The Disclosure Obligation under Regulation Best Interest

While this blog is typically focused on issues pertinent to investment advisers and their associated persons, Regulation Best Interest also extends to “associated persons of a broker dealer”. Many clients that I represent have relationships with broker-dealers and are responsible for supervising persons who are “associated persons of a broker dealer”. I often refer to these investment advisers as “hybrid advisers”.

One aspect that broker-dealers and their associated persons must adhere to in order to comply with Regulation Best Interest is the Disclosure Obligation. This post begins by providing the exact language of the Disclosure Obligation, provides broker-dealers with a high level checklist to comply with the Disclosure Obligation, and then provides more detailed tips for broker-dealers and associated persons in order to meet the requirements under the Disclosure Obligation.

Below is the precise language of the Disclosure Obligation under Regulation Best Interest:

(i) Disclosure obligation. The broker, dealer, or natural person who is an associated person of a broker or dealer, prior to or at the time of the recommendation, provides the retail customer, in writing, full and fair disclosure of:

(A) All material facts relating to the scope and terms of the relationship with the retail customer, including:

(1) That the broker, dealer, or such natural person is acting as a broker, dealer, or an associated person of a broker or dealer with respect to the recommendation;

(2) The material fees and costs that apply to the retail customer’s transactions, holdings, and accounts; and

(3) The type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer; and

(B) All material facts relating to conflicts of interest that are associated with the recommendation.

Initial Steps to Comply with the Disclosure Obligation under Regulation Best Interest

  1. Understand the specific requirements imposed by Regulation Best Interest.
  2. Identify existing disclosures already made to retail customers, when they are made during the customer relationship, and where they are made.
    • Consider brokerage agreements
    • Confirmation enclosures with account statements and other regular communications
    • Prospectuses
    • Pending Form CRS Draft
  3. Identify gaps between existing disclosures and disclosures required under Regulation Best Interest, which are stated above in the section (i)(A)-(B). There is also added commentary on these requirements following this checklist.
  4. Identify how these gaps will be cured prior to the effective date of Regulation Best Interest.  Consider:
    • Whether new disclosure will be generic or customized for the specific customer or transaction.
    • The timing of these new disclosures.
    • Whether the disclosure will be made initially (or upon the effective date of Regulation Best Interest), or must be made at the time of recommendation, or orally.
      • Oral disclosure may be made when facts not reasonably known at the time the written disclosure is provided are being supplemented. Personally, I would avoid relying on oral disclosures where possible.
      • Trade confirmation and prospectus delivery can continue to be used following recommendations to layer disclosure. Generic disclosure can be provided in a disclosure document and the confirmation or prospectus can be relied on to solidify those disclosures. For example, an disclosure might inform the customer that mutual funds typically have internal expenses between x-y%, of which the broker-dealer typically retains between 0-0.25% in rule 12b-1 fees. Customers should refer to the prospectus and their confirmation they receive to see the specific expense ratio and rule 12b-1 fees the broker-dealer receives.
      • When relying on oral or post-recommendation supplemental disclosure, firms should describe in writing how these supplements will be made[1]
    • How will the firm document oral disclosures?
  5. Consider the delivery of Form CRS and documenting its delivery
    • Initial Delivery – Before or at the earliest of:
      • a recommendation of an account type, a securities transaction, or an investment strategy involving securities;
      • placing an order for the retail investor; or
      • the opening of a brokerage account for the retail investor.
    • Continued Delivery Obligations – A firm must deliver the most recent Form CRS to a retail investor who is an existing client or customer before or at the time it:
      • opens a new account that is different from the retail investor’s existing account(s);
      • recommend that the retail investor roll over assets from a retirement account into a new or existing account or investment; or
      • recommend or provide a new brokerage or investment advisory service or investment that does not necessarily involve the opening of a new account and would not be held in an existing account, for example, the first-time purchase of a direct-sold mutual fund or insurance product that is a security through a “check and application” process, i.e., not held directly within an account.
    • CLIENT NOTE: Ensure that electronic delivery is able to be relied upon, if that is the intended delivery method.
  6. Ensure that the firm has procedures to continue its review of disclosures and insure that it continues to comply with the Disclosure Obligation.

Tips for Identifying Disclosure Obligations under Regulation Best Interest

  • (1) Capacity in which the broker, dealer, or such natural person is acting as a broker, dealer, or an associated person of a broker or dealer
  • Dually registered associated persons and associated persons who are not dually registered but only offer broker-dealer services through a firm that is dually registered as an investment adviser with the Commission or with a state, must disclose whether they are acting (or, in the case of the latter, that they are only acting) as an associated person of a broker-dealer in order to satisfy the Disclosure Obligation.
  • An associated person of a dual-registrant who does not offer investment advisory services must disclose that fact as a material limitation in order to satisfy the Disclosure Obligation.
  • Use of term “adviser” and “advisor” by (1) a broker-dealer that is not also registered as an investment adviser or (2) a financial professional that is not also a supervised person of an investment adviser would be a violation of the Disclosure Obligation under Regulation Best Interest.
  • A broker-dealer may disclose that: “All recommendations will be made in a broker-dealer capacity unless otherwise expressly stated at the time of the recommendation; any such statement will be made orally.” In this case, no further oral or written disclosure would be required until a recommendation is made in a capacity other than as a broker-dealer.
  • Note – The adopting rule release does not state that an associated person who renders services through a hybrid investment adviser could disclose that all recommendations will be made in an investment advisory capacity unless otherwise expressly stated at the time of the recommendation, and that any such statement will be made orally. I believe that this is a reasonable approach and consistent with the regulatory framework, but I am seeking further assurances from the staff of the SEC.
  • Similarly, a broker-dealer may disclose that: “All recommendations regarding your brokerage account will be made in a broker-dealer capacity, and all recommendations regarding your advisory account will be in an advisory capacity. When we make a recommendation to you, we will expressly tell you orally which account we are discussing”). In this instance, no further disclosure of capacity is necessary.

(A)(2) The material fees and costs that apply to the retail customer’s transactions, holdings, and accounts

  • Should generally build upon disclosure in the Form CRS.
  • Does not mandate individualized fee disclosure particular to each retail customer
  • Broker-dealers may disclose “material facts” about material fees and costs in terms of more standardized numerical and narrative disclosures, such as standardized or hypothetical amounts, dollar or percentage ranges, and explanatory text where appropriate. The disclosure should accurately convey why a fee is being imposed and when the fee is to be charged.
  • A broker-dealer might initially disclose a range of product fees, and later supplement that information with more particularized information by delivering the product prospectus.
  • Broker-dealers may refer the customer to any issuer disclosure of the security being recommended, such as a prospectus, private placement memorandum, or offering circular, where more particular information may be found.
  • Ranges may be used and designed to reasonably reflect the actual fee to be charged. For example, a statement that a charge may be “between 5 and 100 basis points” would not be accurate if the fee is in almost all instances between 85 and 100 basis points.

(A)(3) The type and scope of services provided to the retail customer, including any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer

  • Only requires disclosure of material facts relating to the type of services provided (e.g., the fact that the broker-dealer monitors securities transactions and investment strategies) and the scope of services (e.g., information about the frequency and duration of the services).
  • Should disclose whether the broker-dealer has account minimums or similar requirements.
  • May be able to rely on existing disclosures in account opening agreement or other account opening related documentation.
  • If the firm places material limitations on securities or investment strategies, the firm would need to describe the material facts relating to those limitations. Examples of these material limitation include, but are not limited to:
    • Recommending only proprietary products (e.g., any product that is managed, issued, or sponsored by the broker-dealer or any of its affiliates), a specific asset class, or products with third-party arrangements (e.g., revenue sharing, mutual fund service fees).
    • Recommending only products from a select group of issuers, or making IPOs available only to certain clients, could also be considered a material limitation.
    • If an associated person of a dually registered broker-dealer only offers brokerage services, and is not able to offer advisory services, the fact that the associated person’s services are materially narrower than those offered by the broker-dealer would constitute a material limitation.
  • Disclosing that the firm uses the entire universe of securities is not acceptable. Firms may want to disclose the processes for the selection of a “menu” of products that are available for recommendations to retail customers.
  • If an associated person has a distinct investment approach, as may be the case with persons associated with an independent contractor broker dealer, the broker-dealer’s standardized disclosure should indicate how its associated persons will notify retail customers of their own investment approach. While oral disclosure could be relied upon, I would personally recommend a much more formal approach.

(B) All material facts relating to conflicts of interest that are associated with the recommendation.

  • Start with conflicts referenced in Form CRS.
  • Build upon those disclosures.
    • Would include material conflicts associated with recommending: proprietary products, products of affiliates, or a limited range of products, or one share class versus another share class of a mutual fund; securities underwritten by the broker-dealer or an affiliate; the rollover or transfer of assets from one type of account to another (such as a recommendation to roll over or transfer assets in an ERISA account to an IRA); and allocation of investment opportunities among retail customers (e.g., IPO allocation).
    • Also includes how a broker-dealer’s investment professionals are compensated, and the conflicts associated with those arrangements.
    • Where fees and compensation vary depending on what securities transaction or investment strategy involving securities is being recommended.
    • Disclose how sources of compensation may vary, for example being paid directly by the investor, or by a product sponsor, or a combination of both.
    • Discuss how the firm pays its associated persons different rates of compensation depending on the type of security they sell.
    •  Describe if the firm receives different payments from different product providers (e.g., mutual funds) for a variety of reasons, such as payments for inclusion on a broker-dealer’s menu of products offered (sometimes referred to as shelf space).
  • Be certain to discuss the arrangement and the conflict that it presents.
  • Does not require that information regarding conflicts be disclosed on a recommendation-by-recommendation basis. May be initial disclosures.
  • Does not require specific written disclosure of the amounts of compensation received by the broker-dealer or the financial representative.
  • May continue to receive higher compensation for recommending some products rather than others, whether received by the broker-dealer, the associated person, or both, as long as the firm establishes policies and procedures reasonably designed to mitigate the conflicts of interest that create an incentive for financial professionals to place the interest of the professional or broker-dealer ahead of the interest of the retail customer.  In this case, the firm must make full and fair disclosure of the material facts concerning conflicts raised by this practice.

[1] For example, with regard to product-level fees, a broker-dealer could provide an initial standardized disclosure of product-level fees generally (e.g., reasonable dollar or percentage ranges), noting that further specifics for particular products appear in the product prospectus, which will be delivered after a transaction in accordance with the delivery method the retail customer has selected, such as by mail or electronically. Similarly, with regard to the disclosure of a broker-dealer’s capacity, a dual-registrant could disclose that recommendations will be made in a broker-dealer capacity unless otherwise expressly stated at the time of the recommendation, and that any such statement will be made orally. Or, a broker-dealer could disclose that its associated persons may have conflicts of interest beyond than those disclosed by the broker-dealer, and that associated persons will disclose, where appropriate, any additional material conflicts of interest not later than the time of a recommendation, and that any such disclosure will be made orally.

Massachusetts Proposes Fiduciary Conduct Standard for Broker-Dealers, Agents, Investment Advisers, and Investment Adviser Representatives

The Massachusetts Securities Division (the “Division”) of the Office of the Secretary of the Commonwealth filed a notice of a proposed regulation that would subject broker-dealers, agents, investment advisers and their investment adviser representatives (collectively, “Registrants”) to a “fiduciary duty”. This fiduciary duty would include both a duty of care and a duty of loyalty.

The duty of care would require Registrants to use the care, skill, prudence, and diligence that a person acting in a like capacity and familiar with such matters would use, taking into consideration all of the relevant facts and circumstances. It would require Registrants to “make reasonable inquiry” of:

  • The risks, costs, and conflicts of interest related to all recommendations made and investment advice given;
  • The customer’s or client’s investment objectives, risk tolerance, financial situation, and needs; and
  • Other relevant information.

The duty of loyalty would require Registrants to:

  • Disclose all material conflicts of interest;
  • Make all reasonably practicable efforts to avoid conflicts of interest, eliminate conflicts that cannot be avoided, and mitigate conflicts that cannot be avoided or eliminated; and
  • Make recommendations and provide investment advice without regard to the financial or any other interest of any party other than the customer or client.

According to the proposal, “disclosing or mitigating conflicts alone does not meet or demonstrate the duty of loyalty.” This statement is extremely ambiguous and would present difficulties for legal and compliance departments to know whether its disclosures or methods of mitigating conflicts are sufficient under the rule.

According to the Division’s website, dates for a hearing and comment period on the proposed rule will be announced at a later time. We will continue to monitor this proposal and provide updates on how it will impact our clients.

WEBINAR: Understanding and Leveraging the Proposed Advertising Rules

On Tuesday, November 19, 2019, my colleague and I hosted a webinar entitled “Understanding and Leveraging the Proposed Advertising Rules.” The presentation discussed the U.S. Securities and Exchange Commission’s November 4, 2019, proposed amendments to the advertising rules and the cash solicitation rules under the Investment Advisers Act of 1940. A copy of the webinar is available here.

Webinar: Understanding and Leveraging the Proposed New Advertising Rules


November 19, 2019
12:00pm – 1:00pm EST

On November 4, 2019, the U.S. Securities and Exchange Commission proposed amending rules 206(4)-1 and 206(4)-3 under the Investment Advisers Act of 1940 (the “Advisers Act”). These two rules govern advertisements and cash referrals under the Advisers Act.

Join attorneys from Stark & Stark as they discuss these proposed amendments and how the rules, business development, and advertising will change.

Initial Thoughts on Proposed Amendment to Rules Governing Investment Adviser Advertisements and Solicitation

On November 4, 2019, the U.S. Securities and Exchange Commission proposed amendments in Release Number IA-5407 to amend rule 206(4)-1) and rule 206(4)-3) under the Investment Advisers Act of 1940 (the “Advisers Act”). These two rules govern advertisements and cash referrals under the Advisers Act. The purpose of this post is to provide my initial impressions of the 500+ page rule release. In the near future, I’ll be participating in a webinar discussing the proposed changes in greater depth. In addition, we may be developing more formal guidance on these issues.

  1. New Definition of Advertisement – The proposed rule would define “advertisement” as “any communication, disseminated by any means, by or on behalf of an investment adviser, that offers or promotes the investment adviser’s investment advisory services or that seeks to obtain or retain one or more investment advisory clients or investors in any pooled investment vehicle advised by the investment adviser.” There are 4 specific carve-outs from the definition:
    • Certain live, spoken communications that are not broadcast on any medium,
    • Responses to unsolicited requests for information (but does not include performance results provided to Retail Investors or communications that include hypothetical performance)
    • Investment Company and Business Development Company advertisements, and
    • Regulatory notices and filings.
  2. General Catchall – The proposed rule will continue to have a general catchall against advertising practices that are fraudulent, deceptive, or manipulative. The legal standard will remain a negligence standard, and scienter will not be required to prove violations.
  3. Prohibition Against Untrue Statements or Omissions – The proposed rule would prohibit advertisements that include any untrue statements of a material fact, or that omit a material fact necessary in order to make the statement made, in the light of the circumstances under which it was made, not misleading.
  4. Prohibition Against Unsubstantiated Material Claims – The proposed rule would prohibit advertisements that include material claims that are unsubstantiated. Think guarantees and claims about an adviser’s skill that can’t be substantiated (e.g., we are the best in the business at options.).
  5. Prohibition Against Untrue or Misleading Implications or Inferences – As proposed, the rule would prohibit any advertisement that includes an untrue or misleading implication about, or is reasonably likely to cause an untrue or misleading inference to be drawn concerning, a material fact relating to an investment adviser. This means advisers wouldn’t be able to cherry-pick favorable testimonials or account performance. Account performance and strategy performance selection must be presented “fair and balanced”.
  6. Failure to Disclose Material Risks or Other Limitations – The proposed rule would prohibit advertisements that discuss or imply any potential benefits without clearly and prominently discussing material risks or other limitations associated with the potential benefits. Hyperlinking to disclosure as proposed would not meet the clear and prominent test as proposed.
  7. Limits on References to Specific Investment Advice – The proposed rule would prohibit a reference to specific investment advice where such investment advice is not presented in a manner that is fair and balanced. This proposed amendment would open up the door to advisers showing past specific investments that performed favorably if the intent is to show the adviser’s “philosophy and process”. This opens up the door to showing best and worst performers or discussing certain market timing practices. For example, an adviser can specifically discuss pre-2008 investment decisions to exit specific securities and purchase different securities as long as that discussion is fair and balanced. One point to consider is that the proposed rule would extend to past specific investment advice, which is considerably broader than the current prohibition. It would apply regardless of whether the advice was acted upon, or reflected actual portfolio holdings, or was profitable.
  8. Performance Presentations
    • General Standard -The proposed rule would prohibit any advisers from including or excluding performance results, or presenting time periods for performance, in a manner that is not fair and balanced. The proposing release favorably cites to Clover Capital as a good example of disclosures that should be considered in a performance presentation, but does not mandate strict adherence to those requirements.
    • Net-of-fee performance presentations would still be required for “Retail Persons” and net performance result would be required in any Retail Advertisement that includes gross performance results. Notably, the threshold for non-Retail Advertisement would be quite high–qualified purchasers and knowledgeable employees. The proposal also would extend to private fund investors and could create some unintended side effects for current fund marketing practices.
    • Retail Advertisements would have to be presented net-of-fees and use certain standard performance measures (i.e., 1-5, and 10-year presentations). If showing gross performance, a presentation would also need to present net performance with at least equal prominence and in a format designed to facilitate comparison with gross performance.
    • The proposed rule contemplates showing performance net of the deduction of a model fee that is equal to the highest fee charged to the relevant audience of the advertisement.
    • The proposed rule introduces a new concept and definition called “extracted performance”. “Extracted performance” would be defined as “the performance results of a subset of investments extracted from a portfolio.” Advisers would be required in the advertisement to provide (or offer to provide promptly) the performance results of the entire portfolio in these circumstances to prevent investment advisers from cherry-picking certain performance results. It remains to be seen whether the Staff would actually be accepting of “offers to provide” the other data.
    • The proposed rule would condition the presentation of hypothetical performance on (i) an adviser adopting policies and procedures reasonably designed to ensure that a hypothetical presentation is disseminated only to persons for which it is relevant to their financial situation and investment objectives, and would further require the adviser to provide additional information about the hypothetical performance that is tailored to the audience receiving it, such that the recipient has sufficient information to understand the criteria, assumptions, risks, and limitations, (ii) providing sufficient information to enable the recipient to understand the criteria used and assumptions made in calculating such hypothetical performance, and (iii) the adviser providing (or, when the recipient is a Non-Retail Person, offering) sufficient information to enable the recipient to understand the risks and limitations of using hypothetical performance in making investment decisions.
    • The proposed rule with respect to testimonials would apply to targeted or projected performance returns regarding any portfolio or to the investment services offered or promoted in an advertisement. It wouldn’t apply to more general discussions of markets.
  9. Green-lighting Use of Testimonials – Unlike the current rule, the proposed rule would permit the use of testimonials and endorsements.
    • Definitions – The proposed rule would defines “testimonial” as “any statement of a client’s or investor’s experience with the investment adviser or its advisory affiliates, as defined in the Form ADV Glossary of Terms. It would define an “endorsement” as “any statement by a person other than a client or investor indicating approval, support, or recommendation of the investment adviser or its advisory affiliates, as defined in the Form ADV Glossary of Terms.” Client lists and partial client lists would fall outside the bounds of the rule.
    • To use a testimonial or endorsement, the proposed rule would require that an adviser clearly and prominently disclose, or the investment adviser reasonably believe that the testimonial or endorsement clearly and prominently discloses, that the testimonial was given by a client or investor, and the endorsement was given by a non-client or non-investor, as applicable.
    • Also, the testimonial or endorsement would need to clearly and prominently disclose cash or non-cash compensation being provided. Examples of non-cash compensation in the proposed release include a reduction or waiver of advisory fees or cross-referral relationships.
    • Query who the first big name testimonial or endorsement will be?
  10. Sensible Approach to Social Media – As proposed, the Staff is providing some flexibility for favorable ratings on LinkedIn and other social media review sites. The release states, “[c]ontent regarding the investment adviser on third-party hosted platforms that solicit users to post information, including positive and negative reviews of the adviser, generally would not be ‘by or on behalf of’ the investment adviser unless the adviser took affirmative steps to influence the content of those reviews or posts, such as providing a user with wording to submit as a review or editing the content of a post.” Some other great guidance in the proposed rule: “[S]o long as the adviser does not selectively delete or alter the comments or their presentation. We believe such treatment for third-party content on the adviser’s own website or social media page is appropriate even if the adviser has the ability to influence control over the commentary but does not exercise it. Likewise, we would not consider an adviser that merely permits the use of “like,” “share,” or “endorse” features on a third-party website or social media platform to implicate the proposed rule.” This type of guidance is practical and long overdue.
  11. Blessings of Yelp and Angie’s List – The proposed rule would permit an adviser to notify clients about the existence of a third party review site without suggesting that the investor leave a positive review or not leave a negative review.
  12. Approval Process – Similar to FINRA rules, the proposed rule would require there to be a formal review and approval process within an investment adviser for most advertisements (excluding certain one-on-one presentations and oral communications that are broadcast (but not scripts, storyboards or other written preparations)).
  13. Referrals for Private Funds – The rule release contemplates extending the requirements of the cash solicitation rule to the referrals of investors to private funds. It is silent on whether that practice triggers registration as a broker-dealer under the Securities Exchange Act. However, this is an important issue for “finders” and other distribution channels.
  14. Changes to Solicitation Rule
    • The proposed rule would abandon the requirement for the solicitor to deliver a copy of the adviser’s brochure.
    • It would be expanded to cover all cash and non-cash compensation arrangements. It remains to be seen how informal referral relationships with other professionals would work (for example, accountants and lawyers).
    • It also would also eliminate the requirement that an adviser obtain a signed and dated acknowledgment from the client. Advisers would be free to create their own policies and procedures to determine whether the solicitor has complied with the rule.
    • As proposed, the rule would exempt certain de minimis payments (less than $100 in any 12 month period). It would also permit nonprofit programs the ability to provide a list of advisers to interested parties (Think NFL Players Association or CFP Board referral programs).
  15. Amendments to Form ADV – As proposed, advisers would be required to report in their Form ADV whether they engage in performance advertising, use testimonials or use what are commonly referred to now as “past specific recommendations”. Presumably this would raise a firm’s risk profile and increase the likelihood of examination.
  16. New Input Process for Smaller RIAs – In the first of its kind, this rule release has an appendix dedicated to seeking the input of smaller investment advisers. I applaud Chairman Clayton and Director Blass for focusing on smaller advisers.

SEC Considering Proposal to Amend the Advertising Rules

My thoughts on the new Advertising Rule

Back in March 2019, Mark Schoeff from InvestmentNews reported that the U.S. Securities and Exchange Commission (“SEC”) was contemplating amending Rule 206(4)-1 under the Investment Advisers Act of 1940 (the “Advertising Rule”) . Before that, Reuters made a similar report in March. Before that, the Investment Adviser Association reported in January of 2018 that the SEC was moving forward. In fact, the SEC included these on their regulatory agenda as early as Fall 2018 with a notice of proposed rule making expected in April 2019. It looks like things are moving forward, because the Commission included this on their regulatory agenda for Spring 2019 again.

As of today, November 11, 2019, ThinkAdvisor and Financial Advisor IQ/Ignites are reporting that the SEC is announce proposed amendments to the Advertising Rule tomorrow.

It will be interesting to see what the rule proposal entails, but I am hopeful that the new rules help modernize the Advertising Rule. If I were drafting the rule release (and I am clearly not), I would make sure that it addresses these points:

  1. More Flexible Framework – Section 206 of the Investment Advisers Act generally makes it unlawful to engage in fraud or deceit. Over the last 80 years, the SEC has written no-action letters, drafted written guidance, and brought enforcement actions against investment advisers, which has shaped what fraud and deceit mean for investment advisers. I think it is time that the vast majority of the enlightened wisdom from those letters, guidance, and orders be wiped clean. It is time to start with a fresh deck and determine what is fraudulent and deceitful in this new world we live in. Let the words “fraud” and “deceit” stand for themselves and let us as an industry re-examine what practices we are comfortable with accepting.
  2. Hypothetical Back-tested Performance – I would permit the use of hypothetical back-tested performance for use in any format (electronic, retail or one-on-one presentations). However, the focus should be on (i) whether the context of the performance presentation is false and misleading, and (ii) whether the underlying data is accurate. Disclosure that accompanies a back-tested presentation should clearly be labeled: “This performance is not real. It was created using mathematical assumptions or algorithms and should not be relied upon in making your investment decision.” The SEC could also create a template disclosure document that must accompany presentations that contain back-tested materials. Instead of putting the burden on managers to use 8 point font at the back of a presentation, the SEC could product a half-page document explaining the benefits and detriments of back-testing. I think this is important because startup managers need to be able to compete with established managers. I think it is still important that performance presentations should generally be shown “net of fees”.
  3. Death to Anti-Testimonial Rule – Yes, testimonials run the risk of confusing investors. Yes, people are easily swayed by what their friends or paid spokespersons might tell them. However, the current framework is absolutely insane and farcical. It is time to entirely eliminate the testimonial rule. Instead, the rule should require disclosure of paid spokespersons. See FTC advertising rules already in existence. Also, any person who receives a benefit (either monetary or non-monetary) for making testimonials should have to make similar disclosures.
  4. Loosen Up Restrictions on Past Specific Recommendations – I believe the new proposed rules should allow investment advisers to discuss past specific recommendations in an electronic format, so long as that presentation hyperlinks to a website dedicated to all of their current recommendations and the recommendations that they have made in the past year. I am open to extending this period beyond a year. I am also open to seeing this opened up to non-electronic mediums too. If an investment adviser wants to tout performance in a Facebook ad, tweet or other electronic distribution, then they should simply show what is behind the curtains. The current rule and the relief provided by the Staff is inoperable.

Again, these views are mine alone. They don’t reflect the view of Stark & Stark, any client of Stark & Stark, or any of my colleagues. However, hopefully they become the view of the SEC soon.

NASAA Adopted Model Cybersecurity Rule

Back in May 2019, NASAA adopted the Investment Adviser Information Security and Privacy Model Rule, which is supposed to serve as a guide or template for state securities regulators to implement their own rules governing cybersecurity. A copy of the adopted rule is available here.

As part of the rule-making process, I submitted a comment letter to NASAA with a couple of thoughtful suggestions.

  1. I proposed that the NIST framework be optional. I don’t believe there is a one-size-fits-all approach for investment advisers and selecting a specific framework might not be in the best interest of the investing public, the industry or state regulators. Cybersecurity is a nascent and constantly evolving field and selecting a single framework for a model rule and future state laws could present unique challenges at a later date. Also, requiring investment advisers to follow a specific framework does not harmonize with the first aspect of the proposed rule that requires investment advisers to adopt policies and procedures that are “reasonably designed”. Needless to say, NASAA disagreed with me.
  2. I also proposed that NASAA reconsider its application of the rule to only state-registered investment advisers. In the proposed rule, NASAA deemed it “fraudulent or unethical behavior” to not maintain a cybersecurity program in accordance with its rule. However, that would be a legal fiction, because there isn’t anything unethical about the rule. They probably realized that this wouldn’t pass legal scrutiny and now the proposed rule, if adopted by a state, should only be applicable to state-registered advisers.
  3. I also proposed that annual deliver of a privacy policy is unnecessary, and that delivery should only be required initially, and when there are changes to an investment adviser’s privacy policy. This is how the amended Gramm-BLeach-Bliley Act treats investment advisers registered with the U.S. Securities and Exchange Commission. NASAA disagreed.

If you are associated with a state-registered investment adviser, you will want to keep a close eye on your state’s securities regulator and track whether they propose or adopt any rules governing information security.

State Licensing Requirements for Employees Engaged in Business Development

Section 203A(b) of the Investment Advisers Act of 1940 (the “Advisers Act”) states:

(1) No law of any State or political subdivision thereof requiring the registration, licensing, or qualification as an investment adviser or supervised person of an investment adviser shall apply to any person—(A) that is registered under section 80b–3 of this title as an investment adviser, or that is a supervised person of such person, except that a State may license, register, or otherwise qualify any investment adviser representative who has a place of business located within that State; (emphasis added).

As such, the federal law preempts state regulation of “supervised persons” of investment advisers registered with the U.S. Securities and Exchange Commission (SEC), unless those supervised persons are also “investment adviser representatives”.

Whether a person who is responsible for business development and client introductions (i.e., a solicitor) on behalf of an investment adviser registered with the SEC is subject to state licensing turns on two issues:

  1. Whether the solicitor is a supervised person, and
  2. Whether he or she is an investment adviser representative. 

A supervised person is defined in section 202(a)(25) of the Advisers Act as:

(i) any partner, officer, director (or other person occupying a similar status or performing similar functions), or employee of an investment adviser, or (ii) any other person who provides investment advice on behalf of the investment adviser and is subject to the supervision and control of the investment adviser. (emphasis added).

If an investment adviser registered with the SEC structures a relationship with a person responsible for business development and client introductions as an employee-employer relationship, then that person should be viewed as a supervised person.  In this case, this employee would only be subject to state licensing if they meet the definition of investment adviser representative under rule 203A-3(a) under the Advisers Act.  The term investment adviser representative generally means a supervised person of the investment adviser:

(i) who has more than five clients who are natural persons (other than excepted persons []); and

(ii) more than ten percent of whose clients are natural persons (other than excepted persons []).

For purposes of this definition, an “excepted person” is a natural person who is a “qualified client” under the Advisers Act.  This definition includes (i) natural persons who have a net worth of more than $2,100,000 (excluding their primary residence), and (ii) natural persons who have $1,000,000 under the management of the investment adviser immediately after entering into their contract. 

The SEC created this system in an effort to ensure that those providing investment advice primarily to retail investors as opposed to businesses, their retirement plans, educational institutions, charitable institutions and other type of sophisticated investors would remain subject to state licensing.  In the adopting rule release accompanying rule 203A-3, the SEC staff made it clear that it drafted the definition to omit “high net worth individuals from treatment as natural persons…because of their wealth, financial knowledge, and experience…” and that these people “do not need the protections of state qualification requirements.”  Therefore, by definition, a supervised person could have an infinite number of clients that are non-natural persons or that are high net worth individuals without becoming subject to state licensing (assuming that they do not have more than five natural person clients who are not excepted persons).

An issue that was also addressed in the adopting release for rule 203A-3 was whether a client of the investment adviser is a client of the supervised person for purposes of counting the five client limitation imposed by the definition of investment adviser representative. In the adopting release, the SEC staff noted that “some advisory firms consider each person to whom the firm provides advisory services to be a client only of the firm and not of any individual supervised person.”  In response, the SEC staff noted that whether clients of an investment adviser will be considered those of a supervised person depends on whether the person “has substantial responsibilities with respect to the client’s account or communicated advice to the client.  If more than one supervised person provides advice to a client, the client should be attributed to each supervised person.” 

Therefore, if a supervised person of an investment adviser registered with the SEC is solely responsible for introducing clients to the firm, does not have substantial responsibilities for a client’s account, and does not communicate investment advice to the client, then they should not be subject to state licensing as “investment adviser representatives”.

This analysis does not turn on (i) where the employee is located, (ii) where the employee locates his or her clients, (iii) whether the employee receives incentive-based compensation[1], and (iv) whether the employee has other employers.

If a person involved in business development or client introductions does not meet the definition of “supervised person” or meets the definition of “investment adviser representative”, an investment adviser would be required to analyze state law to see whether that person is subject to licensing or qualification as an “investment adviser” or “investment adviser representative”.


[1] However, the Employee Retirement Income Security Act of 1974 may impose limitations on the receipt of incentive-based compensation relating to employee benefit plans, which is outside the scope of this guidance.

New CFP Board Code and Standards

On October 1, 2019, the CFP Board’s new Code and Standards became effective. For those who haven’t received or read them yet, they are available here. The CFP Board will begin enforcing the new Code and Standards on June 30, 2020.

Although there are certainly other changes, the two biggest changes from the prior Code and Standards for investment advisers are:

  • Fiduciary Duty. The current Standards impose a fiduciary duty on a CFP® professional when providing Financial Planning. The new Standards extends the application of the fiduciary duty to all Financial Advice. “Financial Advice” is defined by the CFP Board as communication between the CFP® professional and the client which, based on its content, context, and presentation, may be reasonably viewed as a recommendation that would influence the client to take, or not take, a specific action with respect to the development or implementation of a financial plan, or advising a client with respect to financial assets to invest purchase, hold, gift, or sell those assets. The communication may also include the selection and retention of other persons to provide financial or professional services to the client. Finally, discretionary authority over the financial assets of a client is deemed financial advice. Whether Financial Advice is given is an objective inquiry. “The more individually tailored the communication is to the client, the more likely the communication will be viewed as Financial Advice.” If a CFP ® professional provides or makes available marketing materials, general financial education materials or engages in general financial communications, s/he has not provided Financial Advice as long as a reasonable person would not view the services as Financial Advice.
  • Monitoring Obligations. The new Standards requires a CFP® professional to (a) address monitoring and updating responsibilities (including by communicating very specific information to the Client concerning the scope of the respective responsibilities), (b) monitor the Client’s progress, (c) obtain current qualitative and quantitative information, and (d) update goals, recommendations, or implementation decisions. The standard makes clear that several of the requirements apply only when the CFP® professional has monitoring or updating responsibilities. As a default, a CFP® professional will be responsible for implementing, monitoring, and updating the Financial Planning recommendation(s) unless specifically excluded from the Scope of Engagement.

I am working with numerous clients seeking to ensure compliance with the CFP Board’s new Code and Standards, and am happy to discuss your firm’s situation.

Division of Investment Management Releases FAQs on Financial Conflicts for RIAs

On Friday, October 18, 2019, the U.S. Securities and Exchange Commission’s Division of Investment Management released “Frequently Asked Questions Regarding Disclosure of Certain Financial Conflicts Related to Investment Adviser Compensation.” The FAQs discuss certain compensation arrangements and related disclosure obligations arising from both the investment adviser’s fiduciary duty and Form ADV. Nothing in the FAQs should come as a surprise to investment management attorneys. However, now is a good time for investment advisers to analyze all of their financial incentives and conflicts of interest and ensure that they are appropriated mitigated and disclosed.

https://www.sec.gov/investment/faq-disclosure-conflicts-investment-adviser-compensation