concerns about excessive payments—will no doubt create new line-drawing complications over time.
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OTHER REVISIONS TO THE COMPLEX OF EXEMPTIONS
The 2015 proposed rule would have added, revised or revoked a number of other PTEs dealing with investment activities. The final PTEs are, on balance, similar to what was proposed, with some modifications:
EXEMPTION COVERED ACTIVITY FINAL CHANGES
PTE 75-1, PART II(2)
Sales of nonproprietary mutual funds by broker-dealer
Revoked, and now covered in PTE 86-128.
PTE 75-1, PARTS
III, IV
Underwritings and market-making
Incorporates Impartial Conduct Standards from the BICE (without the warranty).
PTE 75-1, PART V
Extension of credit to a plan/IRA in connection with a securities transaction
Revised: (1) to permit investment advice fiduciaries to receive compensation on arm’s-length credit extended to avoid a failed securities transaction (other than a failure caused by the fiduciary) if Rule 10b-16 or comparable disclosure is provided in advance; and (2) recordkeeping provisions.
NEW PTE
Principal transactions in certain assets
• Available to investment advisers, broker-dealers and banks who are investment advice fiduciaries (“Financial Institutions”).
• Permits Financial Institutions to effect principal transactions and riskless principal transactions in “principal traded assets.”
• Financial Institutions can also rely on BIC exemption for riskless principal transactions.
• “Principal traded assets” include debt securities, certificates of deposit and interests in unit investment trusts under the Investment Company Act.
• “Debt security” is cross-referenced to SEC Rule 10b-10, and includes certain registered debt securities issued by U.S. companies, U.S. Treasury securities, and certain agency debt securities and asset backed securities.
• Financial Institution must acknowledge fiduciary status, adhere to impartial conduct standards and implement policies and procedures designed to prevent violations of impartial conduct standards.
• Financial Institution must refrain from giving or using incentives for Advisers to act contrary to the Best Interest of the Retirement Investor.
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EXEMPTION COVERED ACTIVITY FINAL CHANGES
NEW PTECONT’D
Principal transactions in certain assets
• Financial Institution must seek to obtain best execution reasonably available for principal transactions.
• Financial Institution must provide a written confirmation complying with SEC Rule 10b-10.
• Financial Institution must provide annual list of principal transactions effected.
PTE 77-4
Allocation by discretionary asset management fiduciary to proprietary mutual funds
Incorporates Impartial Conduct Standards from the BICE (without the warranty).
PTE 80-83
Use of proceeds from sale of securities to reduce or retire indebtedness
Incorporates Impartial Conduct Standards from the BICE (without the warranty).
PTE 83-1Mortgage pool investment trusts
Incorporates Impartial Conduct Standards from the BICE (without the warranty).
PTE 86-128
Commissions for the execution of securities transactions by a fiduciary; agency cross-transactions
• Revoked for investment advice fiduciaries to IRAs in securities and agency cross-transactions. Investment management fiduciaries meeting conditions get relief.
• Clarifies that § 408(b)(2) relief, and disclosures, may be required in addition to PTE 86-128 compliance.
• Revised to provide that relief is available only for compensation to the fiduciary or a Related Entity in the form of a brokerage commission or sales load paid by the plan/IRA for executing the transaction; no relief for any form of indirect compensation.
• Adds relief for non-IRA principal transactions in nonproprietary mutual funds; the only compensation permitted is the commission (sales load) disclosed by the mutual fund; retains conditions from PTE 75-1 and adds the PTE 86-126 anti-churning requirement.
• Incorporates Impartial Conduct Standards from the BICE (without the warranty).
• Clarifies that trustees can rely on recapture of profits exception.
• The fiduciary rather than the plan must satisfy recordkeeping requirements.
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NEW COMPLIANCE STRATEGY?
For retirement product and service providers working with ERISA plans and IRAs, the regulatory structure permits a three-tier compliance strategy to deal with conflicted interest and other fiduciary considerations:
• Avoid fiduciary status—the only type of provider to which these conflict of interest and other standards attach—if that status is unintended and inappropriate. The Final Rule greatly narrows the circumstances in which this will be a viable compliance strategy.
• If a fiduciary, negate any conflicted interest by, e.g., enterprise-wide fee leveling, or returning the economic benefit of any varying revenue to the plan or IRA, or by outsourcing the advice leading to that varying revenue to an independent financial expert. This remains an effective compliance strategy under the Final Rule.
• If a fiduciary and the conflicted interest cannot be negated, rely on an applicable statutory or administrative PTE. It appears that the BICE as modified may be a universally applicable compliance solution. There are, however, various other exemptions for specific investment products (PTE 77-4 or 84-24 for proprietary mutual funds, for example, or ERISA § 408(b)(4) for interest-bearing bank products) or types of advice (e.g., the § 408(g) exemption enacted in the Pension Protection Act for participant-level advice) that are also available in specific circumstances.
The chart above enumerates a number of these alternative solutions, and common circumstances in which they are available, that may properly form part of a compliance strategy after the Final Rule.
COMMON INVESTMENTS
401(K) PLAN-LEVEL SERVICES401(K) PARTICIPANT IRA OWNER
MID/LARGE/MEGA MICRO/SMALL
Any
• Not a fiduciary• Limit services to investment education• Seller's exception
• Negate any conflicted interest• Enterprise-wide fee neutrality• Return economic benefit of varying revenue to plan/IRA (Frost Bank Advisory Opinion)• Outsource advice to independent financial expert (Sun America Advisory Opinion)
PTE 86-128 for execution of securities transactionNot a fiduciary/platform exception
Non-proprietary mutual fund/agency
BICE BICEBICE
§ 408(g)BICE
§ 408(g)
Proprietary mutual fund/agency
BICEPTE 84-24
BICEPTE 84-24
BICE§ 408(g)
PTE 84-24
BICE§ 408(g)
PTE 77-4 (for discretionary account)
AnnuityBICE
PTE 84-24 (if fixed)§ 408(b)(8) (if VA)
BICEPTE 84-24 (if fixed)§ 408(b)(8) (if VA)
BICE§ 408(g)
PTE 84-24 (if fixed)§ 408(b)(8) (if VA)
BICE§ 408(g)
PTE 84-24 (if fixed)§ 408(b)(8) (if VA)
CDsBICE
§ 408(b)(4)BICE
§ 408(b)(4)
BICE§ 408(g)
§ 408(b)(4)
BICE§ 408(g)
§ 408(b)(4)
Collective investment fund
BICE§ 408(b)(8)
BICE§ 408(b)(8)
BICE§ 408(g)
§ 408(b)(8)N/A
Alternatives BICE BICEBICE
§ 408(g)BICE
§ 408(g)
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U.S. Securities and Exchange Commission, Office of Compliance Inspections and Examinations, National Exam Program: Examination Priorities for 2016
Submitted by: Clifford E. Kirsch
Sutherland Asbill & Brennan LLP
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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EXAMINATION PRIORITIES FOR 2016
I. Introduction
This document identifies selected 2016 examination priorities of the Office of Compliance Inspections and Examinations (“OCIE,” “we,” or “our”) of the Securities and Exchange Commission (“SEC” or “Commission”). In general, the priorities reflect certain practices and products that OCIE perceives to present potentially heightened risk to investors and/or the integrity of the U.S. capital markets.1
OCIE serves as the “eyes and ears” of the SEC. We conduct examinations of regulated entities to promote compliance, prevent fraud, identify risk, and inform policy.2 We selected our 2016 examination priorities in consultation with the Commissioners, senior staff from the SEC’s regional offices, the SEC’s policy-making and enforcement divisions, the SEC’s Investor Advocate, and our fellow regulators.
This year, our priorities are organized around the same three thematic areas as last year:
1. Examining matters of importance to retail investors, including investors saving for retirement;
2. Assessing issues related to market-wide risks; and
3. Using our evolving ability to analyze data to identify and examine registrants that may be engaged in illegal activity.
This document does not address OCIE’s examination priorities for the national securities exchanges, which we are addressing separately.
II. Protecting Retail Investors and Investors Saving for Retirement
Protecting retail investors and retirement savers remains a priority in 2016, and it will likely continue to be a focus for the foreseeable future. Retail investors of all ages face a complex and evolving set of choices when determining how to invest their money. Additionally, as investors are more dependent than ever on their own investments for retirement,3 the financial services industry is offering a broad array of information, advice,
1 This document was prepared by SEC staff, and the views expressed herein are those of OCIE. The Commission has expressed no view on this document’s contents. It is not legal advice; it is not intended to, does not, and may not be relied upon to create anyrights, substantive or procedural, enforceable at law by any party in any matter civil or criminal.
2 The regulated entities that OCIE examines include investment advisers, investment companies, broker-dealers, municipal advisors, transfer agents, exchanges, clearing agencies, and other self-regulatory organizations.
3 For decades, employers have shifted from offering defined benefit pensions to defined contribution plans, such as 401(k) accounts, that place funding and investment risk directly on participants. Today, it is estimated that approximately $16.5 trillion is invested in defined contribution plans (including individual retirement accounts and annuity reserves), while approximately $8.2 trillion is invested in defined benefit plans. See Nari Rhee, “Retirement Savings Crisis: Is it Worse than We Think” (June
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products, and services to retail investors to help them plan for, and live in, their retirement years. We are planning and/or conducting various examination initiatives to assess risks to retail investors that could arise from these trends.
ReTIRE. In June 2015, we launched a multi-year examination initiative, focusing on SEC-registered investment advisers and broker-dealers and the services they offer to investors with retirement accounts.4 We will continue this initiative, which includes examining the reasonable basis for recommendations made to investors, conflicts of interest, supervision and compliance controls, and marketing and disclosure practices.
Exchange-Traded Funds (“ETFs”). We will examine ETFs for compliance with applicableexemptive relief granted under the Securities Exchange Act of 1934 and the Investment Company Act of 1940 and with other regulatory requirements, as well as review the ETFs’ unit creation and redemption process. We will also focus on sales strategies, trading practices, and disclosures involving ETFs, including excessive portfolio concentration, primary and secondary market trading risks, adequacy of risk disclosure, and suitability, particularly in niche or leveraged/inverse ETFs.
Branch Offices. We will continue to review regulated entities’ supervision of registered representatives and investment adviser representatives in branch offices of SEC-registered investment advisers and broker-dealers, including using data analytics to identify registered representatives in branches that appear to be engaged in potentially inappropriate trading.
Fee Selection and Reverse Churning. We will continue to examine investment advisers and dually-registered investment adviser/broker-dealers that offer retail investors a variety of fee arrangements (e.g., asset-based fees, hourly fees, wrap fees, commissions). We will focus on recommendations of account types and whether the recommendations are in the best interest of the retail investor at the inception of the arrangement and thereafter, including fees charged, services provided, and disclosuresmade about such arrangements.
Variable Annuities. Variable annuities have become a part of the retirement and investment plans of many Americans.5 We will assess the suitability of sales of variable annuities to investors (e.g., exchange recommendations and product classes), as well as the adequacy of disclosure and the supervision of such sales.
Public Pension Advisers. We will examine advisers to municipalities and other government entities, focusing on pay-to-play and certain other key risk areas related to advisers to public pensions, including identification of undisclosed gifts and entertainment.
2013), a publication of the NATIONAL INSTITUTE ON RETIREMENT SECURITY; see also “Retirement Assets Total $24.8 Trillion in Second Quarter 2015” (Sept. 2015), a publication of the INVESTMENT COMPANY INSTITUTE.
4 See OCIE Risk Alert, “Retirement-Targeted Industry Reviews and Examinations Initiative,” June 22, 2015, http://www.sec.gov/about/offices/ocie/retirement-targeted-industry-reviews-and-examinations-initiative.pdf.
5 See SEC Investor Publications, “Variable Annuities: What You Should Know,” April 18, 2011,http://www.sec.gov/investor/pubs/varannty.htm.
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III. Assessing Market-Wide Risks
The SEC’s mission includes not only protecting investors and facilitating capital formation, but alsomaintaining fair, orderly, and efficient markets. We will examine for structural risks and trends that may involve multiple firms or entire industries. In 2016, we will focus on the following initiatives:
Cybersecurity. In September 2015, we launched our second initiative to examine broker-dealers’ and investment advisers’ cybersecurity compliance and controls.6 In 2016, we will advance these efforts,which include testing and assessments of firms’ implementation of procedures and controls.
Regulation Systems Compliance and Integrity (“SCI”). We will examine SCI entities to evaluate whether they have established, maintained, and enforced written policies and procedures reasonably designed to ensure the capacity, integrity, resiliency, availability, and security of their SCI systems.7
This will include, among other things, assessing the resiliency of their primary and back-up data centers, evaluating whether computing infrastructure components are geographically diverse, and assessing whether security operations are tailored to the risks each entity faces.
Liquidity Controls. Amidst the changes in fixed income markets over the past several years, we will examine advisers to mutual funds, ETFs, and private funds that have exposure to potentially illiquid fixed income securities. We will also examine registered broker-dealers that have become new or expanding liquidity providers in the marketplace. These examinations will include a review of various controls in these firms’ expanded business areas, such as controls over market risk management, valuation, liquidity management, trading activity, and regulatory capital.
Clearing Agencies. We will continue to conduct annual examinations of clearing agencies designated systemically important, pursuant to the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Areas for review will be determined through a risk-based approach in collaboration with the Division of Trading and Markets and other regulators, as applicable.
IV. Using Data Analytics to Identify Signals of Potential Illegal Activity
Since our examination program is risk-based, we are always striving to detect risks across those industries and within those firms that we oversee. In all of our examination initiatives, including those highlighted in this section, we utilize data and intelligence from our own examinations, as well as from regulatory filings, to identify registrants that appear to have elevated risk profiles. A few of our initiatives that leverage our capabilities in the area of data analytics include:
Recidivist Representatives and their Employers. We will continue to use our analytic capabilities to identify individuals with a track record of misconduct and examine the firms that employ them. For example, we will assess the compliance oversight and controls of investment advisers that have employed such individuals after they have been disciplined or barred from a broker-dealer.
6 See OCIE Risk Alert, “OCIE’s 2015 Cybersecurity Examinations Initiative,” Sept. 15, 2015, https://www.sec.gov/ocie/announcement/ocie-2015-cybersecurity-examination-initiative.pdf.
7 For the definitions of “SCI entities” and “SCI systems” see Regulation Systems Compliance and Integrity, Release No. 34-37639, http://www.sec.gov/rules/final/2014/34-73639.pdf.
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Anti-Money Laundering (“AML”). We will continue to examine clearing and introducing broker-dealers’ AML programs, using our analytic capabilities to focus on firms that have not filed the number of suspicious activity reports (“SARs”) that would be consistent with their business models or have filed incomplete or late SARs. We will also continue to assess broker-dealers’ AML programs, with a particular emphasis on (1) the adequacy of the independent testing obligation, to ensure that these programs are robust and are targeted to each firm’s specific business model, and (2) the extent to which firms consider and adapt, as appropriate, their programs to current money laundering and terrorist financing risks.
Microcap Fraud. We will continue to examine the operations of broker-dealers and transfer agents for activities that indicate they may be engaged in, or aiding and abetting, pump-and-dump schemes or market manipulation. We will also assess whether broker-dealers are complying with their obligations under the federal securities laws when publishing quotes for or trading securities in the over-the-counter markets.
Excessive Trading. We will continue to analyze data, including data obtained from clearing brokers,to identify and examine firms and their registered representatives that appear to be engaged in excessive or otherwise potentially inappropriate trading.
Product Promotion. We will focus on detecting the promotion of new, complex, and high risk products and related sales practice issues to identify potential suitability issues and potential breaches of fiduciary obligations.
Through collaborative efforts with the Division of Economic and Risk Analysis, we will continuously enhance our analytic approach and capabilities in these areas through the use of new technologies and risk-based initiatives.
V. Other Initiatives
In addition to examinations related to the themes described above, we expect to allocate examination resources to other priorities, including:
Municipal Advisors. We will continue to conduct examinations of newly-registered municipal advisors to assess their compliance with recently adopted SEC and Municipal Securities Rulemaking Board rules. This initiative will continue to include industry outreach and education.8
Private Placements. We will review private placements, including offerings involving Regulation D of the Securities Act of 1933 or the Immigrant Investor Program (“EB-5 Program”)9 to evaluate whether legal requirements are being met in the areas of due diligence, disclosure, and suitability.
8 See OCIE’s Industry Letter for the Municipal Advisor Examination Initiative, August 19, 2014, https://www.sec.gov/about/offices/ocie/muni-advisor-letter-081914.pdf.
9 The EB-5 Program is a federal visa initiative, administered by United States Citizenship and Immigration Services. It provides apath to legal U.S. residency for foreign investors who make a qualifying investment in a commercial enterprise in the United States that creates or preserves at least ten permanent full-time jobs for qualified U.S. workers. See EB-5 Immigrant Investor Program description at http://www.uscis.gov/eb-5.
510
5
Never-Before-Examined Investment Advisers and Investment Companies. We will continue conducting focused, risk-based examinations of selected registered investment advisers and investment company complexes that we have not yet examined.10
Private Fund Advisers. We will examine private fund advisers, maintaining a focus on fees and expenses and evaluating, among other things, the controls and disclosure associated with side-by-side management of performance-based and purely asset-based fee accounts.
Transfer Agents. In addition to our examinations of transfer agents’ timely turnaround of items and transfers, recordkeeping and record retention, and safeguarding of funds and securities, we will examine transfer agents providing paying agent services for their issuers, focusing on the safeguarding of security-holder funds.
VI. Conclusion
This description of OCIE priorities is not exhaustive. While we expect to allocate significant resources throughout 2016 to the examination issues described herein, our staff will also conduct examinations focused on risks, issues, and policy matters that arise from market developments, new information learned from examinations or other sources, including tips, complaints, and referrals, and coordination with other regulators.
OCIE welcomes comments and suggestions about how we can better fulfill our mission to promote compliance, prevent fraud, monitor risk, and inform SEC policy. If you suspect or observe activity that may violate the federal securities laws or otherwise operates to harm investors, please notify us at http://www.sec.gov/complaint/info_tipscomplaint.shtml.
10 See OCIE’s Letter to Never-Before Examined Investment Advisers, February 20, 2014, http://www.sec.gov/about/offices/ocie/nbe-final-letter-022014.pdf. See also OCIE Risk Alert, “OCIE’s Never-Before-Examined Registered Investment Company Initiative,” April 20, 2015, http://www.sec.gov/about/offices/ocie/ocie-never-before-examined-registered-investment-company-initiative.pdf.
511
NOTES
512
17
An Investment Adviser’s Fiduciary Duty (July 13, 2016) (PowerPoint slides)
Lorna A. Schnase
Attorney at Law
© 2010–2016 Lorna A. Schnase
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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520
NOTES
521
NOTES
522
I - 1
Index
A
Advisor Conflicts of Interest advisors can and should do, 226–227 affiliates, 225 compensation arrangements, 226 proprietary products, 226 revenue sharing, 225–226
Advisor Reliance on Compliance Consultants
hangs in balance, 207–208
C
Compliance and Exams for Investment Adviser Lawyers
adviser exams, basics, 422–426 advisers, recordkeeping, 438–439 current issues, 426–438 introduction, 421–422
D
DOL’s Expanded Definition of Investment Advice Fiduciary
exemptions ERISA and revised complex,
477-479 other revisions, 498–500 restructured complex, 485–495
final revised fiduciary definition, 480–482
introduction, 473 Investment Education vs. Fiduciary
Advice, 483–484 new compliance strategy, 500 person acting under ERISA, 474 revised PTE 84-24, 496–497
E
Examination Priorities for 2016 assessing market-wide risks, 509 conclusion, 511
illegal activity, using data analytics identify signals, 509–510
introduction, 507 other initiatives, 510–511 retirement, protecting retail investors
and investors saving, 507–508
F
Faculty Bios Chris Stanley, 30 Clifford E. Kirsch, 19–20 G. Philip Rutledge, 27 Heather L. Traeger, 33 Jeffrey C. Morton, 25 Kenneth Berman, 21–22 Lorna A. Schnase, 28 Maureen Baker Fialcowitz, 23 Michael Hershaft, 24 Peter M. Rosenblum, 26 Steven A. Yadegari, 34 Steven W. Stone, 31–32 Vanessa Scott, 29
Form ADV investment adviser registration and
report form general instructions, 231–243 part 1A
civil judicial action disclosure reporting, 313–316
criminal disclosure reporting, 305–307
form, 265–283 instruction, 245–256 regulatory action disclosure
reporting, 309–312 schedule A, 285 schedule B, 287 schedule C, 289 schedule D, 291–303
part 2A appendix 1, wrap fee program
brochure, 333–337 firm brochure, 323–332 general instructions, 317–318
523
I - 2
preparing, firm brochure, 319–321
part 2B, brochure supplement, 339–344
updates conclusion, 221 materiality and promptly, 220–221 requirements
delivery, 220 filing, 219–220
I
Investment Adviser about, 37
Advisers Act to financial planners, application, 40–41
advising others, 39 compensation, 39 definition
persons excluded, 41–47 security, 40
engaged in business, 38 affiliates and associated persons,
56–58 extraterritorial application, 58–59 introduction, 37 registration
advisers to pension plans, 55 dual-registration with CFTC, 55 persons exempted, 47–55
state registration and regulation, 55–56 Investment Adviser’s Fiduciary Duty
appendix A, 197–202 basic duties to particular adviser,
153, 519 conduct, standard, 519
Negligence vs. Gross Negligence, 186–190
state of mind, scienter, willfulness, 190–192
duties be altered or waived, 154–157 duties owes to clients, 152–153 emerging issues impact, 518
assess client’s mental competence, 179–182
oversee sub-advisers and other service providers, 175–177
protect client assets from business disruptions, 182–184
robo-advisers, 184–185 vote proxies, 177–179
examples, 157–158 act in good faith, 171–173 care, 158–162 disclosure, 173–174 loyalty, 162–170 obedience, 170–171
fiduciary duties, discharge policies and procedures, 193–194 training, 194
framework, 516 legal basis
common law, 142 Dodd-Frank Act
advisers, 145–146 municipal advisors, 146–147
federal statutory law, 142–145 other sources
Blue Sky laws, 149 broker-dealer laws, 151–152 ERISA, 149–151 Investment Company Act,
sections 36(a) and 36(b), 148–149
practical tips, 520 relationship between adviser and
clients, fundamental nature, 141–142
Investment Advisers Act 1940, Act, 65–74 Employee Retirement Income
Security Act of 1974, 78–81 Financial Industry Regulatory
Authority, 81 investment advisory profession, 63 Investment Company Act of 1940,
75–77 law, sources, 63–65 private associations, 81 state law, 74–75
Investment Advisers and New Client Relationships
anti-money laundering Bank Secrecy Act, 398–399 criminal money laundering laws,
400 enforcement actions, 403–404
Form ADV (Cont’d)
524
I - 3
OFAC sanctions, 399 optional AML programs,
400–401 reliance, financial institutions,
401–403 appendix A, 407–412 brochure rules
CFTC, 360–362 enforcement actions, 362–363 generally, 358–360
client accounts, custody, 387–394 conclusion, 405 ERISA requirements, 394–398 fiduciary obligations, 380–387 investment advisory contracts
legal requirements, 374–376 suggested provisions, 377
overview, 349 privacy rules
enforcement actions, 367–369 regulations
S-AM, 369–370 S-ID, 370–373 S-P, 363–367
schedules, 413–416 side letters, 377–378 solicitation
cash solicitation rule, 349–352 enforcement actions, 355–357 FCPA, 355 pay to play, 352–355
tax considerations, 404 voting proxies, 378–380
Investment Advisers to Private Funds basic thresholds, 445–446 changes, basic approach, 443–444 definitions, 444–445 exemption
private fund adviser, 447–448 venture capital fund advisers,
448–450 foreign private advisers, 451–453 Private Fund Investment Advisers
Registration Act of 2010, 443 reporting and continued federal
regulation, 453 rules define and current system, 444
N
National Society of Compliance Professionals
new compliance paradigm, 465–466
P
Program Schedule attracting clients and establishing the
investment adviser-client relationship, 12
brokerage and trading practices; investment adviser compliance programs, 12
how do investment advisers register; the disclosure regime; the advisers’ fiduciary duty, 11
private funds, 12 the SEC’s 2016 exam program and
“hot” topics in the investment adviser industry, 13
who is an investment adviser; regulatory jurisdiction, 11
S
SEC to RIAs beware ides of May, 213–214
SPVs and Relying Advisers letters
2012 staff, 459–460 SEC staff, 457–458 SPVs and 2005 staff, 458–459
proposed Umbrella changes to Form ADV and related release, 461
State Registration of Investment Advisers control person discipline, USA 2002
concept, 135–136 denial of application, basis, 124–125 exclusions, definition, 106–108 federal regulatory action, 135 post-registration requirements,
130–133 public disclosure, 134–135
525
I - 4
registration requirements, 109–110 registration, exemptions, 110–111 regulatory audits and inspections,
133–134 renewal, termination, withdrawal
and transfer, registration, 125–129 representative exclusions, definition,
108–109 representative registration
requirement, 111 representative registration,
exemptions, 111–112 representatives under state securities
laws, dual registration, 112 state registration process
Central Registration Depository, 112–113
consent to service of process, 114–115
examination requirements, 115–117
Investment Adviser Registration Depository, 113
senior-specific certifications and professional designations, use, 117–118
time period for action on application, 118–119
uniform forms, 113–114
state regulation, introduction, 85–87 state regulatory jurisdiction over
investment advisers Advisers Act, anti-fraud rules,
98–99 anti-fraud provisions, 96–97 exempt reporting advisers under
Dodd-Frank, 93–95 fiduciary standard, 95–96 home state rules, 92–93 no self-regulatory organization,
95 NSMIA, 89–91 representatives, 100–102 states permitted SEC’s notice,
91–92 transitioning between regulatory
regimes, 97–98 under state securities laws,
definition, 102–105 substantive requirements relating to
investment adviser applications brochure, 122–123 investment advisory contracts,
124 net worth and bonding,
119–122 solicitor’s disclosure, 123
Uniform State Securities Acts, 87–89
State Registration of Investment (Cont’d)
526
