Thursday, May 27, 2010

Settlor Functions

Apparently, the term "settlor functions" has been known to appear on the Series 65/66 exams, so let's take a brief look at this concept. As you know, ERISA says that pension funds and 401(k) plans are run by "fiduciaries" such as the CEO, investment advisers managing the assets, members of the board who oversee the plan, etc. But, the CEO is a fiduciary only when he's managing the plan or directing the investment advisers, for example. He's not a fiduciary to the plan participants and beneficiaries just because he's the CEO. It's the function, not the title, that makes him a fiduciary. So, when a plan fiduciary is actually just making "business decisions," called "settlor functions" by ERISA, he/she is not performing fiduciary functions. I'm looking at a letter from the Department of Labor, in which the Assistant Secretary of the Department explains that "in light of the voluntary nature of the private pension system governed by ERISA, the Department has concluded that there is a class of discretionary activities which relate to the formation, rather than the management, of plans. These so-called 'settlor functions' include decisions relating to the establishment, termination and design of plans and are not fiduciary activities . . . "

So, the decision to start or terminate a retirement plan is considered a business decision (settlor function), not a fiduciary matter. The exam might expect you to know that the following decisions are considered "settlor functions" and not fiduciary activities:

--Choosing the type of plan or options in the plan

--Amending the plan

--Requiring employee contributions/changing contribution levels

--Terminating a plan

I'll have to think up some practice questions for future posts. With any luck the exams won't go very deep into this topic. I'm still struggling to understand why investment adviser representatives actually need to know anything about this topic. As if relevance actually played a role in placing a question on the Series 65/66.

3rd Prong - business standard

Ok, we've looked at the question of whether somebody is providing investment advice, and whether that somebody receives compensation as a result of it. What, then, do the regulators mean when they ask, "Is the person in the business of providing investment advice?" ? In SEC Release IA-1092, the regulators state that, "Under section 202(a)(11), an investment adviser is one who, for compensation, (1) engages in the business of advising others as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or, alternatively, (2) issues or promulgates reports or analyses concerning securities as part of a regular business. Each of these two alternatives in the statutory definition of investment adviser contains a business test -- one involves 'engaging in the business' of advising others while the other involves issuing reports about securities as 'part of a regular business.' While the business standards established under Section 202(a)(11) are phrased somewhat differently, it is the staff's opinion that they should be interpreted in the same manner." As the release then states, "The giving of advice need not constitute the principal business activity or any particular portion of the business activities of a person in order for the 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." Okay, what the heck does that mean? It means that there is really no objective standard whatsoever used to determine if someone is "in the business of providing investment advice." There is no guidance based on the percentage of income the advisory services comprise of a professional's total compensation, and there is no guidance based on the frequency with which the advice is provided. As that famous judge said about pornography, he can't define it, but he knows it when he sees it. Great. Let's see what the SEC has to say next: 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 transactionbased compensation if the client implements the investment advice, or (iii) on anything other than rare, isolated and non-periodic instances, provides specific investment advice. The SEC then writes, "For the purposes of (iii) above, "specific investment advice" includes a recommendation, analysis or report about specific securities or specific categories of securities (e.g., industrial development bonds, mutual funds, or medical technology stocks). It includes a recommendation that a client allocate certain percentages of his assets to life insurance, high yielding bonds, and mutual funds or particular types of mutual funds such as growth stock funds or money market funds. However, specific investment advice does not include advice limited to a general recommendation to allocate assets in securities, life insurance, and tangible assets." In other words, good luck trying to push the edge of that envelope. As if you're going to build a career telling people that they really oughta, you know, invest in securities, life insurance, and tangible assets, but, unfortunately, that's all you can really tell them. You can't tell them which types of securities to invest in, let alone which companies they might want to invest in. Good luck getting anybody to pay your bill for that "advice," right? Also, did you notice that if you merely "hold [yourself] out as an investment adviser or as one who provides investment advice," guess what--you're an investment adviser. In other words, if you pass out business cards announcing that you are available to provide investment advice, or if you put up a billboard trying to pull in new clients, you are definitely "holding yourself out as an investment adviser." Then again, if you do NOT hold yourself out as an investment adviser and privately advise not more than 15 clients, the SEC won't make your register. The states, however, can do what they want in that case--you have an office somewhere, maybe that state will require you to register. What do you want, a clear answer? Sorry, you're dealing with the regulators here, who like everything to remain at least as clear as mud.
What if somebody is a financial planner who avoids giving specific advice on securities? The SEC explains that, "In applying the foregoing tests, the staff may consider other financial services activities offered to clients. For example, if a financial planner structures his planning so as to give only generic, non-specific investment advice as a financial planner, but then gives specific securities advice in his capacity as a registered representative of a dealer or as agent of an insurance company, the person would not be able to assert that he was not 'in the business' of giving investment advice." So, the way I read all this mumbo jumbo is that if you provide specific investment advice for compensation, and you do it more than once in a VERY great while, you are in the business of providing investment advice and will almost certainly have to register, either with the SEC or the state regulators.

Thursday, May 13, 2010

Practice question on the 2nd prong

Let's try to apply what we've been discussing about the "three-pronged approach" to the following practice question:

Which of the following least likely meets the definition of an "investment adviser"?
A. an individual who merely rents a billboard in State A announcing the availability of "total financial planning services"
B. a financial planner limiting her services to budgeting, bill paying, and credit score improvement
C. a newsletter writer who covers mid-cap technology stocks and sends the newsletter to paid subscribers based on market index movements
D. a geological engineer who charges a flat fee to help investors determine promising royalty trusts and limited partnership interests involved with oil & gas exploration

EXPLANATION: the phrase "holding itself out to the public" often messes with people. But, the individual who rents a billboard is doing exactly that--holding herself out to residents of the state as being in the business of providing investment advice. Close enough--she's an adviser. The newsletter writer loses his exclusion by blasting out his so-called "newsletter" based on "market developments." He's only a newsletter writer if he's publishing a newsletter that goes out to a general audience on a regular circulation--if the thing goes out based on market developments, he's an adviser. The engineer would not be an adviser if he's merely telling partnerships whether there is or is not oil/gas underground worth trying to extract, but this guy is telling investors what to invest in, for compensation. He is also an adviser. While "financial planners" usually do meet the definition of "investment adviser," that is only if part of their service involves securities. If, on the other hand, they keep it to non-securities matters, they escape the definition.


2nd Prong, Compensation

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In any case, let's look at the next prong in the "three-pronged approach" to defining investment advisers: does the person receive compensation as a result of providing investment advice? Many candidates have a hard time with this one. They think that the compensation has to be in the form of money, but "compensation" includes any form of economic benefit. So, if you get a test question about a finance professional in a rural area who provides total financial planning and investing checkups in exchange for sacks of potatoes or sides of beef, that finance professional is receiving compensation for his advice and would meet the definition of "investment adviser." Also remember that the compensation does not have to be paid by the person receiving the advice. In the previous blogpost we had an insurance agent charging advertisers while providing advice to site visitors--makes no difference who pays him. He's getting compensation indirectly for providing investment advice. Close enough for rock and roll. Or, maybe a test question has somebody giving employees of a large company portfolio allocation advice and charging the company, not the employees. Again--makes no difference who pays him. He's providing investment advice and receiving compensation. He meets the definition of "investment adviser." What if a newsletter writer charges subcribers $300 a year for monthly emailed newsletters discussing large cap value stocks? Is that compensation? Yes. Is the newsletter writer providing investment advice? No. He's just writing a newsletter, just expressing his opinions as guaranteed by the 1st Amendment to the US Constitution.
In other words, you gotta think hard and carefully when dealing with these issues. Look for a practice question on the compensation issue in the next few blog posts.

Practice question on the 1st prong

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Either way, let's apply what we discussed in the blog post before last, the one discussing "Does the person provide investment advice?" Here goes:

Which of the following least likely meets the definition of an "investment adviser"?
A. a certified public accountant who includes a 401(k) portfolio allocation service with his tax preparation services at no extra charge
B. an insurance agent who publishes a website in which visitors receive allocation strategies based on data they input; only site advertisers are charged
C. a writer of an Internet newsletter who publishes recommendations on small cap stocks to paid subscribers on the 15th of each month
D. a lawyer who offers total financial planning services to certain clients

EXPLANATION: this is a tough question. You have to find three people who do meet the definition of "investment adviser" and cross them out. The one who does not meet the definition is your answer. Right? Okay, what about the accountant--accountants are not investment advisers, right? Right?
Wrong--nobody ever said that. An accountant is not an investment adviser if he/she is not providing investment advice. But, this CPA is providing specific investment advice. Even though he doesn't itemize the bill with a charge for the advice, the advice is part of the services for which he receives compensation. This accountant is an investment adviser. The insurance agent might not receive compensation from site visitors, but he receives compensation from somebody as a result of providing specific advice. The insurance agent is also an investment adviser. The lawyer is holding himself out as a "total financial planner" to the public. I'd say he's an adviser. However, the newsletter writer gives no investment advice specific to anyone's individual needs. Therefore, he least likely meets the definition of "investment adviser."


Tuesday, May 11, 2010

So, Bob, Whadaya Think a' Goldman Sachs?

Without expressing any opinions on the Goldman Sachs situation, let me see if I can relate it to what you're studying for your exam. This is what the SEC is alleging so far in their civil suit: a sophisticated securities product called a "synthetic CDO" (collateralized debt obligation) based on residential mortgage-backed securities was marketed by Goldman Sachs to their investors. What investors didn't know, allegedly, is that Goldman Sachs allowed a hedge fund to help select the mortgage-backed securities for the portfolio and then bet against the portfolio. The marketing materials made it appear that the hedge fund's interests were aligned with those of the investors, when, in fact, their interests were in conflict with investors. Where's the conflict? If true, the hedge fund was able to structure a portfolio that would likely collapse and profit from that while, meanwhile, the investment bankers are selling the portfolio to investors, as if it's a good investment. Ouch. How many times have you read and tried to understand the phrase "undisclosed conflict of interest"? Well, this is one of those, apparently. Selling securities while concealing important/material facts is a big no-no, as all the big players know-know. Again, I'm not saying that's what happened; I'm just explaining how the SEC's actions relate to "undisclosed conflicts of interest" and "ommissions of material fact in the offer/sale of any security." There will be big, thick books written on this topic. I just wanted to relate the development to what you're studying in a brief blog post. By the way, if you have a few minutes, check out the actual SEC complaint at

Thursday, May 6, 2010

1st Prong SEC IA 1092

The so-called "three prongs" discussed in SEC Release IA-1092 include the following:
Does the person provide investment advice on securities?
Is the person in the business of providing investment advice?

Does the person receive compensation for the advice?

Let's look at the first prong in this post--does the person provide investment advice? A person is only providing investment advice if the advice involves securities--either their value or the advisability of buying, holding, or selling them. For example, a financial planner that deals only with insurance and budgeting would not meet the definition of "investment adviser." On the other hand, a sports agent who helps his clients determine how much money to invest in the stock market and how much in, say, real estate, or bank products, probably would meet the definition of "investment adviser," even if the advice does not involve specific securities--just the fact that he's telling people how much to invest in the securities markets is close enough for rock 'n' roll. Remember that a person could meet the definition of "investment adviser" whether meeting with people in person, or through emails and websites. So, if a professional provides individualized recommendations or financial plans by email or website only, that professional is an investment adviser. However, if somebody merely writes a newsletter on investing that does not provide any advice based on the needs of individuals, that person is a publisher, not an investment adviser. Doesn't matter how much the subscription costs; this person simply does not meet the definition of "investment adviser." Where this exclusion could be lost, however, is if the so-called "newsletter" is sent out based on "market developments." In other words, if this so-called "newsletter writer" is really just charging people to tell them when to buy or sell based on charts or trading patterns, that person does meet the definition of "investment adviser" and would probably have to register. So, if you get a question about a "newsletter writer," try to determine if this person is expressing his opinions to a general audience and, therefore, not an adviser; or is this person really telling people when to buy or sell securities based on "market developments" and, therefore, functioning as an investment adviser who uses market timing?
A lawyer could be determining the value of an illiquid investment in, say, an oil & gas drilling operation, when doing trust or estate work--does that make him an investment adviser? Probably not--that advice on securities values is "solely incidental" to his profession. But, that doesn't mean that lawyers can't be investment advisers. If they start providing investment advice, then they need to get registered. But, if they only work with securities to the extent required by their legal work, that's a different ballgame. Similarly, if your CPA "advises" you to maximize your IRA account, that's what she's supposed to do to help your tax situation. She's not an investment adviser if she's only doing tax preparation work. However, if the CPA starts providing financial planning services or "portfolio allocation" services, then she would be an invesment adviser and would need to register.
Don't try to memorize a bunch of bullet points here--train your mind to analyze each situation. How is the person functioning in the question? Are they giving specific advice on securities for compensation? If so, they're an adviser. If not, they're probably not an adviser.
We'll keep looking at this "three-pronged approach" over the next several blog posts. Once you begin to understand this material, a lot of other issues should fall into place.