What in the world is a church bond?

When you're reading the Uniform Securities Act, it's easy to look at the information as if somebody just made it all up. In the live classes, people sometimes stop me and ask something like, "Whoah, hold on, Bob--a church bond? What the heck is a church bond?" Here goes. Religious organizations frequently raise money by selling debt securities to investors. I have an offering circular on my desk for a $240 million offer of various debt securities by a Lutheran organization that funds various missions. The offering is for the "mission investment fund," and on the front page of the offering circular we see that these securities have not been registered with the SEC in reliance on an exemption under the Securities Act of 1933 . . . but that this does not imply that any regulator has approved (or disapproved) of the securities, and any statement to the contrary is a criminal offense.
What does that mean? It means these debt securities do not have to be registered, period. But to raise $240 million, the organization has to disclose to investors all kinds of financial information. If any of that information is deceptive, this offer of securities is still subject to anti-fraud regulations, meaning the organization could face criminal prosecution and civil lawsuits. If the offering circular overstates the amount of money taken in through collections or bequests, that's a mistatement of a material fact. If the document leaves out some bad news that might have made investors think twice, thats' an ommission of material fact. So the offer of these securities is definitely subject to anti-fraud statues. It's just not subject to registration.

Exempt Securities in the Real World

I taught a live Series 65 class this past week for the accounting firm who does tax work for my S-corp. It was amazing how quickly this group of five CPAs can absorb new, complex information, but we definitely hit the wall when we covered the Uniform Securities Act's provisions for securities. One of the CPAs said at the end of that section, "That seems to be the most vague of all the information we've covered."
Amen, brother. Regulators like things nice and vague when it comes to "securities." They like vague phrases like "investment contract" or "anything commonly known as a security" because it allows them to fit just about anything under that category if they want to regulate it. So, step one is this: does the investment meet the definition of a "security"? If so, it is subject to anti-fraud rules, whether it has to be registered or not (exempt). That means that a fixed annuity or a whole life insurance policy is not even subject to anti-fraud regulations. Why not? Neither one is a "security." Then, there are securities that are excused from registration requirements. They're still securities, so anti-fraud rules still apply. These securities just don't have to be registered. They are excused/exempted from the registration requirements. For example bank stock does not have to be registered with securities regulators. Neither do church bonds. A church bond is sold with an offering circular rather than a prospectus. But, that doesn't imply that the investment is somehow safer than other debt securities, and the offering circular will announce that at the very beginning. To see how this stuff works in the real world, please check out an offering circular for a "church bond" or series of "mission investments," really, at:
www.bigfilespassthetest.com/securities.
You'll notice that the investments are being sold by employees, who receive no special compensation for sales (not agents). You'll notice that the expenses incurred to sell the investments are about $1 million per year. You'll notice all the disclosure that is provided . . . because even though the securities aren't registered, they are subject to anti-fraud rules. Investors have to be informed of all the risks involved; otherwise, they could sue if they lose money. Spend some time with this document, and I'm confident you will begin to understand "exempt securities" and securities registration issues in general much, much better. Enjoy.

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

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.