AdvisorCounsel Law Blog

On Wednesday, December 16, 2020 at 10:00 am, it is looking highly like that the U.S. Securities and Exchange Commission will adopt amendments to the advertising rules under the Investment Advisers Act of 1940.

If you are interested, here is a link to the notice announcing the meeting (and the likely vote). The hearing will be available by webcast on the Commission’s website at www.sec.gov. I will be tuning in and live tweeting @advisercounsel.

My predictions:

1. We will see a new principles-based rule governing advertisements.
2. We will see the approval of testimonials and endorsements.
3. All communications, not just written communications, will be treated as advertisements. The rule will apply equally to podcasts, videos, TikTok, and more.

Assuming the rule is approved, I will be blogging about what it means for investment advisers, investment adviser representatives, registered fund managers, marketers, web developers, and public relation firms shortly thereafter. If there are any specific angles you are interested in hearing about, feel free to reach out in the meantime.

On December 1, 2020, New York Attorney General James announced rules that will require the licensing of investment adviser representatives (“IARs”) in New York. IARs will be required to register through the Central Registration Depository/Investment Adviser Registration Depository. If you render investment advice from a place of business in New York, now is the time to begin reviewing the rule and your licensing obligations. This new law applies even if you previously filed a NY-IAQ on behalf of a state-registered investment adviser.

Beginning on February 1, 2021, IARs of both state-registered and federally registered investment advisers will be required to meet examination requirements and register with the state. The licensing fee is $200 and will be the second most expensive in the country behind Georgia.

The rule contains an implementation period, which will allow those currently engaged in business to continue their business without an approved registration until December 2, 2021.

The rule also provides for an examination waiver for people who have been serving as IARs for at least two years prior to February 1, 2021 so long as they are not disqualified. Disqualifying events include being subject to any regulatory or civil action, proceeding or arbitration, either pending or in the preceding ten (10) years from the date of application, that would require disclosure on Form U4, or that person has been notified or has reason to believe that they currently are or remain the subject of a regulatory or law enforcement investigation related to investment-related activities.

The Office of the Attorney General provided helpful information for financial professionals and compliance departments that summarize what should be done to apply and request an examination waiver.

If you need any help (i) in determining whether you qualify for an examination waiver, (ii) how to file a Form U4, (iii) whether you must amend your firm’s notice filings, (iv) when you must file your application, or (v) in preparing and submitting your Form U4, do not hesitate reaching out.

I applaud the North American Securities Administrators Association (“NASAA”) for proposing a model rule to assist state securities regulators in implementing a mandatory continuing education program for investment adviser representatives (“IAR”) in their jurisdiction. These efforts are long overdue to convince the public that the rendering of financial advice is a legitimate profession. A copy of the press release announcing the model rule is available here. A copy of the model rule is available here.

The Shortcomings

There are a few problems with the proposal, but the biggest ones are:

1. The model rule is only a model rule. It doesn’t require any NASAA member to implement the rule. Based on my experience, very few NASAA members adopt non-core model rules, and those that do, usually take quite a bit of time to do so. Some states have extensive rulemaking processes that need to be followed and others are at the discretion of their legislators. Reputable designations like the CFP, the CFA , IMCA, and CPAs have continuing education programs already, but other financial professionals could potentially take advantage of the resulting patchwork framework by moving their places of business to avoid continuing education.
2. The model rule, if implemented by members, wouldn’t and couldn’t require any continuing education for the hundreds if not thousands of financial professionals who do not meet the definition of “investment adviser representative” under Rule 203A-3. These professionals might cater to only a few clients or high net worth clients and thereby avoid meeting the definition of “investment adviser representative”.
3. If the model rule is adopted by a NASAA member, if challenged, it could be deemed unconstitutional as it relates to IARs associated with investment advisers registered with the U.S. Securities and Exchange Commission (“SEC IARs”).

The Constitutionality of the Proposal

The remainder of this post deals with the last issue. By the numbers, there are almost 4 times more SEC IARs than their state counterparts (roughly 97,000 to 27,000). So any policy change or rule seeking to further legitimize the profession and improve education must guarantee that it reaches the entire universe of SEC IARs.

Why is the model rule potentially unconstitutional? Section 203A(b) of the Investment Advisers Act of 1940 (the “Advisers Act”) states:

Federal law preempts states from registering, licensing, or qualifying a “supervised person” of an investment adviser, except that it may license, register, or qualify an “investment adviser representative” who has a place of business within that state. This begs the question whether a continuing education program with ongoing requirements is a form of qualification or goes beyond the statute’s authority.

Legislative Intent

One of the principle canons of statutory constructions states: “Where the language is unambiguous, there is no occasion for the application of rules of construction.” By that, lawyers mean that where a law is clear on its face, we need not look any further. Reasonable minds might disagree on whether continuing education is a form of qualification. Merriam Webster defines “qualification” as “a condition or standard that must be complied with (as for the attainment of a privilege).” I leave it to readers to form their own opinions.

Another canon of statutory construction states that courts, “determine legislative intent by examining not only the literal words of the statute, also the reasonableness of proposed constructions, the public policy behind the statute, and its legislative history.”

Assuming that the statute is ambiguous, where would courts look for legislative intent? The National Securities Markets Improvement Act of 1996 (“NSMIA”) amended Section 203A of the Advisers Act by creating the current federal-state licensing dynamic and the qualification issue. The intent of Congress, in the words of Senator Paul Sarbanes is a bit murky:

Senator Sarbanes’ remarks can be interpreted in a few ways. First, they suggest that the Senate is content with the status quo and there aren’t need for wholesale changes–in terms of the regulation of investment professionals. His statement makes clear that state regulators are being limited–albeit not in an unduly manner. On the other hand, his statement seems to suggest that the law grants states with continued authority to prevent investors from facing “sharp practices.”

At the time of the passage of NSMIA, the only requirement for an “investment adviser representative” to become licensed to render advice in most states was to take and pass the Series 65 examination or the Series 7 and the Series 66 examinations. The new continuing education requirement could be viewed as a substantial change of the status quo.

If the model rule is to be accepted as constitutional, judges would be wise to examine the public policy implications. Assuming education accomplishes its goal, states that adopt the model rule will likely have a more educated and ethical body of licensed financial professionals. As a practicing lawyer, I have substantial doubts about the efficacy of continuing education. I attend courses regularly where every attorney is doing other work or playing on their phones.

Putting aside the efficacy of continuing education, not all states will adopt the model rule and the timing of adoption can vary greatly. Each state can also tweak the requirements of the educational requirement (e.g, 6 ethical credits and 6 product/practice credits vs. 2 ethical credits and 10 product/practice credits). It will likely result in a patchwork of different requirements for continuing education depending on where the financial professional resides and could be susceptible to evasion or identifying the least burdensome jurisdiction.

Conclusion

I think NASAA’s heart and head were in the right place. However, I think there are a number of issues with the proposal, and I look forward to continue tracking the legislation as it is proposed throughout the country.

[1] NSMIA; Conference Report; Congressional Record Vol. 142, No. 139 (Senate – October 01, 1996).

On Monday, OCIE released a Risk Alert focused on their recent observations from focused examinations of investment advisers that operate out of multiple locations or branch offices. I provided a summary of that guidance here.

So what does this mean for investment advisers who operate multiple offices or branch offices? Advisers should review their policies and procedures and determine whether they sufficiently address business being conducted at these offices. Firms should consider the following:

Code of Ethics

• Are “access persons” at these offices subject to the firm’s Code of Ethics?
• Do employees prepare and submit initial holdings reports, quarterly transaction reports, and annual holdings reports?
• Do employees at these offices report their gifts and entertainment appropriately?
• Does the office have sufficient policies and procedures to prevent insider trading?
• Is the business aware of and does it understand all outside business activities engaged in by employees?
• Is the business tracking political contributions of branch office employees?

Advertising and Communications with the Public

• Does the business treat advertisements and marketing activity consistently across branch offices?
• Is social media use and review comparable across branch offices?
• Are advertisements reviewed and approved in a similar manner?
• Are performance presentations reviewed by the headquarters? Are backtested performance presentations being used without knowledge?
• Are third-party rankings or awards being used in advertisements without approval?
• How are client complaints handled at branch offices?
• Are electronic communications (both internal and external) handled similarly?

Custody Related Issues

• Does the business have policies and procedures to identify instances where a branch office activity could deem the business to have custody under Rule 206(4)-2?
  • Most commonly, I see issues in:
    • identifying “related persons” that may be deemed to have custody under the rule;
    • not identifying employees that have agreed to serve as trustee or executor for non-familial clients;
    • serving as a general partner or manager of a private investment vehicle;
    • receiving checks that are inadvertently made payable to the business or receiving stock certificates from clients;
    • obtaining check writing authority from clients;
    • obtaining login credentials to a client’s bank or brokerage account that provides the employee with ability to transfer assets; and
    • maintaining authority over a client’s managed account that provides broad disbursement authority without compliance with no-action guidance issued by the Staff.
• If the branch office is deemed to have custody, does the business have policies and procedures to comply with Rule 206(4)-2?
  • Are client funds or securities maintained with a qualified custodian?
  • If you open an account with a qualified custodian on your client’s behalf, either under the client’s name or under your name as agent, do you notify the client in writing of the qualified custodian’s name, address, and the manner in which the funds or securities are maintained, promptly when the account is opened and following any changes to this information?
  • Do you have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each of your clients for which it maintains funds or securities, identifying the amount of funds and of each security in the account at the end of the period and setting forth all transactions in the account during that period?
  • Are the client funds and securities subject to an actual examination annually by an independent public accountant (or do you rely on the limited partnership audit exception)?

Investment Advice, Disciplinary Histories, and Litigation Risks

• Do you have policies to identify and document instances of disciplinary or litigation events?
• Do you have procedures to closely monitor individuals with disciplinary or litigation histories with a view towards how they render advice?
• Have clients been notified of employee disciplinary events requiring disclosure under Form ADV Part 2B?
• Especially when representatives serve as portfolio manager, but in all instances, have clients received appropriate disclosure of the strategy being managed by their portfolio manager?
• Does the firm disclose all material conflicts of interest associated with rendering of investment advice at branch offices?
  • Are representatives at branch offices recommending investments where they have a material ownership interest or business relationship?
  • Are representatives receiving any type of kick-back or revenue sharing for recommending an investment?
  • Are representatives selecting or recommending non-optimal securities for a client (such as more expensive share classes)?
  • Are disclosures regarding wrap fee programs accurate? Has the business disclosed additional fees and expenses, including potential trade away fees?
• Does the business automatically rebalance client accounts, and if so, does the business take steps to avoid paying short-term redemption fees?

Administrative and Billing Issues

• Does the business supervise billing performed by branch offices?
• Does the business review advisory agreements entered into by branch offices to ensure that clients are being charged the appropriate fee?
• Are credits and reimbursements being applied consistently?

Recommendations from the Staff

• The Staff suggested that businesses with “centralized processes mitigated instances in which supervised persons or branch offices had independent billing options or fee arrangements that deviated from client agreements or disclosures.”
• The Staff hinted that advisers that automate and/or centralize their review and approval of personal transaction activity and educate employees on their code of ethics and personal trading policies were better positioned for compliance.
• The Staff intimated that uniform portfolio management and centralized trading was favorable.
• The Staff favorably highlighted compliance testing and periodic reviews of essential activities at branch offices and focused on portfolio management, monitoring trading and management activities, and supervision that did not focus exclusively on self-reporting.

This is not intended to be a verbatim recitation of the Staff’s guidance and serves to highlight some of the key points raised by the Staff. Compliance officers and legal counsel should review the Staff’s guidance and review their policies and procedures in light of this guidance.

Today, OCIE released a Risk Alert focused on their recent observations from focused examinations of investment advisers that operate out of multiple locations or branch offices.

These examinations focused on whether the examined investment advisers had adopted and implemented reasonably designed written policies and procedures and implemented investment advice in an appropriate manner. As a summary, the staff reviewed firms’ main and branch office practices for:

(1) compliance with various rules under the Investment Advisers Act of 1940, including Rule 204A-1 and Rule 206(4)-2;

(2) the adherence by branch offices to comply with disclosures and agreements with clients relating to fees and expenses;

(3) the oversight of investment recommendations, and ensuring that those recommendations are suitable and consistent with disclosures to clients;

(4) management and disclosure of conflicts of interest; and

(5) allocation of investment opportunities.

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:

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.