On June 17, 2021, the Commission ordered that Rule 205-3 under the Investment Advisers Act of 1940 be amended so that the term “qualified client” means (i) natural person who, or a company that, immediately after entering into the contract has at least $1,100,000 under the management of the investment adviser; and (ii) a natural person who, or a company that, the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,200,000. Both prongs have increased by $100,000 to keep pace with inflation.
The amendments become effective August 16, 2021.
While the amendments do not have any retroactive effect, investment advisers should review their policies and procedures, offering documents, and client agreements to make sure that these amendments are reflected in all performance-based compensation arrangements by August 16, 2021.
The most frequent quip I hear from owners and executives of investment advisers relating to compliance is that what keeps them up at night is they “don’t know what they don’t know.” I sympathize with them about the unknown and try and help insure that they are positioned to be compliant with federal and state securities laws. Rule 206(4)-7 requires each registered adviser to review its policies and procedures annually to determine their adequacy and the effectiveness. This rule serves as an annual reminder of the knowledge gap that owners and executives face without a trusted legal and compliance partner. This post is intended to provide a high level overview for owners and executives of things they ought to consider as part of this annual review process.
The annual review should consider any compliance matters that arose during the previous year, any changes in the business activities of the adviser or its affiliates, and any changes in the Advisers Act or applicable regulations that might suggest a need to revise the firm’s policies or procedures. A firm would be prudent to review recent enforcement action and examination trends.
The firm’s policies and procedures should be reviewed taking into consideration the nature of the firm’s operations. The policies and procedures should be designed to prevent violations from occurring, detect violations that have occurred, and correct promptly any violations that have occurred.
The firm should take time to identify conflicts and other compliance factors creating risk exposure for the firm and its clients in light of the firm’s particular operations, and then ensure that the firm’s policies and procedures address those risks.
The firm should confirm that the CCO is competent and knowledgeable regarding the Advisers Act and empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the firm.
The firm should consider the following sources for performing the annual review: a) interviews, b) testing, and c) review of exceptions from the prior year.
Review prior year’s review and recent deficiency letters from regulators.
At a minimum, the firm’s policies and procedures should address the following issues to the extent that they are relevant:
Review the firm’s portfolio management and trading processes. This should include:
A review of how the firm allocates investment opportunities among clients,
How it aggregates block trades,
A review of the consistency of portfolios with similar investment objectives,
Disclosures by the adviser regarding portfolio management processes,
Review of any client-imposed and regulatory restrictions,
Review of soft dollar arrangements and allocation of mixed usage, and
Review of best execution (while I disagree with the SEC Staff that this concept extends to mutual fund purchases, adviser’s should consider whether their purchases and sales of funds and share classes through a specific broker-dealer or custodian are appropriate).
Review trading by the firm and its personnel.
Review the accuracy of disclosures made to investors, clients, and regulators, including account statements and marketing material.
Review the safeguarding of client assets from conversion or inappropriate use by personnel.
Review for the accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction.
Review the firm’s marketing material and services, including the use of solicitors.
Review how the firm values client holdings and charges fees based on those valuations. Review disclosures and agreements to insure that they are all in agreement.
Review of the firm’s safeguards for the protection of confidential client information.
Review the firm’s business continuity and succession plans.
It is always a good practice to have an independent party to provide a second set of eyes on the firm’s policies and procedures and their annual review. If you have concerns whether your firm has any gaps in its compliance program or whether it is properly documenting its review properly, do not hesitate reaching out.
Recently, Bruce Kelly of InvestmentNews published “Advisers, shoot for $100 million in AUM before going indie“. The article summarized a virtual conference panel that InvestmentNews RIA Summit held where the message from most panelists seemed to have suggested that investments advisers starting their business with less than $100 million under management would be better served not starting their own business. I want to dispel that notion.
State Registered RIAs By the Numbers
As of December 31, 2020, there were approximately 17,454 state-registered investment advisers. In almost all cases, these investment advisers manage less than $100 million in assets. In New York, registration with the U.S. Securities and Exchange Commission becomes mandatory where an investment adviser manages more than $25 million in assets. Even with this weird regulatory wrinkle, New York still has 828 state-registered investment advisers, which is the fourth most among all the states. These numbers were down just a tick from the December 31, 2019 figures when there were 17,533 state-registered investment advisers and 845 New York registered advisers. If we interviewed all of these businesses, I would imagine the vast majority of them would tell you that they were happy with their decision to start their own business.
Let’s consider a financial advisor with a book of business of $50 million charging 1% on all of their client business. They are contemplating (i) starting their own investment adviser, (ii) transitioning their book of business to a corporate investment adviser, and (iii) remaining with a wirehouse. The example assumes they would be entitled to count all of their revenue towards their production figures, but as we know, some wirehouses do not give credit for smaller accounts. This example also doesn’t consider the retention bonuses and other golden handcuffs that wirehouses pay, but now you can see where that pot of money is created. Lastly, this example assumes that the Corporate RIA and the Wirehouse will bear salaries for an administrative person, but sometimes those expenses are split between the financial advisor and the firm.
Corporate RIA (85%)
Advisory Fee Revenue
($15,000) – registration and compliance costs, entity formation, insurance
($5,000-$150,000) other overhead expenses
$335,000-$480,000 (W-2 AND K-1)
$425,000 (1099 or W-2)
The reason why the independent investment adviser’s expense range varies so much is because it single-handedly controls its expenses. It can determine whether to hire an assistant, whether and where to maintain a physical office, what technology to use. These expenses can vary quite a bit, but as the example shows, this is where the economic outcomes really turn.
Investment advisers with less than $100 million under management at the time of registration generally must register with one or more state securities authorities as opposed to the SEC (with the exception of New York, as discussed above). If an investment adviser will have clients or places of business in multiple states, it might require registering with more than one state securities authority. This can increase registration costs, slow down the registration process, and potentially create some additional compliance work.
An investment adviser that is registered with a state is subject to various compliance requirements. At a minimum, they will need to prepare and maintain Form ADV. Many state securities laws also require the maintenance of written policies and procedures designed to prevent and detect violations of applicable law. For simpler investment advisers, neither of these requirements is overly burdensome and both can be outsourced to experienced professionals. I personally do not believe in skimping with either Form ADV or policies and procedures as I have seen more than enough instances where doing so has caused later deficiencies and regulatory issues.
There are also a number of growing investment advice business models that don’t contemplate having ANY assets under management. These include financial planning and advice firms where investment advisers don’t manage any assets on an ongoing basis. I have spoken to a number of these firms and they appear to be doing quite well.
In any event, a relatively simple investment adviser does not require a full-time, dedicated compliance officer. I have seen many smaller organizations where a founder or client-facing adviser wears the compliance hat, and as long as (i) he or she is willing to put in the effort, (ii) has some available time each month or quarter, and (iii) has some resources for compliance , there is no reason that these organizations can’t be successful.
There are so many examples of investment advisers with less than $100 million under management that are successful. If you asked their founders whether they are happy, content, or fulfilled, I am guessing you would get a lot of positive feedback. In fact, I can count on one hand the number of investment advisers that I have worked with over the years that have intentionally gone back to working for another business (excluding as part of a succession plan). Below are just a few stories from people who weighed in on Twitter about their own personal stories of success in starting their businesses with less than $100 million. Would love to see more success stories in the comments.
Next time you hear an industry professional, a consultant, or a headhunter tell you that the line of demarcation for successfully launching an investment adviser is $100 million, I would simply encourage you to review your personal wants and needs. If they can best be accomplished at a Wirehouse or Corporate RIA, then that is what I would recommend. If they can best be accomplished by starting your own investment adviser, I’ll be available to help you through that process. If you need an introduction or recommendation of a Wirehouse or Corporate RIA that might best fit your situation, I could also probably help out with that too.
One of the most frequently asked questions I receive from investment advisers is whether they can enter into an advisory relationship or manage assets for a client located in a foreign country. Like the United States, foreign jurisdictions have laws that require registration for rendering investment advice to individuals residing within their jurisdiction. This post is intended to provide a bit more context for advisers trying to work through these issues.
Custodian Representations and Paperwork
Every major investment adviser custodian (i.e., Schwab, Fidelity, TD Ameritrade) requires an investment adviser to complete additional paperwork when opening oan account for a client in a foreign jurisdiction or when a client requests to receive their account statements in a foreign jurisdiction. That paperwork serves a few different purposes, but most importantly it is designed to protect the custodian from regulatory risk. Among other things, the paperwork requires an investment adviser to represent that it is either appropriately licensed in the foreign jurisdiction or exempt from licensing in the foreign jurisdiction due to its relationship with the client in the foreign jurisdiction. For example, the exact language of the TD Ameritrade representation is below:
Chief Compliance Officers and principals at investment advisers have to make difficult decisions when weighing their ability to make this representation. Without becoming authorized to render advice in the foreign jurisdiction or knowledge of an exclusion from registration under the law in the foreign jurisdiction, it could be quite difficult to make this representation in good faith.
The most recent edition was published in 2012 and may not contain the most current information.
It only contains a survey for roughly the 40 wealthiest nations.
It doesn’t account for Brexit.
I find myself hoping that Marcia MacHarg would update the treatise, but it appears that she is now retired. I’ve considered publishing a simpler treatise focused solely on cross-border wealth management, but then I break out in cold sweats.
2. Online Research
After reviewing the treatise, I perform an online search to either confirm my early research or find an initial answer. At this point, I cross my fingers and pray that I can locate a copy of the local law in English. Most often an English version or translation is available. Sometimes it is not. Even if it is available, it is often extremely ambiguous. In the best cases, I can determine that there is a clear exemption or exclusion for cross-border services. However, at this point, if the answer isn’t clear, I reassess with the client. Sometimes the client is comfortable making a business decision to proceed on the limited information that is available. Sometimes they want more definitive guidance, in which case we seek out local counsel.
3. Potential Engagement of Local Counsel
If a client is still uncomfortable making the representation and the client relationship is sufficiently valuable, then it may be worth exploring engaging local counsel. I have addressed these issues for many years now and have developed relationships with legal practitioners across the globe.
I’d be happy to assist your firm in assessing the risk of making representations to your custodian or facilitating guidance under local law. There is nothing I enjoy more than helping clients find solutions to their problems. Nothing disappoints me more than having to say “no” to an entrepreneurial client.
I have a lot of respect for compliance professionals, Chief Compliance Officers, legal counsel and anyone in a regulated environment that is trying to keep their client out of trouble. At the same time, I occasionally am told stories involving compliance consultants that blow me away. So I decided to compile a list of signs that may signal you need a new compliance professional or a law firm to assist you with compliance.
I drafted this report for you. It identifies every single deficiency that I uncovered. There are a lot of them and things don’t look so good for your firm. It is a roadmap for the Division of Examinations, FINRA, or a state securities regulator. I didn’t consider whether the contents of this report were privileged before sending it to you. Good luck!
When you need to reach them for a compliance emergency, you can’t. They clock out at 4:30 or 5:00pm and aren’t prepared to help you or your business get it right after hours.
They tell you what everyone else is doing, what you “need” to be doing; and they don’t tell you what the law actually says you must be doing.
They defer to telling you “no”, because it makes their life easier.
They aren’t able to provide you with a risk assessment to make informed business decisions.
Hold on…that is a legal document. I can’t help you out with that. You are going to have to contact a lawyer.
Hold on…that is a legal question. I can’t help you out with that. You are going to have to contact a lawyer.
When asked about exploring a new, but related line of business, they tell you that they don’t have any experience with that area.
They write poorly, but you need them to draft written responses to a deficiency letter.
They gave you incorrect advice and it cost you time, money or energy to correct.
On March 18, 2021, the staff of the Division of Investment Management released an FAQ regarding the new marketing rule. The new rule becomes effective May 4, 2022, but has a compliance date of November 4, 2022. The FAQ makes clear that an adviser may comply with the new rule prior to November 4, 2022, but they must be fully compliant with all aspects of the new rule when they opt in to compliance. The full text of the FAQ is set forth below:
Investment advisers with their principal place of business in foreign jurisdictions have recently become subject to moratoriums on registration because the U.S. Securities and Exchange Commission (the “Commission” or the “SEC” ) and its Staff have concerns that these foreign applicants may be unable or unwilling to make their books and records available for inspection or examination due to local privacy laws. Israel is one of those countries. The United Kingdom was one of these jurisdictions until late 2020.
The SEC’s position, while well-intentioned, is not supported by the law. It also ignores the fact that (i) there are a number of registrants in these jurisdictions that have had their applications for registration deemed effective while local privacy laws were already in effect, and (ii) a number of registrants and exempt reporting advisers have clients, offices, or employees in jurisdictions subject to moratorium and the SEC and its Staff have never expressed concern over their compliance with local privacy laws.
This post walks through the law governing registration and approval as an investment adviser to show that the SEC is acting beyond its statutory authority. In doing so, it concludes that Section 203 of the Investment Advisers Act of 1940 (the “Advisers Act”) requires the SEC to approve otherwise valid applications and address the consequences of local privacy law through other means.
The Law and Issue
Section 203(a) of the Advisers Act states, “it shall be unlawful for any investment adviser, unless registered under this section, to make use of the mails or any means or instrumentality of interstate commerce in connection with his or its business as an investment adviser.”
Paragraph (c) goes on to provide the requirements for registration and the approval process. It reads:
The Staff is currently relying on subsection (e)(1) for denying these applications. That subsection permits denial if the applicant could be found to have “willfully made or caused to be made in any application for registration or report required to be filed with the Commission under this subchapter, or in any proceeding before the Commission with respect to registration, any statement which was at the time and in the light of the circumstances under which it was made false or misleading with respect to any material fact, or has omitted to state in any such application or report any material fact which is required to be stated therein.”
As grounds for the moratoriums, the SEC Staff is relying on the affirmation on the Execution Page to Form ADV, which states: “I certify that the adviser’s books and records will be preserved and available for inspection as required by law.” The Staff believes that advisers in jurisdictions subject to moratorium have arguably made false or misleading statements in an application, granting them the authority to reject these applications, because the applicant might be in breach of local law if they comply with an examination request under Section 204. However, this position is too attenuated to survive scrutiny. The reference to “law” on the Execution Page is referencing the Investment Advisers Act and not foreign privacy laws. There is no hint in any proposing or adopting release concerning Form ADV that this reference means anything other than the Investment Advisers Act. There is no precedent for the SEC denying applications because an adviser might theoretically be in violation of local tax, zoning, or employment law.
These applicants have every reason to believe they are making these affirmations in good faith and can knowingly or unknowingly violate local privacy laws without causing their affirmations on Form ADV to be false or misleading.
In any event, every investment adviser registered with the SEC that has a client, employee, or office in Israel (or any other foreign jurisdiction subject to a moratorium) would be making the same alleged false or misleading statement. For this reason, the Staff’s position is simply unfair.
I spent a considerable amount of time debating whether to publish this post. I sought a lot of feedback from colleagues and friends. Lawyers–including myself–in this industry do not want to offend the SEC, any Commissioner, or its Staff. That was never my intention in publishing this article. However, I think we all need to be open to constructive criticism and acknowledge when our decisions are not based in the law, are arbitrary, or unfair.
It is also important to step back and understand that new applicants want to avoid litigating with the SEC to obtain registration. It doesn’t serve as a good introduction to regulated life in the United States. So new applicants are left either (i) avoiding business in the US, (ii) bringing their activities onshore, or (iii) trying to lobby their local governments to provide some sort of privacy relief. All of these solutions are less than ideal.
I believe the SEC should discontinue the practice of moratoriums immediately and work with Congress and foreign governments to seek assurances on local privacy law.
Its official. The Marketing Rule was published in the Federal Register this morning on March 5, 2021. This means that the rule will become effective on May 4, 2021. The new rule contemplates an eighteen-month transition period between the effective date of the rule and the compliance date. This means your firm should be prepared to comply by November 4, 2022. You should immediately begin reviewing all of your current solicitor and referral relationships and existing marketing. You should also begin developing policies and procedures designed to comply with the new rule.
On December 22, 2020, the U.S. Securities and Exchange Commission adopted amendments to Rule 206(4)-1 under the Investment Advisers Act of 1940 relating to advertisements. Among other things, these amendments, when effective, will permit testimonials. The rules are currently under review by the Biden Administration and won’t become effective until 60 days after they are published in the Federal Register. There is some ambiguity whether an investment adviser registered with the State of New Jersey will be able to take advantage of the amendments to Rule 206(4)-1. I suspect there is similar ambiguity under other state’s laws and regulations.
New Jersey Statute 49:3-53(a)(3) makes it unlawful to “to engage in dishonest or unethical practices as the bureau chief may by rule define in a manner consistent with and compatible with the laws and regulations of the Securities and Exchange Commission [and other organizations]. New Jersey Statute 49:3-53(f) makes it “unlawful for any person soliciting advisory clients to make any untrue statement of a material fact, or omit to state a material fact necessary to make the statements made, in light of the circumstances under which they are made, not misleading.”
New Jersey Annotated Code 13:47A-6.3 (a)(18) and (a)(52) were promulgated by bureau chiefs to define certain dishonest and unethical practices. New Jersey Annotated Code 13:47A-6.3 (a)(18) makes the following practice “dishonest and unethical” and prohibited:
New Jersey Annotated Code 13:47A-6.3 (a)(52) makes the following practice “dishonest and unethical” and prohibited:
While there is potential conflict between these two passages, I interpret New Jersey Statute 49:3-53(a)(3) as only authorizing the Bureau chief to define dishonest or unethical practices so long as they are consistent with and compatible with the laws and regulations of the Securities and Exchange Commission. I believe it would be unconstitutional for the Bureau to take the position that an investment adviser registered with the State of New Jersey would be engaged in a dishonest or unethical practice while in compliance with Rule 206(4)-1. Therefore, investment advisers registered with the State of New Jersey ought to be able to take advantage of the amendments to Rule 206(4)-1 so long as they aren’t in violation of New Jersey Statute 49:3-53(f), which is nearly identical to the general prohibition in Rule 206(4)-1(a)(1).
There has been a lot of debate this year about the fairness of advisory fees. Who am I kidding? This is a debate that has been going on for years now. In this post, I address what the law says about advisory fees (but not performance-based fees). In my next post I plan to share some ideas that I have on the fairness and value of advisory fees.
Congress and the SEC have deferred to market forces in considering whether an advisory fee is appropriate. The SEC Staff has historically taken the position that “an investment adviser that charges a fee ‘larger than that normally charged by other advisers’ (based on factors such as size of the account, location, and nature of the business of the advisory firms being compared) has a duty under Section 206 of the Advisers Act to disclose to clients that the same or similar services may be available elsewhere at a lower fee.” The SEC Staff previously opined that this disclosure was necessary for engagements at 3%. More recently, the Staff has suggested that this disclosure would be required if an investment adviser’s fee is 2%. See, Investment Advisers: Law & Compliance § 8.03 (2020). Notably, the recent Commission Interpretation Regarding Standard of Conduct for Investment Advisers was silent on the issue of fees charged directly by investment advisers.
The SEC’s position makes sense. In the absence of specific laws, we lawyers often look to other bodies of law for precedent. One common body is the law governing agency and principal relationships–which fits quite nicely in discussing investment adviser’s relationships with their clients. The Restatement of Agency, which is a treatise summarizing the law suggests, “An agreement between a principal and an agent may also set the agent’s right to compensation at an amount or rate that is standard or customary in a particular industry.” See, Section 8.13. This follows the position of Congress and the SEC (or perhaps Congress and the SEC follow this position).
These are the reasons why we haven’t seen any real change in the industry attacking asset-based fees or the 1% fee in general. As long as a 1% fee can be considered standard or customary, it won’t be going anywhere.
Obviously, a fiduciary has an obligation to act prudently in carrying out its duties, deal fairly with clients, and make full disclosure of all material facts regarding its fees. However, this is satisfied by selecting investments that are appropriate (which may or may not be low-cost investments), accurately disclosing fees in a contract between an adviser and its client, and charging fees only according to that contract. There isn’t any obligation for an investment adviser to disclose its fees on its website so that competitors can undercut prices. There isn’t any obligation to offer the lowest rate in town or in a niche. There isn’t any legal obligation to charge an hourly rate. There isn’t even any obligation to prove your value. As it relates to the value proposition, the law simply requires that you disclose to the client: (i) your services, (ii) your fees, and (iii) that you perform the agreed upon services. The law allows clients who believe they aren’t receiving value to seek recourse or walk away from the relationship.
Investment advisers also need to comply with their obligations under Form ADV and Form CRS, but that is a slightly different topic.
* I would also note that certain state securities authorities have their own views on what fees are appropriate and what is required of investment advisers to earn fees. For example, certain states seem to prohibit subscription-based fees, because they somehow believe that advisers aren’t capable of proving they provide value in each month. If only they knew the same could be said about any other fee arrangement.