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.

Are you an adviser or not?

There is a subtle difference between the following two questions:

1. Is the firm an investment adviser?
2. Does the investment adviser have to register?

The first question is talking about an "exclusion," while the second is talking about an "exemption." In other words, some entities simply don't meet the definition of "investment adviser." An accounting firm that encourages clients to make IRA contributions is not an investment adviser. Neither is a bank or savings & loan. Whatever the Investment Advisers Act of 1940 or various state securities laws have to say about investment advisers, it does not apply to the accountants in our example, a bank, or an S & L. Why not?

They are not investment advisers.

On the other hand, an adviser in Rhode Island might have a couple of financial planning clients move to Massachusetts--if so, the Rhode Island investment adviser is excused/exempt from registration requirements in Massachusetts. As long as he isn't soliciting new business in Massachusetts, and as long as he has no more than 5 of these clients there, he is exempt from registration requirements.

But he is an investment adviser. And that's important to note because if you're not an investment adviser, then the Investment Advisers Act of 1940 has nothing to say to you. But, if you are an investment adviser who simply doesn't have to register--exempt--then, some parts of the Investment Advisers Act of 1940 still apply to you. At the risk of going overboard, let's look at the difference. Section 205 of the Act requires the contract between advisers and clients to contain at least 3 main items. But, it clearly doesn't apply to advisers who are exempt from registration requirements:

No investment adviser, unless exempt from registration pursuant to section 203(b), shall make use of the mails or any means or instrumentality of interstate commerce, directly or indirectly, to enter into, extend, or renew any investment advisory contract, or in any way to perform any investment advisory contract entered into, extended, or renewed on or after the effective date of this title, if such contract--
provides for compensation to the investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client;
fails to provide, in substance, that no assignment of such contract shall be made by the investment adviser without the consent of the other party to the contract; or
fails to provide, in substance, that the investment adviser, if a partnership, will notify the other party to the contract of any change in the membership of such partnership within a reasonable time after such change.

On the other hand Section 206, the anti-fraud statute, applies to anyone who meets the definition of investment adviser, even those who are exempt from registration requirements:

It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly--
to employ any device, scheme, or artifice to defraud any client or prospective client;
to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;
acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.

So, if you're not an investment adviser, even Section 206's anti-fraud statute is outside of your world. But, while an adviser with an exemption would not have to comply with Section 205's requirement for client contracts, they're still an investment adviser, so they're still stubject to Section 206's anti-fraud statute. They don't have to comply with most of the Act of 1940, but if they're an investment adviser, they had better not do anything deceptive or misleading, even if they are excused from registration.

On the test and in the real world, it is difficult to know for sure if you meet the definition of "investment adviser." The State of Ohio has an excellent flow chart that helps people decide this crucial question. Take a look at it--very helpful stuff:

http://www.com.ohio.gov/secu/docs/Investment%20Adviser%20Flowchart.pdf

Out-of-State Adviser with 5 clients

A former Pass the 65(c) customer wrote me an email this evening that touches on a few important testable points. He wrote:

I used your program to pass the 65 test in AZ. Thanks so much.

One of my coworkers and I have a disagreement on the number of clients you can have vs. the number of people you can solicit outside of the state you are registered. I say you can have 5 clients outside the state. He says you can only solicit to 5 outside the state and once you solicit 5, you cannot solicit or have more clients even if you get none. Who is right?

Thanks for the help!

I RESPONDED:

Great job on passing a tough test!
Basically, the de minimis exclusion for an out-of-state adviser with no more than 5 clients in another state accomodates financial planners who might have a few clients who end up moving to various states. So, if a few of your clients move to Florida, you can be their adviser without paying licensing fees to Florida. As always, there is a catch. Remember that this exclusion is predicated on the fact that you are not soliciting new clients in the other state. If you're going to solicit clients, or "hold yourself out as an adviser," the other state is going to want you to register. Plus, how can you solicit five clients? To get five clients, I think you'd better call more than 5 people--more like 500 people. Right? The state laws generally say that an adviser can commit fraud even when just soliciting clients, so they like to get people registered if they're "holding themselves out as being an investment adviser in their state." So, your co-worker isn't quite right, either. It's not that you can solicit five people. It's a question of, are you soliciting and "holding yourself out to the public as being an adviser," or not? If you are, you have to register. If you're not, you can have up to 5 clients, as long as you have no physical presence/place of business in that other state.

Here is a snippet from a state law, Pennsylvania's. Their Act states that you're not an investment adviser if you/your firm are: a person who has no place of business in this State and, during the preceding twelve-month period has had not more than five clients in or out of this State and does not hold himself out generally to the public as an investment adviser.

The bold statements are why your buddy is partly right--in general most states won't grant you the de minimis exclusion if you're holding yourself out as being an adviser to the public in their state, which is what you'd be doing by calling or writing to potential clients, or advertising, or even handing out brochures or business cards at a garage sale. In fact, if you sat at a local tavern or diner and simply talked to anyone too slow or lonely to walk away from you about your advisory services, you would be "holding yourself out to the public as an investment adviser."

You both would probably like an absolute answer, but it would depend on the state, the wording of their own statutes, their reading of their own statutes, and their list of priorities. To be on the safe side, get registered before you start soliciting advisory clients in any state. The de minimis exclusion really only works when you have existing clients who happen to move to another state. Once you "hold yourself out to the pubic as being an investment adviser," that state likes to make you register.
And, I'd be on the safe side with all state licensing issues. You're usually talking about an annual fee of a few hundred dollars to get registered and renew each year.

Defining Investment Advisers

Which of the following professionals least likely meets the definition of an "investment adviser"?

A. an accountant who charges only a nominal fee to help tax clients with allocation strategies for their retirement accounts
B. an individual who writes a financial newsletter for compensation to a group of subscribers in several states
C. a financial planner
D. an insurance agent who occasionally provides financial planning services to his clients

EXPLANATION: according to the so-called "three-pronged approach" developed by the SEC's Release IA-1092, the individual has to be giving advice that is specific to the client's situation in order to meet the definition of "investment adviser." The writer of a financial newsletter is just a publisher/writer enjoying his First Amendment rights. Of course, an adviser who never meets face-to-face with clients would still be an adviser if he wrote up his personalized recommendations and sent them to each of his clients. The key here is the specificity--is the adviser writing to a general audience, or is he advising individuals based on their unique situations? The newsletter writer is just a publisher, not an adviser. The accountant is crossing the line by charging to help with investments. The financial planner is the perfect example of an investment adviser. And the insurance agent becomes an adviser as soon as he holds himself out as a professional who provides financial planning services. The only caveat there is that if the financial advice had absolutely nothing to do with securities, the insurance agent would escape the definition of "investment adviser." But that would require him to talk only about, say, credit cards, personal budgeting, real estate, and fixed annuities.
ANSWER: B

Investment Adviser Registration Requirements

Here is a likely question on your Series 65 or 66 exam:

If an investment adviser is properly registered in State X, where it maintains its main office, and the adviser is also registered in State Y, what is true if the Administrator of State Y requires higher net capital than what is required in State X?
A. The Adviser must obtain a surety bond to cover State Y's requirement
B. State Y can not have a higher requirement than State X
C. The adviser does not need to comply with the higher requirement in State Y
D. The SEC must provide no-action relief to the adviser

EXPLANATION: you'll find this rule in the Investment Advisers Act of 1940, and it makes perfect sense. If the adviser is properly registered in State X and meets the state's financial requirements, the firm can not be forced to meet the other state's higher requirement. Similary, a state regulator can not tell a federal covered adviser that their net capital isn't high enough--that's the SEC's job.

ANSWER: C

Are they an investment adviser?

There is a subtle but important difference between an exclusion and an exemption. When the exam talks about investment advisers who are "exempt," they are referring to investment advisers who are not required to register.
Period.
In other words, these entities are definitely investment advisers because they provide financial planning services or manage portfolios or act as consultants. They simply don't have to register. For example, if you're an investment adviser in Wauwatosa, Wisconsin, a few of your financial planning clients might one day wake up on a cold February morning and in a moment of clarity move the hell out of the upper Midwest. Let's say that five of your clients move to Arizona--do you have to register in Arizona to keep serving them?
No. You would claim the "de minimis" exemption that says you're exempt from Arizona registration requirements based on two important facts: 1) you have no place of business in the state of Arizona and 2) you have no more than 5 non-institutional clients in the state.
On the other hand, there are entities that simply do not meet the definition of "investment adviser." They are excluded from the definition, in other words. A bank is not an investment adviser. Neither is a bank holding company. Many bank holding companies and banks are related to an investment advisory subsidiary (Wells Fargo/Wells Capital Management), but the bank is not the adviser, and neither is the bank holding company that sits above the other entities. A lawyer who talks about the value of securities only so far as his profession requires him to is not an investment adviser.
It probably seems hard to believe that this difference between exemptions and exclusions could actually matter, but it actually does. When the Investment Advisers Act of 1940 says that something is prohibited of "any investment adviser," it means that if you meet the definition of "investment adviser," this is a prohibition for you, even if you don't have to register. In other places, "the Act" uses language like "it shall be prohibited for any investment adviser registered or required to be registered under this Act," which means exactly what it implies--if you're exempt from registration, this rule does not apply.

Anyway, fun stuff to be sure, which is why I decided to share it with the community so early on a Friday morning. On another note, today's Friday Free Broadcast covers FINRA/SRO rules and reg's, which is actually a big topic on the Series 65 and 66 exams--pull down a Friday Free Broadcast schedule on the home page of our websites under Get Free Stuff.