1. Investment Adviser Status Questions
1.2 Definition under the Investment Advisers Act of 1940
1.3 Entities Excluded from the Definition
2. Investment Adviser Registration under Investment Advisers Act of 1940
2.2 Form ADV
2.3 SEC Approval of the Form ADV
2.4 Termination of Registration
2.5 Exemptions from Registration
3. Foreign Investment Adviser Status
4. Mutual Fund Regulation
4.1 Federal and State Regulation
4.2 Portfolios and Disclosure Documents
Investment advisers find themselves in a period of rapid growth and exciting new developments. New types of advisory services, such as wrap fee arrangements and mutual fund asset allocation programs, have exploded onto the scene while new participants, such as banks, insurance companies, broker-dealers, and foreign entities, are becoming increasingly involved in investment advisory activities.
Investment advisers come in many shapes and sizes. On one end of the spectrum, a single person can be an adviser. At the other end of the spectrum, an adviser may be a large corporation that employs thousands of people, including money managers, marketing experts, financial analysts, lawyers, and accountants. The scope of investment adviser activity also varies. Some advisers limit their activity to producing a financial plan while other advisers manage client money (on either a discretionary or non-discretionary basis).
While many advisers are affiliated with brokerage firms, banks, or insurance companies, many others are independent entities. Some advisers serve only individuals, while others serve only institutions, including mutual funds, pension plans, hedge funds, and offshore funds. Of course, many advisers serve both individuals and institutions.
This rapid growth has been accompanied by increases in regulatory scrutiny. Today’s advisers are faced with difficult questions concerning the applications of various statutes, including the Investment Advisers Act, state investment adviser laws and the Investment Company Act. Those responsible for guiding money managers through this maze of regulation are investment management lawyers and compliance personnel.
Prior to 1997, advisers were directly regulated both by the Investment Advisers Act of 1940, a federal statute, as well as by state securities laws. Legislation that became effective on July 8, 1997, reallocated federal and state regulation of advisers. Generally, larger advisers fall under the Investment Advisers Act while smaller advisers are left to the states.
If an adviser manages investment company assets, the Investment Company Act of 1940 will govern important aspects of the adviser’s conduct.
Advisers are not subject to regulation by any self-regulatory body, such as the National Association of Securities Dealers. Although the Securities and Exchange Commission submitted a legislative proposal to Congress in 1989 calling for the self-regulation of investment advisers, it was not enacted.
The SEC’s Division of Investment Management is the operating division primarily responsible for administering the Investment Advisers Act. The Division’s Chief Counsel Office is responsible for interpretations of legal and policy issues arising under the Advisers Act. The Division’s Office of Disclosure and Adviser Regulation is responsible for rulemaking under the Advisers Act. Other offices outside the Division of Investment Management also play a role in administering the Advisers Act. These include the Office of Compliance Inspections and Examinations, which, together with the SEC regional offices, inspects advisers. Also, the Office of Applications Report Services is responsible for processing adviser registration forms.
1. INVESTMENT ADVISER STATUS QUESTIONS
The starting point for regulation under the Investment Advisers Act is Section 202(a)(11), which defines an investment adviser. The definition is quite broad but tempered by a variety of exemptions. Completing the picture are three exemptions from registration provided for by Section 203(b). Entities that are exempted from registration under the Advisers Act remain subject to its antifraud and other substantive provisions, while those excluded from the definition of investment adviser are removed from all of the Act’s requirements. In addition to handling status determinations under the Advisers Act, the investment management lawyer will often be called upon to address adviser status determinations under state law (particularly with respect to state-registered advisers) and the Investment Company Act..
The definition of investment adviser in many state statutes parallels the definition in the Investment Advisers Act. Some variations include states that allow advisers to have a certain number of resident clients before registration is required; states that do not require registration for advisers whose only clients are institutions; states that include in their definition of investment adviser persons who “hold themselves out” as investment advisers; and states that provide that broker-dealers and their agents who hold themselves out as advisers cannot rely on the broker-dealer exclusion.
Some novice investment management lawyers mistakenly believe that the definition of “investment adviser” under the Advisers Act is identical to the definition of investment adviser in the Investment Company Act. In fact, investment adviser is defined in Section 2(a)(20) of the Investment Company Act by reference to advisory services provided to investment companies. Practically speaking, entities that are investment advisers under the Investment Company Act are often investment advisers under the Investment Advisers Act. One notable exception is banks serving as advisers to investment companies. Although the Advisers Act provides an exclusion for banks, no similar exception is provided under the Investment Company Act.
1.2 The Definition under the Advisers Act
“Investment adviser” is defined in Section 202(a)(11) of the Advisers Act as any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.
This definition consists of three elements, each of which must be satisfied for an entity to be covered by the Act. First, the entity must be engaged “in the business” of providing advice or of issuing analyses or reports concerning securities. Second, the advice, analysis, or report must be with respect to “the value of securities” or the “advisability of investing in, purchasing or selling securities.” Third, the advice, analysis, or report must be provided in return for “compensation.” As will be seen, the three elements are interrelated: the principles underlying one element are often relevant to the other elements.
The law in this area is based primarily on an SEC staff interpretative release, Release 1092, which sets forth basic principles to be used in applying the three definitional elements and some of the exclusions. The specific issue addressed by Release 1092 is the applicability of the Advisers Act to financial planners and nontraditional financial service providers. However, the principles underlying the release are generally recognized to have broader application, particularly with respect to the three definitional elements. Numerous no-action letters have clarified the application of many of these principles. Below we examine the three elements.
“Engaging in the Business”
Whether this standard is satisfied depends primarily upon how frequently and regularly the “adviser” provides “advisory services” and whether such services are provided under conditions which suggest that their provision constitutes a business activity. Release 1092 summarizes as follows:
The giving of advice need not constitute the principal business activity or any particular portion of the business activities in order for a person to be an investment adviser under Section 202(a)(11). The giving of advice need only be done on such a basis that it constitutes a business activity occurring with some regularity. The frequency of the activity is a factor, but is not determinative.
The release sets forth three factors that determine whether someone is engaging in the business of providing advice. The staff considers a person to be “in the business” of providing advice if the person: (i) holds himself out as an investment adviser or as one who provides investment advice; (ii) receives any separate or additional compensation that represents a clearly definable charge for providing advice about securities, regardless of whether the compensation is separate from or included within any overall compensation, or receives transaction-based compensation if the client implements the investment advice, or (iii) on anything other than rare, isolated and non-periodic instances, provides specific investment advice. No one factor is wholly determinative, the result reached being dependent upon “all the facts and circumstances.”
The concept of “holding out” is essentially a concept of voluntary action (i.e., a person voluntarily presents himself to the public as providing advisory services). In several no-action letters, the SEC staff has broadly defined when an individual will be considered to have held himself out as an investment adviser. Factors evidencing that an individual has done so include public advertising seeking advisory clients (for example, in the yellow pages, professional listings, newspapers, etc.); designating himself as an investment adviser on business stationery or on a business card; or encouraging word-of-mouth referrals from existing clients.
“Special or additional compensation” is clearly established by a separate fee charged specifically for investment advice. Also, if the facts show that a “clearly definable” element of a single fee is being charged for investment advice, this would satisfy the compensation element.
The concept of special or additional compensation has been addressed at length in SEC staff no-action letters mostly in the context of a broker-dealer’s provision of advisory services, which will be discussed later. In short, the key element is whether the facts show that the fee, though charged for a collection of services for establishing a non-advisory service, varies according to whether investment advice is provided.
As for “specific investment advice,” Release 1092 states that it includes advice respecting specific securities or categories of securities, allocation of capital in specific percentages between various investment media including life insurance, particular types of mutual funds, high yield bonds, etc., but not “advice limited to a general recommendation to allocate assets in securities, life insurance and tangible assets.”
Providing Advisory Services Concerning Securities
Two factors must be considered in determining whether an entity is providing advisory services concerning securities. First, the advice provided must be with respect to an instrument or instruments which satisfy the Act’s definition of a “security.” Therefore, advice limited to whether to invest directly in commodity futures, real estate, art work, a non-security business opportunity, or some other non-security medium does not subject its provider to regulation as an investment adviser.
Second, there must be a “judgmental” element to the advice. In other words, merely providing information or performing recordkeeping or other ministerial duties does not constitute advisory activity. For example, a publication which contains merely a formula for evaluating investment alternatives or data readily available from public sources, with no element of selection, and which does not present the data in a manner which seeks to sell securities, is not subject to regulation under the Act. Similarly, computer software providing a database meeting the criteria stated above which the purchaser can search to answer queries which it develops, or software containing formulae or other calculational methods to which the purchaser must add its own independent judgments about present or future economic or market conditions, is not investment advisory materials.
In considering this element, it is important to realize that advisory services concerning securities encompass more than just those circumstances where advice is provided which focuses upon specific impending investment decisions and specific investment alternatives available. For example, advice to buy, sell, or hold specific securities or categories of securities, market timing advice respecting switching between investment alternatives, and advice respecting the merits of investing in securities as compared to non-security alternatives, are all considered advisory services about securities. Likewise persons who advise others on the selection of an investment adviser are providing advisory services.
Advice or Reports Provided for “Compensation”
Release 1092 states that the “compensation element is satisfied by the receipt of any economic benefit, whether in the form of an advisory fee or some other fee relating to the total services rendered, commissions or some combination of the foregoing.” As noted above in the discussion of “engaging in the business,” a separate fee charged specifically for investment advice clearly establishes the presence of “compensation.”
In the case of a single fee charged for investment advice and other services, if a “clearly definable element” of the fee is assessed for investment advice, than the compensation requirement is satisfied. Here, the key element is whether the fee, though charged for a collection of services or ostensibly a nonadvisory service, varies according to whether investment advice is provided. We examine this in greater detail below in the discussion relating to “special compensation” with respect to the broker-dealer exclusion.
1.3 Entities Excluded from the Definition
Five specifically identified entities are excluded from the Act’s coverage as well as “such other persons not within the intent of the definition, as the Commission may designate by rules and regulations or order.” The effect of these exclusions is to remove these entities from the Act’s registration requirements and, more importantly, from all of its substantive provisions, particularly the Section 206 antifraud prohibitions.
Generally, the exclusions are based on the existence of some alternative scheme of regulation (e.g., bank regulation) or on the fact that the party is engaging in a professional discipline that does not pose the risks to investors against which the Advisers Act seeks to protect (e.g., teaching).
Banks and Bank Holding Companies
Section 202(a)(11)(A) provides an exclusion for “a bank, or any bank holding company as defined in the Bank Holding Company Act of 1956, which is not an investment company.” The term “bank” is defined in Section 202(a)(2) of the Advisers Act. Foreign banks, savings and loan associations, subsidiaries of bank holding companies, and foreign trust companies seeking to rely on the exclusion have been denied no-action assurance in SEC staff no-action letters.
Lawyers, Accountants, Engineers, and Teachers
In enacting the Advisers Act, Congress recognized that investment advice is provided in conjunction with the activities of certain professionals, particularly lawyers and accountants. Accordingly, Section 202(a)(11)(B) excepts “any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession” from the definition of an investment adviser.
This exception, while covering those professionals who occasionally provide “investment advice” in conjunction with their primary professional services, does not cover those who provide such advice as an independent business. Here, the practitioner is forced to distinguish, for example, accountants that provide accounting services to a client from accountants that are, in effect, acting as investment advisers. The key to making this distinction lies in the “solely incidental” language of the exclusion.
The SEC staff has set forth three factors to determine whether advice is “solely incidental” to normal professional activities and therefore does not constitute a separate business activity. These tests are quite similar to the three criteria which make up the definition of an investment adviser. First, the professional must not hold himself or herself out as providing investment advice to the public. Second, the investment advisory services must also be connected with and reasonably related to the provision of primary professional services. Third, any fee charged for the advisory service must be based on the same factors as are used in developing fees for primary professional services.
Thus, an accountant who proposed to provide a service to its clients employing computer software to track and report upon mutual fund performance and whether the funds would satisfy the clients’ investment criteria was unable to rely on the exclusion, because such activity was not incidental to accounting services and because he held himself out as providing investment advice. Similarly, accountants or lawyers who act as “offeree representatives” on behalf of limited partnerships, explaining the risks and possible returns of the investments, must register, as such advice is not incidental to accounting or legal services.
Teachers teaching a course on investment advisory methods must do so at an accredited school, as part of a curriculum or with a content that demonstrates that the course’s purpose is “education” and not simply the provision of investment advice.
By the very nature of their activity, virtually all broker-dealers and their registered representatives come within the broad sweep of Section 202(a)(11)’s basic definition: they are in the business of advising others for compensation as to the advisability of investing in securities. However, in recognition of the comprehensive regulation to which broker-dealers are subject, Section 202(a)(11)(C) provides an exclusion for “any broker or dealer whose performance of such [advisory] services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore.” As will be seen, a broker-dealer’s registered representatives may also rely on the Advisers Act’s broker-dealer exclusion under certain circumstances.
To rely on the broker-dealer exclusion, two tests must be satisfied: (1) the advice must be “solely incidental” to the firm’s brokerage activities and (2) the broker-dealer may not receive “special compensation” for the investment advice.
The SEC has not provided a definitive standard with respect to what constitutes advisory services that are solely incidental to a firm’s brokerage business. As in the case of the professionals covered in Section 202(a)(11)(B), the advisory service must be “connected with and reasonably related” to traditional brokerage services, that is, not provided as an entirely separate business. But development of a more comprehensive standard has been impeded by the fact that broker-dealers have traditionally provided extensive and varied investment advisory services, making it difficult to set forth a clear rule as to when “incidental” brokerage services end and “investment advisory” services begin.
Clearly, a statement by ABC Brokers that “IBM seems to be a good buy at this price” would be solely incidental. On the other hand, to the extent that advice is less transaction-oriented and more directed to the long-term needs of particular investors, the less it can be said to be solely incidental. For example, the development of a financial plan for a substantial number of clients is arguably not solely incidental. Also, a broker-dealer whose business consists almost entirely of managing client accounts on a discretionary basis or who performs “investment supervisory services” for most clients may not be providing solely incidental services.
The special compensation part of the test has received much greater development. It was addressed at length in an early SEC General Counsel’s Opinion that examined whether special compensation was received by a broker-dealer’s charging of an “overriding commission” or “service charge” on securities transactions effected on exchanges where the broker was not a member.
The Opinion noted that these charges were being imposed under four different approaches. Under the first and second approaches, the charge would be imposed or not imposed or its magnitude would vary depending upon whether or how much advisory service was rendered to the client. Such charges, the Opinion concluded, were “clearly definable” as being compensation for investment advice. Under the third approach, a charge was made or not made or varied in magnitude based on some factor ostensibly other than investment advice; for example, the magnitude of brokerage business done by the client with the broker. Although in principle such a charge would not constitute special compensation because it was not imposed as the result of the provision or the magnitude of advice provided, nonetheless a variable charge was viewed as subject to challenge unless no-action assurance was obtained. In the fourth approach, all clients either paid or did not pay the same charge, thus establishing that no fee was being imposed on account of investment advice.
With the “unfixing” of brokerage commission rates, attention was paid to the issue of special compensation as competition forced down transaction fees and encouraged separate charges for other services provided, including advisory services. The SEC, in a release issued to clarify application of the Advisers Act to brokerage firms in the aftermath of the unfixing of commission rates, indicated that special compensation is “compensation to the broker-dealer in excess of that which he would be paid for providing a brokerage or dealer service alone.” It further noted that such compensation would exist only where “there is a clearly definable charge for investment advice.”
In determining whether a charge was being made for investment advice, the SEC staff will not compare one broker’s fees with another’s, nor will it consider individually negotiated fees to be indicative of a charge imposed because of investment advice. Rather, where the “differential” in fees offered a client could be said to be “primarily attributable” to the rendering of investment advice, a finding of special compensation will be made.
A registered representative of a broker-dealer may also take advantage of the exclusion provided to broker-dealers in Section 202(a)(11)(C). However, to do so, the registered representative providing advisory services must be acting within the scope of his or her employment with the brokerage firm, with the knowledge and consent of the firm, and fully subject to its control.
Therefore, a registered representative with an independent financial planning or other advisory business—that is not subject to the brokerage firm’s control—cannot rely on the broker-dealer exclusion. An issue that frequently arises is whether an insurance agent who is also a registered representative is eligible to rely on the broker-dealer exclusion if the agent/representative analyzes a client’s financial goals in connection with determining the proper amount of insurance to own. The SEC staff has permitted reliance on the exclusion provided the agent/representative does not hold himself out to the public as a financial planner or investment adviser, no special compensation is received for the financial analysis, and the broker-dealer controls the financial analysis activity.
Despite the availability of the exclusion, many registered representatives register as investment advisers or become an associated person of a registered adviser in order to engage actively in the advisory business. At one time, this was not permitted because of the inherent conflict between their status as employees of a broker-dealer, seeking to sell their employer’s inventory or sponsored products, and an adviser’s fiduciary duty to its clients. At present, such registration is permitted. The NASD, however, requires that its member broker-dealers properly supervise the advisory activities of their registered representatives.
The NASD may apply to situations involving registered representative advisory activity. Specifically, when the advisory services result in the execution of securities transactions through a brokerage firm that is different from the representative’s employer, the representative must advise his brokerage employer. This would occur, for example, if the representative works for a full-service brokerage firm and provides advisory services that result in the execution of transactions at a discount brokerage firm.
Moreover, if the representative is compensated for his services, his brokerage firm employer must approve or disapprove of the transaction, must supervise it under the Rules of Fair Practice dealing with supervision (NASD Conduct Rule 3010), and must record it upon its books and records as though it were the employer’s own transaction. In supervising the transaction, the employer is obligated to assure that it is performed in compliance with all securities laws and NASD standards.
If the representative is not compensated for the transaction or if the advisory services do not entail the execution of securities transactions, then he still must notify his employer of his separate advisory business, and the employer must assure that the representative’s advisory clients understand that it is not responsible for the advice and other services being provided.
Publishers and Authors
Section 202(a)(11)(D) excludes from the definition of investment adviser “the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation.” While this exclusion clearly applies to general newspapers and magazines (e.g., the Wall Street Journal), its scope with respect to other types of publications, such as investment newsletters, has not been as certain. 
The exclusion itself uses extremely broad language that encompasses any newspaper, business publication, or financial publication provided that two conditions are met. The publication must be “bona fide,” and it must be “of regular and general circulation.” Neither of these conditions is defined, but the two qualifications precisely differentiate “hit and run tipsters” and “touts” from genuine publishers.
Presumably a “bona fide” publication would be genuine in the sense that it would contain disinterested commentary and analysis as opposed to promotional material disseminated by a tout.
Moreover, publications with a “general and regular” circulation would not include “people who send out bulletins from time to time on the advisability of buying and selling stocks… ,” or “hit and run tipsters.” Because the content of petitioners’ newsletters was completely disinterested, and because they were offered to the general public on a regular schedule, they are described by the plain language of the exclusion.
2. INVESTMENT ADVISER REGISTRATION AND DISCLOSURE: THE FORM ADV
Registration under the Investment Advisers Act is effected by filing the Form ADV with the SEC and paying a $150 fee. The Form ADV, which was developed jointly by the SEC and the North American Securities Administrators Association (NASAA), is also used to register with state jurisdictions by those advisers that are required to be state registered. The Form ADV consists of two parts. Part I is principally for use by regulators. Part II serves as the basis for the disclosure document the adviser must provide to each of its advisory clients.
In parceling through registration requirements, a distinction needs to be made between the adviser itself and individuals associated with the adviser (e.g., employees). With respect to SEC-registered advisers, registration is required of the adviser itself. State-registered advisers are required to register themselves, but many states also require registration of individuals associated with the adviser. Also states have the authority to require registration of an “investment adviser representative” of an SEC-registered adviser who has a “place of business” in the state.
While the financial marketplace may demand proficiency and demonstrable knowledge on the part of the adviser, federal law does not impose any qualification requirements. States generally have a different philosophy with respect to qualification standards: many states require that individuals associated with state-registered advisers pass certain examinations, states have authority to qualify “investment adviser representatives” of an SEC-registered adviser who have a “place of business” in that state.
2.2 Form ADV
Parts I and II of the Form ADV set forth a series of questions that must be answered. As a preliminary matter, it is important to note that in responding to these questions one must be guided by Section 207 of the Advisers Act, which makes it unlawful for any person willfully to make any “untrue statement of a material fact in any registration application or report” filed with the SEC or “willfully to omit to state in any such application or report any material fact which is required to be stated therein.”
Part 1 of the ADV begins with information identifying the registered entity. The adviser must state its full name and the name under which it conducts business, if different. The adviser must provide the address of its principal place of business and the hours during which it conducts business at the location. If the adviser keeps books and records required under the Advisers Act at a location other than its principal place of business, it must also disclose the location where it keeps the books and records and the hours business is conducted there.
The adviser must identify its owners and persons that participate in its management. For this purpose, the form contains separate schedules for corporations (schedule A), partnerships (schedule B), and other business organizations (schedule C). Generally, if the adviser is organized as a corporation or partnership, it must disclose both intermediate and ultimate holders of a 5 percent interest. For example, when a 5 percent owner of the adviser’s equity securities is a corporation, the adviser must identify any shareholder that owns a 5 percent stake in the corporation. Similarly, if the second-tier shareholder is a corporation, the adviser must name all 5 percent shareholders in the second corporation.
In addition, the adviser must submit a schedule D for each of a long list of individuals associated with it, including direct owners of a 10 percent or greater interest, the adviser’s directors and executive officers, individuals who determine the general investment advice to be given to clients (if there are more than five such individuals, the schedule needs to be submitted only for their supervisors), and any person who was the subject of a disciplinary order reported in the Form ADV. The schedule D for each individual lists all secondary and post-secondary schools attended, employers over the most recent ten-year period, professional qualifications, and detailed information on any disciplinary actions taken against the individual.
The adviser must answer a series of specific questions concerning whether it or one of its affiliates has been the subject of a judicial or regulatory order involving a crime, financial misconduct, or insolvency. Affiliates include any person named in the adviser’s applicable schedule or any individual or firm that directly or indirectly controls or is controlled by the applicant, including any current employee except one performing only clerical, administrative, support, or similar functions.
The adviser must disclose whether it or a related person has custody of any customer funds or securities and the amount of such property in custody. Related persons include officers, directors, and partners of the adviser and any person directly or indirectly controlling, controlled by, or under common control with the adviser, including any non-clerical, non-ministerial employee. The SEC defines custody broadly to include the authority to obtain possession of or to appropriate client’s funds, which may reach arrangements authorizing automatic payment of adviser fees.
The adviser must answer whether it manages customer portfolios on a discretionary or non-discretionary basis and whether it offers financial planning services. Additionally, the adviser must disclose whether during the past fiscal year it recommended to a client any security in which it had an ownership or sale interest, other than the receipt of customary broker commissions.
The adviser also must file Schedule I, the schedule adopted by the SEC subsequent to the 1996 amendments to the Investment Advisers Act. It is used by the SEC to screen advisers as to eligibility for SEC registration (as opposed to state registration).
Part II of Form ADV serves as the basis for the adviser’s disclosure document. Disclosure is intended to inform clients of the adviser’s services, qualifications, and potential conflicts of interest. With respect to disclosure of potential conflicts of interest, note that the Supreme Court, in SEC v. Capital Gains Research Bureau, held that Section 206 of the Advisers Act imposes a fiduciary duty on investment advisers, including a duty to make appropriate disclosure of conflict situations.
Advisers must furnish each advisory client and prospective client either a copy of a completed Part II of Form ADV or another written document, called a “brochure,” containing at least the information required by the form. The completed Part II or the brochure is filed with the SEC (with respect to SEC-registered advisers) or states (with respect to state-registered advisers) along with the adviser’s ADV Part I. Also, advisers are required to deliver the ADV Part II or brochure forty-eight hours before the client enters into the advisory contract or, if the client has the right to cancel the advisory contract without penalty for a period of five days, at the time the client enters the contract.
The SEC exempts from the delivery requirement clients that are registered investment companies and clients that contract exclusively for impersonal advisory services. Clients that pay $200 or more for impersonal advisory services, however, are entitled to receive a copy of the disclosure statement if they make a written request for it. An adviser whose clients are exempt from the delivery requirement must still complete Part II of Form ADV for submission to the regulators.
An adviser is required to regularly update its Form ADV. Each year, the adviser must deliver or offer in writing to deliver to each advisory client a copy of the updated disclosure statement. Similar to the exemption provided during the initial delivery requirements, an exemption from the annual disclosure requirement applies to clients that are registered investment companies or that contract for impersonal advisory services requiring a payment of less than $200.
Part II of Form ADV consists primarily of a series of questions about the adviser’s services and fee structure, answered by checking the appropriate boxes. In contrast, brochures are typically prepared in narrative form. The brochure must contain the information required by Part II of Form ADV; however, it need not follow the same format. We discuss below the information required to be included in the Form ADV Part II.
[A] Adviser Background and Information
The form requires a description of the adviser’s services. The adviser must disclose what services it offers clients and indicate the approximate percentage of its revenue that comes from each category of service. The adviser must disclose its basic fee schedule and state whether its fees are negotiable. The adviser must indicate the nature of its client base, including the type of institutions it serves, and the types of financial instruments on which it offers investment advice. In addition, the adviser must disclose conditions it imposes on providing investment supervisory or management services, including any minimum asset value required for maintaining a managed account.
If an adviser performs substantially different services for different clients, the SEC allows it to omit from the disclosure statement delivered to a particular client any information required by Part II of Form ADV that pertains only to advisory services not rendered or fees not charged to that client. This enables the adviser to tailor brochures to be more useful and readable for different classes of clients.
The form requires a description of the nature of the adviser’s investment advice. The adviser must specify what method of security analysis—charting, fundamental, technical, or cyclical—it uses. The adviser must identify its main sources of information on securities it recommends—whether, for example, it inspects corporate activities or relies on analyses prepared by third parties. In addition, the adviser must indicate what investment or trading strategies it recommends to clients, such as long- or short-term purchases, short sales, margin transactions, or writing options.
The adviser’s investment supervisory procedures must be described. An adviser that manages investment accounts or holds itself out as providing financial planning services must describe how it reviews client accounts. The adviser must disclose the frequency and level of reviews, the number of reviewers, what instructions reviewers receive, and the number of accounts each individual reviews.
Also, the educational and business background of individuals who provide investment advice must be described. The adviser must disclose the post-secondary education and business experience during the preceding five years of each principal executive officer and individual who participates in establishing the general parameters of the adviser’s investment advice. The adviser also must state whether it imposes any standards related to education or business experience on individuals who formulate or give investment advice to clients.
[B] Other Activities
Also, business activities of the adviser that may give rise to conflicts of interest with the client must be disclosed. The adviser must describe any business activity it conducts or products it sells apart from its providing of investment advice, and state the amount of time it devotes to the other activity. The adviser must state whether it is registered in another capacity as a financial intermediary or whether it has a material relationship with another firm that is so registered.
[C] Participation or Interest in Client Transactions
In addition, the adviser must disclose any financial interest it may have in client transactions. Interested transactions include buying or selling securities from the adviser’s portfolio, acting as a broker for compensation, and recommending investment products in which the adviser has a financial interest.
[D] Investment or Brokerage Discretion
The form requires disclosure of the nature of the adviser’s investment and brokerage discretion. The adviser must state whether it has the authority to select the securities traded by a client, the broker used in client transactions, or the commission rates paid. An adviser that has brokerage discretion or that recommends brokers to clients must disclose the factors it considers in selecting brokers and determining that a broker’s commissions are reasonable. If products or services provided to the adviser influence the adviser’s decision as to the selection of brokers, the adviser must disclose the nature of the service provided, whether the client may pay commission rates that are above market, whether the research benefits all of the adviser’s clients or only those paying for the service, and what procedures, if any, the adviser used during the past fiscal year to direct clients’ transactions to a particular broker.
In 1995, the SEC proposed a separate reporting requirement for investment advisers that receive services or other benefits in exchange for directing their clients’ brokerage. In new Form ADV-B, an adviser would identify the brokers to which it most frequently had directed business, state the amount of commissions paid to each broker, and describe the services provided by the broker. This rule proposal was met with significant industry criticism and the SEC has not sought adoption.
[E] Additional Compensation
In addition, Part II of Form ADV calls for a description of other compensation that the adviser receives from or pays to third parties in connection with its advisory business. The adviser must disclose any arrangement under which it receives an economic benefit, including non-research services, from a person that is not a client for providing advice to clients. The adviser also must disclose any compensation it pays to third parties for client referrals.
[F] Disclosure of Balance Sheet
Finally, Part II of Form ADV requires that advisers who have custody of client assets or whose clients must prepay more than $500 in advisory fees at least six months in advance provide a balance sheet for their most recent fiscal year on Form ADV Schedule G.
Disclosure of the balance sheet enables clients to evaluate whether the adviser has the financial ability to meet its obligations. The balance sheet must be prepared in accordance with generally accepted accounting principles and audited by an independent public accountant.
Investment advisers who are sole proprietors must show the assets and liabilities of the advisory business separate from their personal or other business accounts. Advisers must include the balance sheet in the disclosure statement delivered to each client whose assets the adviser holds in custody or who makes the specified prepayment of advisory fees.
As noted previously, the SEC defines custody broadly and the term may reach arrangements authorizing automatic payment of adviser fees. Also, an adviser may be subject to the balance sheet requirement because it is deemed to have custody of property held by one of its affiliates.
2.3 SEC Approval of the Form ADV
Within forty-five days after the adviser files Form ADV, the SEC must either grant the application or initiate proceedings to deny registration. Grounds for denying registration are the failure to comply with requirements of the registration process or a finding by the SEC that the adviser’s registration would be subject to revocation or suspension.
The ADV, in contrast to some other types of filings made with the SEC (e.g., prospectuses filed under the Securities Act of 1933), is not subject to extensive staff review. Generally, the SEC staff does not engage in considerable dialogue with the adviser to assure that the document is accurate or complete. Largely, because of this, it is unlawful for a registered adviser to represent or imply that it has been sponsored, recommended, or approved by, or that its abilities or qualifications have been passed on by, the United States or any federal agency. The SEC staff does not object, however, if a registered adviser indicates his or her status as a registered adviser.
2.4 Termination of Registration
The adviser’s registration continues indefinitely until the SEC suspends or revokes it or until the adviser withdraws. Grounds for suspension or revocation include the adviser reporting information to the SEC that is false or misleading; the adviser having been convicted of a felony; or the adviser having violated any provision of the federal securities laws or related laws.
The SEC may issue a revocation or suspension order only after administrative hearing subject to SEC rules of practice.
The adviser may withdraw from registration by assigning its registration to a successor firm or by filing a Form ADV—W with the SEC. A successor to a registered adviser is deemed registered if, within thirty days from the date of its succession, it files an application for registration on Form ADV, unless the SEC denies registration to or revokes or suspends registration of the successor. If the successor firm arises as a result of a change in the adviser’s form of business organization or state of incorporation, the adviser may file an amendment to its current Form ADV in lieu of filing a new registration.
The SEC encourages any adviser who suspends its advisory services to withdraw from registration by filing a Form ADV—W. Form ADV—W reports on the adviser’s effort to wind up its advisory business, including whether the adviser has custody of any customer property, whether it has assigned any advisory contracts to another person, and where it intends to store its books and records. A notice to withdraw from registration becomes effective sixty days after the adviser files it, unless prior to the effective date the SEC initiates proceedings to suspend or revoke the adviser’s registration or to impose conditions upon its withdrawal.
2.5 Exemptions from Registration
Section 203(b) exempts three types of advisers from registration. First, the “intrastate exemption” exempts any adviser whose clients are all residents of the state within which the adviser maintains its place of business, and who does not furnish advice or issue reports with respect to securities listed or admitted to unlisted trading privileges on any national securities exchange. Second, the “insurance company” exemption exempts any adviser whose only clients are insurance companies. Third, the “private investment adviser” exemption exempts any adviser who does not hold itself out generally to the public as an adviser, does not act as an investment adviser for any registered investment company or business development company, and during the course of the preceding twelve months has had fewer than fifteen clients. Before 1970, advisers to mutual funds had been exempted from the Advisers Act. This exception was eliminated by Congress to assure that mutual fund investors receive the protections of the Advisers Act.
Each of the Section 203(b) exemptions is very narrow. The prohibition against recommendations of exchange-traded securities prevents all but highly specialized or very small advisers from taking advantage of the intrastate exemption. The insurance company exemption is, as it states, limited to advisers all of whose clients are insurance companies.
The private investment adviser exemption is not available to any adviser who is holding himself out as an adviser to the public generally (e.g., who is actively seeking to increase his client base) or to any adviser that has had more than fifteen clients at any time during the past twelve months, a combination which renders this exemption unavailable to all but a few advisers.
The SEC staff has read “holding out” very broadly and has issued no-action guidance with respect to the fifteen-client limit. For example, advisers must count each member of a limited partnership unless Rule 203(b)(3)-1 applies. Separate subsidiaries incorporated in an effort to avoid registration by providing advisory service to no more than fifteen clients through each subsidiary will be combined and required to register pursuant to Section 208(d).
3. Foreign Investment Adviser Status
Another significant development in this area came with respect to foreign advisers. The term “foreign advisers” means investment adviser companies that: (1) are not registered under the Investment Company Act of 1940; (2) are organized under laws of a jurisdiction other than the United States ore any state thereof; (3) maintain their place of business outside of the United States and (4) do not offer their securities to “United States persons”. In a 1992 Report, the Division of Investment Management proposed a new approach to determining the need for and scope of regulation of foreign investment advisers. The 1992 Report noted that the Act was applied to foreign advisers on an "entity" basis. That is, when an investment adviser, whether domestic or foreign, registered under the Act, all of its activities everywhere in the world became subject to the Act. This created problems for a foreign adviser that was subject to different and usually less intrusive regulatory requirements (particularly with respect to performance-based compensation) in its home country and other countries of operation.
Section 203(a) of the Advisers Act requires any investment adviser that uses the United States mails or any other means or instrumentality of interstate commerce in connection with its business as an investment adviser to register with the Commission, unless the adviser is exempted from registration. The Division of Investment Management previously has taken the position that, once registered, domestic and foreign advisers are subject to all the substantive provisions of the Advisers Act with respect to both their United States and non-United States clients.
As interest in investing outside of the United States has grown, so has interest in obtaining the advice of foreign investment managers.
Foreign advisers may be reluctant to register with the Commission, however, because the Advisers Act may prohibit them from engaging in business practices with their foreign clients that are both legal and customary in their home countries. Further, non-United States clients would not expect the Advisers Act to govern their relationship with a non-United States adviser.
The Division has permitted a foreign adviser to avoid subjecting all of its operations to the Advisers Act by forming a separate and independent subsidiary to provide advice to United States clients. Under the Division's position in Richard Ellis (pub. avail. Sept. 17, 1981), a subsidiary will be "regarded as having a separate, independent existence and to be functioning independently of its parent," thereby permitting the foreign parent to remain unregistered, only if the subsidiary: (1) is adequately capitalized; (2) has a buffer between the subsidiary's personnel and the parent, such as a board of directors a majority of whose members are independent of the parent; (3) has employees, officers and directors, who if engaged in providing advice in the day-to-day business of the subsidiary entity, are not otherwise engaged in an investment advisory business of the parent; (4) makes the decisions as to what investment advice is to be communicated to, or is to be used on behalf of, its clients and has and uses sources of investment information not limited to its parent; and (5) keeps its investment advice confidential until communicated to its clients.
While the Richard Ellis conditions have provided a framework that permits foreign advisers to offer advice to United States clients, many foreign advisers find it difficult to operate under these conditions. For example, foreign advisers often have been unwilling to dedicate their most senior personnel solely to a United States-registered subsidiary. United States clients therefore may find it difficult to gain access to the services of the adviser's most experienced employees.
The Division recently reexamined its interpretation of the reach of the Advisers Act and recommended that it be modified. The Division concluded that the policies and purposes of the Advisers Act, coupled with legal analyses that have been applied in other securities law contexts (i.e., the conduct and effects tests), lead to the conclusion that a more flexible interpretation is appropriate.
Under the Division's approach, the substantive provisions of the Advisers Act generally would not apply with respect to a foreign registered adviser's non-United States clients. Foreign registered advisers, however, will be required to keep certain records and to provide the Commission access to foreign personnel with respect to all of their activities, since activities involving non-United States clients may have a significant effect on United States clients or markets. This will enable the Commission to monitor and enforce the adviser's performance of its obligations to its United States clients and to ensure the integrity of United States markets.
Consistent with the conduct and effects approach, the Division also will allow non-United States advisers greater flexibility than permitted under Richard Ellis in organizing United States-registered subsidiaries. The Division will recognize separateness if the affiliated companies are separately organized (e.g., two distinct entities); the registered entity is staffed with personnel (whether physically located in the United States or abroad) who are capable of providing investment advice; all persons involved in United States advisory activities are deemed "associated persons" of the registrant; and the Commission has adequate access to trading and other records of each affiliate involved in United States advisory activities, and to its personnel, to the extent necessary to monitor and police conduct that may harm United States clients or markets.
Foreign advisers sought to avoid these problems by forming subsidiaries or affiliates that registered under the Advisers Act and concentrated solely upon serving the U.S. market. Consistent with the “Ellis no-action letter" discussed above, only that entity's operations were required to comply with the Act. However, to rely on Ellis, satisfaction of five conditions was necessary in order to be considered "separate and independent" of its parent or affiliates. Three of these conditions, particularly that requiring separation of personnel employed in foreign and U.S. operations, were viewed as unworkable by foreign advisers. Practically, this denied U.S. investors access to the most knowledgeable of foreign advisers, who were reserved by the adviser for its foreign clients.
The 1992 Report recommended a "conduct and effects" test, a standard historically applied in defining the extraterritorial reach of the securities laws' antifraud provisions. Under the conduct test, a registered adviser in compliance with U.S. securities laws must provide services performed in the United States, whether for foreign or domestic investors. Under the effects test, where advice is provided to a U.S. citizen or resident or has other significant effects upon the United States, that advice must be provided in compliance with U.S. securities laws. Advice provided to a foreign national by advisers located in a foreign country would generally not be considered subject to U.S. securities laws.
Accordingly, the 1992 Report recommended modifying the Ellis conditions with respect to foreign advisers, consistent with the conduct and effects test. Under the new approach, the SEC would recognize separateness if the affiliated companies are separately organized and the U.S. registered affiliate was staffed with personnel capable of providing investment advice. In addition, all personnel involved in U.S. advisory activities were required to be "associated persons" of the registered U.S. affiliate and subject to its supervision. Finally, the SEC must be provided with access to trading and other records and to personnel of affiliates as necessary to monitor conduct that might harm U.S. investors.
The SEC staff has issued several no-action letters applying the conduct and effects approach, thereby adopting a clearly less restrictive policy than that applied under Ellis. In Uniao de Bancos de Braileiros S.A., the staff granted no-action relief where a foreign adviser created a U.S. registered subsidiary to provide advice to U.S. citizens, and further stated that U.S. securities laws would not be applied to investment advice which that subsidiary provided to its non-U.S. clients unless that advice involved conduct or effects in the United States.
4. Mutual Fund Regulation
4.1 Federal and State Regulation
A. Federal Regulation
No segment of the securities industry is more strictly regulated at the federal level than mutual funds. Mutual funds are subject to four federal securities acts - the Securities act of 1933, which requires the registration of fund shares, requires prospectus disclosure and strictly regulates the contents of advertising; the Securities Exchange Act of 1934 and the regulations of the National Association of Securities Dealers, Inc., which regulate distributors of mutual funds as broker-dealers; the Investment Advisers Act of 1940, which provides for the registration and regulation of investment advisers to mutual funds; and the Investment Company Act of 1940.
Unlike the other federal securities laws, which are designed to protect investors primarily through disclosure, the Investment Company Act imposes a series of detailed, substantive requirements and restrictions on the structure and day-to-day operations of mutual funds. The core objectives of the Act are to:(1) ensure that investors receive adequate, accurate information about the mutual fund; (2) protect the physical integrity of the fund's assets; (3) prohibit or regulate forms of self-dealing; (4) restrict unfair and unsound capital structures; and (5) ensure the fair valuation of investor purchases and redemptions.
This extensive scheme of SEC regulation at the federal level imposes a strict discipline on mutual funds to which other pooled investment vehicles generally are not subject and provides an important source of investor confidence in the integrity of the mutual fund industry. Moreover, it should be noted that these SEC-mandated investor protections apply to all fund shareholders and all mutual funds, regardless of the state in which they are incorporated or organized, where they or their advisers are located, or where fund shareholders reside.
B. State Regulation
On top of this extensive system of federal regulation, mutual funds also must comply with regulation by all states in which they are sold. In contrast to federal regulation, the manner in which the individual states regulate funds varies tremendously state by state.
The Institute has identified eighteen variants on mutual fund regulation at the state level—and the result is a crazy-quilt of inconsistent regulation. For example:
Some states exempt all mutual funds from registering their shares for sale, most do not. Of states granting exemptions, some require funds to make a filing, others do not. Some states exempt only some funds from registration. Of these, some actively review the prospectuses of those funds that do not claim the exemption, others do not.
Of those states that do not grant exemptions, some actively review mutual fund prospectuses and written advertising, other do not. Some review prospectuses, but not advertising. Some states impose their own restrictions on mutual fund portfolio investments, most do not.
The mutual fund industry today is quintessentially national in character. Virtually all funs, in order to serve their investors, offer their shares on a nationwide basis. The reasons for this include, among other things, the increasing utilization of nationally available telecommunications and computer networks to communicate with investors; extensive coverage of mutual funds by the national media, which generates inquiries from investors in every state; and the increasingly mobile nature of American investors who may move their place of work and residence from one state to another many times during their lives.
4.2 Portfolios and Disclosure Documents
A. Portfolio Limitations
As noted earlier, the Investment Company Act, together with the rules and regulations promulgated by the SEC under the Act, imposes detailed substantive standards on the operations of mutual funds. Many of these standards are specifically directed to what a fund may invest in. For example, the SEC limits a fund's investments in illiquid securities. Certain types of investment techniques—such as engaging in short sales and writing options—are subject to various restrictions. The manner in which a fund's investments are valued is strictly regulated by the SEC. Money market funds are subject to extensive limitations on their portfolios pursuant to Rule 2a-7. In addition, fund investments in certain instruments are limited by the rules of Commodity Futures Trading Commission.
Even in the face of the SEC's national standards, widely-recognized for their effectiveness, states can and do impose unique restrictions on the management of a fund's portfolio—the essential service our industry provides to shareholders.
Funds are offered on a nationwide basis and portfolios must be managed identically for all of a fund's investors, without regard to the state where they live. Thus, the portfolio restrictions imposed by one state will dictate how the portfolio will be managed for investors in all states. Accordingly, so long as even one state insists upon imposing a condition that will restrict the ability of a portfolio manager to invest his or her fund in a manner consistent with federal law, investors in all states will be adversely affected.
At least eight states have express provisions that impose on funds certain substantive portfolio limitations that are inconsistent with federal law. Although each of these states has been urged repeatedly by mutual funds and NASAA to conform their provisions to federal law, to date, only one—Wisconsin—has taken affirmative steps to eliminate this inconsistency.
Some of these limitations restrict a fund's ability to invest in various assets, including commodities, restricted securities, oil, gas or mineral programs, options and warrants, interests in real estate, and other securities. For instance, Arkansas, California, South Dakota and Texas each limit a fund's investments in options and warrants—though no two of these states do so in the same way. In Texas, a fund may not invest more than 5% of its assets in warrants, and no more than 2% of this 5% may be invested in warrants not listed on the New York or American Stock Exchanges. In California, funds may only invest in options that are issued by the Options Clearing Corporation, which means that a fund may not invest in over-the-counter options or in options listed on foreign exchanges. In Arkansas, a fund may invest up to 5% of its assets in options without further restriction. In South Dakota, a mutual fund may not invest more than 5% in options, other than hedging positions or positions that are covered by cash or securities.
Complying with these various state provisions is not easy or inexpensive. It often requires utilizing complex specialized computer tests to ensure that each investment made by the fund conform to all applicable unique state limits. More importantly, a state's adherence to its unique limitations can frustrate national initiatives of the SEC. For example, i