Determining Whether a Client Can Invest in a Private Investment

I often receive questions from investment advisers on whether their clients can invest in a hedge fund, private equity fund, private company or some other type of private investment. For purposes of this article, I refer to them all as “private investments”. For example, clients will ask “can John Doe’s Trust invest in 123 Capital, LP?” My inevitable answer is always let me review the law and the offering documents and get back to you, because the federal securities laws are a nightmare in this area.

Federal securities laws require investors to meet certain qualifications in order for the securities transaction in question to be exempt from registration. These exemptions are found in two bodies of law–the Securities Act of 1933 (the “Securities Act”) and the Investment Company Act of 1940 (the “1940 Act”). Issuers of these investments have to be careful not to disregard these laws or else they could be found to have engaged in public offerings of non-exempt securities or investment companies, which would have a pretty draconian impact on their business.

The Federal Securities Laws

In practice, the Securities Act exempts from registration securities offered exclusively to “accredited investors”. The 1940 Act permits investment by (i) up to 100 “accredited investors”, or (ii) an unlimited number of “qualified purchasers”, in a pooled investment vehicle without registering as an “investment company”. The Securities Exchange Act of 1934 could also require registration if an issuer has a class of equity securities “held of record” by 2,000 persons.

Where to Begin?

The starting point in conducting analysis on whether a client can invest in a private investment should always be the investment’s governing documents. You should review the partnership agreement or operating agreement, the investment’s offering memorandum, and any subscription agreement that the client will need to execute in order to make an investment. These documents will typically describe what qualifications the investor must maintain in order to be eligible to invest. As alluded to above, these qualifications are determined based on business and regulatory considerations. You will want to primarily search for the terms “accredited investor” and “qualified purchaser”.

Identifying the Standard

The easiest and best place to begin in determining the standard for investment is the investor questionnaire that is usually part of the subscription agreement. As examples, click here and here. You should always be able to determine what the standard is by reviewing the subscription agreement.

Determining Client Eligibility

Once you have identified the standard required of an investor, then you must determine whether your client meets that standard. In a high percentage of instances, you will review a subscription agreement and know pretty quickly whether your client is eligible to invest.

Is your client an “accredited investor”?

Rule 501 of Regulation D under the Securities Act sets forth which investors qualify as “accredited investors”. The determination is made “at the time of the sale of the securities to that person”. While not an exhaustive list, the definition includes:

(1) banks, savings and loan associations, broker-dealers, insurance companies, registered investment companies,

(2) government benefit plans having assets in excess of $5,000,000;

(3) employee benefit plans if the investment decision is made by a fiduciary that is a bank, savings and loan association, insurance company, or registered investment adviser,

(4) employee benefit plans with total assets in excess of $5,000,000 ,

(5) employee benefit plans where investments are self-directed so long as investment decisions are made solely by persons that are accredited investors;

(6) nonprofit organizations (so long as they are not formed for the specific purpose of acquiring the securities offered) with total assets in excess of $5,000,000;

(7) Any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000 (the “accredited investor net worth test”).

(8) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year (the “accredited investor income test”);

(9) Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a person with knowledge and experience in financial and business matters that is capable of evaluating the merits and risks of the prospective investment; and

(10) Any entity in which all of the equity owners are accredited investors.

Is Your Client a “Qualified Purchaser”?

Rule 2(a)(51) under the 1940 Act defines who is a “qualified purchaser”. This determination is also made at the time of acquisition. While not an exhaustive list, the definition includes:

(1) any natural person who owns $5,000,000 in investments (the “qualified purchaser investment holdings test”),

(2) any company that owns $5,000,000 in investments and that is owned directly or indirectly by or for 2 or more immediate family members (the “family member test”);

(3) any trust that is not covered by the family member test and that was not formed for the specific purpose of acquiring the securities being offered, so long as the trustee or other person authorized to make decisions with respect to the trust, and each settlor or other donor of property to the trust is a qualified purchaser; and

(4) any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments.

Fuzziness Surrounding Standards

Most lawyers, compliance officers, and people who routinely invest in private investments don’t have issues determining the status of a person as an “accredited investor” or a “qualified purchaser” where they are advising investors who are natural persons (i.e., Joe or Nancy Smith) and they clearly meet the accredited investor net worth test, the accredited investor income test, or the qualified purchaser investment holdings test. However, the other standards all require a bit more analysis which will inevitably be covered in future posts.

SEC Should Provide Clear Guidance Following Two Ocean Crypto Banking Relief

On October 26, 2020, the Wyoming Division of Banking issued “no-action” relief to Two Ocean Trust stating that i) Two Ocean is permitted to provide custodial services for both digital and traditional assets under Wyoming law, and (ii) that Two Ocean
can refer to itself as a “qualified custodian” as that term is defined under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).

Under Rule 206(4)-2 or the “custody rule”, an investment adviser is generally required to maintain cash or securities for which it is deemed to have custody with a “qualified custodian”. The custody rule defines “qualified custodian” to include, among others, “[a] bank as defined in section 202(a)(2) of the Advisers Act (15 U.S.C. 80b-2(a)(2)).”

Section 202(a)(2) of the Advisers Act defines “bank” as:

(A) a banking institution organized under the laws of the United States or a Federal savings association, as defined in section 1462(5) of title 12, (B) a member bank of the Federal Reserve System, (C) any other banking institution, savings association, as defined in section 1462(4) of title 12, or trust company, whether incorporated or not, doing business under the laws of any State or of the United States, a substantial portion of the business of which consists of receiving deposits or exercising fiduciary powers similar to those permitted to national banks under the authority of the Comptroller of the Currency, and which is supervised and examined by State or Federal authority having supervision over banks or savings associations, and which is not operated for the purpose of evading the provisions of this subchapter, and (D) a receiver, conservator, or other liquidating agent of any institution or firm included in clauses (A), (B), or (C) of this paragraph.

(emphasis added).

The Wyoming Division of Banking effectively concluded that Two Ocean is a trust company meeting all the requirements of prong (C).

Given this outcome, I believe that the SEC’s Division of Investment Management should offer guidance to the industry that reliance on these state-issued no-action letters is reasonable in concluding that an entity is a “qualified custodian” for purposes of the custody rule under the Advisers Act. This level of guidance will only further legitimize the crypto and digital asset movements and provide much needed clarity to the investment management industry.

A Growing Trend for RIAs – Become a One-Stop Shop

As of October 1, 2020, out of 13,810 investment advisers registered with the U.S. Securities and Exchange Commission (SEC), more than 200 reported being actively engaged in the business of being an accountant or accounting firm. Almost a 1,000 reported an affiliation with an accountant or accounting firm. Another 28 reported being actively engaged in the business of being a lawyer or law firm. And 447 reported an affiliation with a lawyer or law firm. The growth in the number of registered investment advisers has seen an increase in the number of firms that offer legal or accounting services.

Investment advisory clients and prospective clients–especially high net worth clients– are continuing to seek out trusted advisers that can render investment, tax, and estate planning services under one roof (a “One Stop Shop”). Conceptually, it makes a lot of sense. Instead of seeing three medical specialists, wouldn’t it be more efficient to receive all those services in a single visit from one business? Wouldn’t you reduce your opportunity costs? Wouldn’t you expect to receive some type of pricing discount?

There are a number of competing forces that prevent everyone from engaging a One Stop Shop. Similarly, there are forces that prevent investment advisers from creating their own One Stop Shop.

Some clients are quite happy with their current tax professionals and estate planning lawyers. Some clients may have very simple tax and estate planning needs and believe that it would be less expensive to seek out individual practitioners instead of bundling their services. Some clients may prefer name recognition for their accountants and estate planning lawyers. Some clients may trust and like their other current professionals.

In addition, some investment advisers rely heavily on centers of influence for referrals. They might determine that bringing these services in-house or merging with an accounting firm or law firm could jeopardize these relationships and referral streams. This is a fair concern.

In any event, before expanding your services as an investment adviser to be a One Stop Shop, you may want to consider the available options and their pros and cons. Below is a short list of available options. I have counseled clients through each of these approaches.

  1. Enter into an engagement letter with accountant or accounting firm. This can be as formal or informal as your business requires. You may determine to start small and engage them to only prepare tax returns for your clients. You may also engage them to assist you with addressing issues that are important to your clients. For example, if one of your clients needs tax planning assistance, you could directly engage the accountant to render those services to your client.
    • Pros: This is typically an inexpensive method. Easy to control costs by negotiating hourly rates or fixed fee in contract.
    • Cons: May not be able to control work flow and timing of deliverables. Introducing other service providers may result in client poaching. Inability to closely supervise work product and client satisfaction.
  2. Hire an accountant or estate planning lawyer on staff. Another option to creating a One Stop Shop might involve hiring one or more accountants or estate planning lawyers. If you will be charging additional or separate fees for these services, this could present an ethical issue for the accountant or estate planning lawyer as it relates to sharing accounting or legal fees with non-lawyers, which most state rules of conduct generally prohibit. It is best to review those rules with any potential hire and make sure that your plan doesn’t run afoul of those rules.
    • Pros: Better able to control work flow and timing of deliverables.
    • Cons: Higher, fixed cost due to salary and benefits typically than entering an engagement letter. Expectation of increased cost in future years. Added liability for errors and omissions (can be offset with insurance).
  3. Enter into a formal merger, acquisition, or re-organize your business with an accounting firm or estate planning law firm. We are seeing more and more name-brand accounting firms push deeper into the wealth management space. A lot of regional accounting firms have also begun offering wealth management services. This trend appears to be continuing.
    • Pros: Can provide in depth knowledge for clients. Likely have an accountant or lawyer with experience to address almost any client issue. Extreme efficiency of communicating between staff members, which are typically in the same office or on electronic communications platforms.
    • Cons: Can create conflicts of interest for the accounting firm or law firm that jeopardizes independence or would require recusal. Additional regulatory, compliance, and disclosure complexity (primary issues include conflicts of interest, insider trading, confidentiality, and data security).

This list and the pros and cons are intended to be a high level discussion for investment advisers evaluating their options. It may not comprehensively address all of the possible options and risk and rewards of each option. You should consult with knowledgeable legal and compliance professionals prior to contemplating your One Stop Shop.

Recent “Guidance” on Form CRS Disciplinary History Is Bad “Law”

Recently, I wrote a post that investment advisers and broker-dealers should review their Form CRS in light of new guidance on the disciplinary history section (Review your Form CRS Disciplinary History Disclosure in Light of New Guidance). As that post addressed, earlier in the month, Commissioner Clayton and Directors Blass and Redfearn put forth a Joint Statement Regarding New FAQs for Form CRS. On the same day as the Joint Statement was issued, the staff of the Division of Investment Management and the Division of Trading and Markets amended its Frequently Asked Questions on Form CRS by adding four new questions and answers.

As a follow up to my earlier post, I wanted to examine this guidance, ponder its intent, poke holes in its legality, and question whether it is even good public policy.

The Relevant Guidance

The guidance from the Joint Statement boils down to two major concepts:

  1. “Firms do not have discretion to leave the answer blank or to omit reportable disciplinary history from the relationship summary. ”
  2. “When responding to the disciplinary history heading in their relationship summaries, firms may not add descriptive or other qualitative or quantitative language.  Adding such language might, intentionally or unintentionally, obfuscate or otherwise minimize the disciplinary history.  However, as we describe below, firms or their financial professionals may provide the relevant disciplinary history directly to retail investors.”

Intent of the Guidance

I think Commissioner Clayton and Directors Blass and Redfearn were feeling pressure from the recent reporting by the Wall Street Journal – Financial Firms Fail to Own Up to Advisers’ Past Misdeeds – on the lack of accurate disclosure on Form CRS. Based on that pressure, they reacted by putting forth the Joint Statement and tried to clear up confusion in the industry regarding disciplinary history reporting on Form CRS. I think their Joint Statement went too far in trying to clear up that confusion, and caused them to provide guidance that is contrary to the Instructions to Form CRS.

Legality of the Guidance

The first bit of guidance referenced above is legally enforceable, was well-intentioned, and was a matter of good public policy. It is based on the Instructions to Form CRS and complies with the intent outlined in the proposing and adopting rule releases.

However, I believe the second bit of guidance is less likely to be legally enforceable, was an overreach in reaction to the Wall Street Journal’s reporting, and is also bad public policy.

The Instructions to Form CRS make it clear that investment advisers and broker-dealers must respond to each question and only include disclosure that is required or permitted by the instructions. Instruction 1.B. states, “You must respond to each item and must provide responses in the same order as the items appear in these instructions. You may not include disclosure in the relationship summary other than disclosure that is required or permitted by these Instructions and the applicable item.” However, instruction 2.B. states, “All information in your relationship summary must be true and may not omit any material facts necessary in order to make the disclosures required by these Instructions and the applicable Item, in light of the circumstances under which they were made, not misleading. If a required disclosure or conversation starter is inapplicable to your business or specific wording required by these Instructions is
inaccurate, you may omit or modify that disclosure or conversation starter.” (emphasis added). Footnote 92 of the adopting release identifies the tension between these two instructions by using the legal signal “Cf.” when comparing the two instructions.

Footnote 91 of the adopting release provides somewhat relevant guidance on instruction 2.B. It states, “We are adopting this provision to ensure that firms are not compelled to include wording in their relationship summaries that is misleading or inaccurate in the context of their business models. This provision may apply in limited circumstances. For example, the headings and conversation starters prescribed by the final instructions are worded at a highly generalized level and cover selected key topics that are broadly applicable to broker-dealers and investment advisers and their relationships with retail investors, irrespective of business model (i.e., relationships and services the firm offers to retail investors, fees and costs that retail investors will pay, specified conflicts of interest and standards of conduct, and disciplinary history).” (emphasis added). This signifies that a firm could add additional content to their discussion on their disciplinary history if they did so to make their disclosure more accurate or less misleading.

In addition, the adopting release goes on to state:

Firms or financial professionals would have the opportunity to provide more information about and encourage retail investors to ask follow-up questions regarding the nature, scope, or severity of any disciplinary history, so that retail investors have the information they need to decide on a relationship. In particular, financial professionals who themselves have no disciplinary history can make clear that a “Yes” disclosure in response to the heading question relates to the firm and other personnel (if applicable) and not to them.

Adopting release at p. 176

The adopting release isn’t clear on whether firms or financial professionals could provide more information in the Form CRS itself, but the ambiguity should be interpreted against the SEC in this case.

Guidance from a single Commissioner or the SEC staff do not have the impact of law. In fact, the Joint Statement acknowledges this in footnote 1. “This statement represents the views of Chairman Clayton and Directors Blass and Redfearn. It is not a rule, regulation, or statement of the Securities and Exchange Commission (“Commission”). The Commission has neither approved nor disapproved its content. This statement has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person.” The introduction to the FAQs have a very similar disclaimer.

This is important because the law in effect is the Form CRS and its instructions. Whereas, guidance is issued to help interpret or clarify an existing law. Whether the Joint Statement and FAQs are even to be considered guidance is up for debate because of the disclaimers they contain. Even if they were to be treated as guidance, I think that a federal court would agree that they are inconsistent with the regulation, which is historically the standard used in determining whether the guidance should be afforded deference. 

Bad Public Policy

I personally don’t understand why an investment adviser or broker-dealer could not provide additional clarification in response to a disciplinary question on Form CRS so long as they do so in a non-misleading way. I believe that the investing public would benefit from having additional, relevant information about the disciplinary history of a firm or a financial professional at a firm. While Chairman Clayton and Directors Blass and Redfearn believe that it could obfuscate or minimize a firm’s reportable disciplinary history, I believe that additional information is fair, and even warranted, in certain instances.

For example, I am aware of a small firm where one of its financial professionals had a single incident that caused the firm to make an affirmative response to the disciplinary history question. The event at issue involved a nearly 30-year old administrative error that resulted in a financial professional temporary having his license to render advice suspended by a state securities regulator in a state that he didn’t even have any clients or prospective clients. I hold this firm and the individual in question in high regard and I think it is unfair that they cannot provide a little bit of context around their affirmative response to make it not misleading.

Chairman Clayton and Directors Blass and Redfearn opted to try and make “black and white” that which is always a balancing act–the federal securities laws.

Should Your Firm Add or Remove Context?

I can’t tell you whether your firm should or should not provide context if it responds affirmatively to the disciplinary history question. That is a business decision. However, you should understand the law, the impact of guidance (and non-guidance), understand that this issue will likely arise during an examination, may be referred to enforcement, and determine whether you are prepared to litigate over this issue. For most investment advisers and broker-dealers with disciplinary histories, the answer will be easy–remove the additional context.

Review your Form CRS Disciplinary History Disclosure in Light of New Guidance

On October 8, 2020, Securities and Exchange Commission’s Chairman Clayton along with Dalia Blass, Director, Division of Investment Management and Brett Redfearn, Director of Division of Trading and Markets released a Joint Statement Regarding New FAQs for Form CRS. The Joint Statement focused on the disciplinary history section of Form CRS, which became effective earlier this year. On the same day as the Joint Statement was issued, the staff of the Division of Investment Management and the Division of Trading and Markets amended its Frequently Asked Questions on Form CRS by adding four new questions and answers.

The most newsworthy guidance under the amended FAQs effectively states that investment advisers and broker-dealers should not include additional information to explain their disciplinary history in Item 4. The precise language of the FAQ states:

Q: If we answer “Yes” in Item 4, may we include additional information in our relationship summary to explain the disciplinary history?

A: No. Item 4 requires a “Yes” or “No” response, along with the required reference to Investor.gov/CRS (Item 4.D.(i)) and the required conversation starter (Item 4.D.(ii)). Item 4 – and the conversation starter in particular – is designed to encourage a discussion regarding the nature, scope, or severity of any disciplinary history, including any differences between the firm’s disciplinary history and the financial professional’s disciplinary history, if applicable. Form CRS does not preclude firms or their financial professionals from providing separately copies of additional regulatory disclosures (e.g., Form ADV Part 2B brochure supplements or a print-out of the IAPD or BrokerCheck “Disclosures” section for the particular firm or financial professional). (Posted October 8, 2020)

This runs counter to what many lawyers and compliance professionals assumed (including myself).

Now is a good time to take a look at your firm’s Form CRS and amend, as applicable. The question remains whether this would be a material change requiring notification to investors, but I would posit that it is not.

On the other hand, it is important to note that the Joint Statement and the FAQs have no legal force or effect, do not alter or amend applicable law, create no new or additional obligations for any person, and have not been approved (or disapproved) by the Commission.  A firm may determine to make a business decision to provide additional content in response to Item 4, but they should do so knowing all of the relevant guidance.

SEC Proposes Exemptive Relief for “Finders” – A Win-Win Scenario?

I was recently quoted by WealthManagement.com on the recent “finders” exemption proposal by the U.S. Securities and Exchange Commission. That proposal would provide clarity to “finders” on how they can avoid allegations that they are acting as broker-dealers in need of registration under Section 15 of the Securities Exchange Act of 1934. The proposal is available here.

The Office of the Advocate for Small Business Capital Formation created a very helpful chart that shows how the proposed finder relief will work, if adopted. That chart is set forth below:

As you can see, the exemption provides two tiers of exemptive relief for finders. Tier 1 provides a finder with the ability to receive transaction-based compensation for (i) simply providing contact information for accredited investors, (ii) to non-reporting (private) companies, (iii) for primary exempt offerings, subject to certain conditions. It would only available for individuals and these referrals are proposed to be limited to once in a 12-month period. My only concern with this tier is that issuers may be able to deceive a finder or ultimately refuse to compensate a finder from their earned compensation, because of how “hands off” the approach must be under the proposal.

Tier 2 allows for the finder to be slightly more involved in the process–namely they can help contact potential investors, distribute offering materials, discuss the issuer, and arrange for meetings.

Lately, I have been finding myself in less agreement with Chariman Clayton on proposals, but I think this proposed relief benefits the industry without necessarily creating any increased risk for the investing public. As a practicing lawyer who works on securities offerings, I see these proposals as a win-win.

These activities are already taking place and investors are already being pitched ideas by unlicensed people who stand to benefit from those pitches. This relief at least provides clarity for the unlicensed people, and at the same time would seem to increase protection for those investors.

The Rise of Fee-Based Annuities and Potential Licensing Issues for Independent Investment Advisers

In recent years, as they have seen the exponential growth of independent investment advisers, insurance issuers have sought creative ways to place their products in the space. Hence the creation of the fee-based variable annuity–a product that was at one time only an arrow in the quiver of the commission brokerage industry.

Now that these products are commission-free, investment advisers can be compensated out of the contracts themselves for providing advice on the contracts and their underlying investments. In fact, the IRS recently made these products more alluring in 2019 when it issued private letter rulings that allowed compensation from the contract without incurring income for the investor.

Investment advisers often overlook the potential regulatory and legal issues that come with recommending these products and providing advice on them. I recently looked into this issue in New York and was a bit surprised at what I found.

NY Insurance Law § 2102(b)(3) states: “[u]nless licensed as an insurance agent, insurance broker or insurance consultant with respect to the relevant kinds of insurance, no person, firm, association or corporation shall receive any money, fee, commission or thing of value for examining, appraising, reviewing or evaluating any insurance policy, annuity or pension contract, plan or program or shall make recommendations or give advice with regard to any of the above.”.

NY Insurance Law § 2107 states that the superintendent may issue an insurance consultant’s license to any person, firm, association or corporation who or which has complied with the requirements of this chapter with respect to either: life insurance, meaning all of those kinds of insurance authorized in paragraphs one, two and three of subsection (a) of section one thousand one hundred thirteen of this chapter; or general insurance, meaning all of those kinds of insurance authorized in paragraphs four through twenty-three of such subsection, as specified in such license.

NY Insurance Law § 1113(a)(2) includes annuities, which suggests that a consultant’s license would be required to receive a fee in exchange for providing recommendations or advice regarding an annuity.

The law itself is unclear on whether an investment adviser would be required to be licensed as an insurance consultant for providing exclusively investment advice regarding the underlying investments in the insurance contract. The conservative approach would seem to err towards licensing.

However, there may be ways to avoid licensing altogether. If the investment adviser structures its services in such a way to avoid rendering any insurance advice on the annuity, it would be hard for the New York Department of Financial Services to allege that licensing would be required. For example, the investment adviser would need to be certain that it isn’t providing any of the services enumerated in NY Insurance Law § 2102(b)(3). This would required implementing safeguards to be certain the the business or its representatives are not examining, appraising, reviewing or evaluating the insurance contract. Also, once a contract is purchased, the investment adviser would need to create further safeguards to avoid providing advice regarding insurance elements of the contract.

For investment advisers who don’t hold an insurance license, it appears that there are a couple of options to further avoid licensing. Based on a press release, Nationwide Advisory Solutions provides a licensed insurance agent service at no cost “to help [investment advisers] enhance their client relationship and eliminate the unnecessary expense of any third party”. In addition, it appears that a cottage industry is popping up to address this very issue. On its website, Allianz references DPL Financial Partners and RetireOne as potential vendors to avoid licensing issues.

To my knowledge, the NY DFS has not brought any enforcement actions against independent investment advisers for acting as unlicensed consultants. Each state’s insurance law will differ, and you shouldn’t make any decision based on New York law or this post. Nonetheless, it seems like a practice that firms should be thinking about critically before jumping into the deep end of offering or interfacing with fee-based variable annuities (and other insurance products).

Morningstar Presentations Present Issues for Investment Advisers

As an attorney in the investment management space, I have seen the use of Morningstar presentations create issues for investment advisers at an increasing rate during examinations conducted by the Securities and Exchange Commissions (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”).

The issues that I have seen typically revolve around the use of hypothetical back-tested performance. Most typically, a financial professional will create a presentation that compares the client or prospective client’s current portfolio to a portfolio being recommended by the financial professional. It will show a distinct improvement in one or more of the following variables: performance, expenses, or risk metrics. These presentations are not reviewed by compliance (or anyone for that matter) prior to their delivery to the client or prospect. OCIE has continually taken issue that these presentations violate Section 206 of the Investment Advisers Act because they are misleading. They also allege that these presentations are “advertisements” under Rule 206(4)-1 and that they violate the rule. The presentations are not typically labeled as hypothetical back-tested performance presentations. Further, the template or stock disclosures provided by Morningstar do not consistently or automatically comply with the no-action letter guidance issued by the SEC.

In any event, if your firm currently permits its financial professionals to use Morningstar presentations (or any similar product or software, such as HiddenLevers), now is a good time to review your policies and procedures. Some things to focus on:

  1. How does your firm train and supervise your financial professionals on the use of Morningstar (and performance presentations in general)?
  2. Does legal or compliance review each presentation before it is provided to a client? If not, how does it ensure compliance with the SEC’s no-action guidance on backtesting?
  3. Have you reviewed the Morningstar presentations and the disclosure and are you confident that your firm’s use of the presentations meets the SEC no-action guidance relating to backtesting?

I believe that Morningstar should try and make some slight re-designs to the presentation formatting and disclosures to maximize the likelihood of compliance for investment advisers. They may also want to provide their users with some type of whitepaper, education, or training to reduce the examination and enforcement risk for users.

* This post was updated on September 22, 2020 at 9:15am to remove any reference to issues involving LPL Financial.

Expungement of Criminal Disclosure on Forms U4, Form U5, and IAPD/Brokercheck

Form U4 requests information about various criminal, regulatory, financial, and litigation matters. While many of these disclosures are relevant and important to clients and prospective clients, others are less important. For example, I have seen countless college incidents. Some involve taxi rides, fake IDs, alcohol, or marijuana. This article is intended to help those who have suffered one of these events contemplate their options for removing these (or even more serious) criminal transgressions. In addition, this article might be helpful for a firm with an otherwise clean Form CRS wanting to explore cleaning up one of their owner’s or employee’s disclosure reporting pages.

The specific questions that appear on Form U4 (which cause information to flow through to the Investment Adviser Public Disclosure and Brokercheck) appear below:

As you will see, certain criminal charges require disclosure regardless of the outcome. These include felony charges and charges involving crimes that potentially implicate moral character (e.g., fraud, false statements or omissions, wrongful taking of property)

If you have an affirmative response to one of these questions on your record, there are a few options to consider:

  1. Is the current disclosure even supposed to be on your record? Many times, I see overly-conservative compliance departments make disclosures to cover themselves. Not all criminal charges or convictions require disclosure. A lawyer with knowledge of the specific state law charges should help you make the determination. Further, an FAQ to Form U4 states: “If a registered person is arrested but not charged with a crime, is the arrest required to be reported? A: No. An arrest without a charge is not required to be reported. (02/13/98)” It could be possible that you were arrested, but not formally charged with the crime. Again, state-specific law will determine whether you could rely on this FAQ.
  2. Removal of Disclosures.
    • It is also possible that a criminal action can be expunged. Each state’s law is a little different on the impact of expungement. For example, an expungement in certain states will make it so the arrest never occurred. In that case, you would not need to report the charge. There is a growing trend under state law to automatically expunge certain cases through diversion programs for certain offenders. However, the effect of expungement is not the same in all states. You will want to closely review your charges, convictions, and the expungement law in your state to determine whether this is a possible exercise.
    • Once you have received an order of expungement from a state court, there is a process to provide that expungement to FINRA, who will remove the expunged disclosure.

If you have any questions about whether your specific charges should be disclosed or can be expunged, do not hesitate reaching out.