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.

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.


ANSWER: b

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."

ANSWER: c

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.

OMG!

So I held an online Series 65/66 class today, and one of the attendees typed a message through the chat window that nearly sent me falling out of my chair. His question, essentially, was this:

I am currently in the process of registering my firm as an RIA. For the past few years I have been trading the online accounts of several friends, who gave me trading authorization. I don't charge any fees; instead, when my friends take their profits, they cut me a check for my share of those profits. This is okay, right?

My response was a little bit nicer than this, but essentially I wrote:
Uh, no, that's about as far from okay as you can possibly get. Why? First, if you're being compensated to manage your friends' accounts, you are an UNREGISTERED investment adviser. Even if you were registered, you can't share so-called "profits" with your clients based on gains on particular stocks. Why not? Because they aren't profits! If you put your friend into, say, 10 stocks, and one of them goes up 200%, you might think of that as a "profit," but what if the other 9 stocks drop 90%? Your friend is losing money big time. If the math doesn't jump out at you, let's try an example. Your friend has $100,000 in 10 stocks, $10,000 for each. One of those stocks goes up 200%, taking it up to $30,000. He sells and gives you a percentage of that, so he's made a "profit" of less than $20,000. The other $90,000 invested is worth only $9,000, now that those stocks dropped 90%. So, where's this "profit" you guys are talking about? YOU made a profit--your friend has lost in the neighborhood of 70-80% of his investment, depending on how much he shared with you. Hey, some friend you are!
That's why advisers get paid a percentage of assets--the whole account, not a percentage of the rare stock that happened to go up. If an adviser wants to share in capital appreciation, he has to use an index that represents the makeup of the client's portfolio, and if he meets or beats that index, then he can get a performance bonus. But, if you think that selling one stock for a gain is the same thing as a profit, you must believe that the stocks that have dropped 90% or more are just "paper losses." As if all stocks have to come back to your purchase price. The NASDAQ (qqqq) used to be at about 5,000. Now, almost 10 years later, it has not even come back to half that value. We could call it a "paper loss," just like we could call Sara Palin a thinker. Wouldn't make it true.
Even if you were doing performance-based compensation the right way, your friends would need to have at least $750,000 under your management, which I doubt is the case.

So, as Marsellus Wallace tells Butch in Pulp Fiction, this is pretty ******** far from "okay."

Or through publications or writings

Here's a good practice question on registration issues for investment advisers:

Diane Davis receives detailed financial information from 19 individuals residing in four states and emails financial plans to them based on the data supplied to her by email. If she charges just $189 per year for this service
A. she does not meet the definition of "investment adviser" due to the amount of compensation
B. she must register with the SEC
C. she meets the definition of "investment adviser"
D. she does not meet the definition of investment adviser because she does not meet with any clients in any of the four states

EXPLANATION: she receives compensation to provide financial plans based on specific situations. Whether she meets face-to-face or advises people "through publications or writings" is not what's relevant. The relevant point is that she gives advice specific to each client and receives compensation for doing so. Don't confuse what Diane is doing with somebody else who might be writing a newsletter on investing that goes out to paid subscribers. Diane is not writing articles--she is advising clients without having to shower or put on make-up. That's all. Also, Diane would have to be in 30+ states to claim federal eligibility. She has no assets under continuous, supervisory management, so she can't reach the $25 million threshold.



ANSWER: C

Series 65 - Likely Test Question

A customer who recently passed his Series 65 exam reports that he saw a question similar to the following:

There is a federally covered advisor with an office in state A, who has clients in state A. He also has 3 non-institutional clients in state B and 3 non-institutional clients in state C. He has 3 more clients in state X and wants to have custody of the clients' accounts in state X. In which states does he have to register?

A. A only
B. A, B, C and X
C. A and X only
D. None, because he is federally registered


My explanation:
The answer is D because this is a federal covered adviser. They notice file in State A, where they have an office. They do NOT need to notice file in State B, State C, or State X because they aren't soliciting new business there (holding out as advisers) and have no more than 5 non-institutional clients. Even if they had more than 5 non-institutional clients in those states, they would not register there; they would only notice file there. Custody has nothing to do with this question. As a federal covered adviser, they'll meet the SEC's net capital requirements under IA Act of 1940. The only authority the states have over SEC-registered advisers is anti-fraud and notice filing authority.

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

Registration of Persons

The Series 65/66 exam usually asks several questions about registration issues for broker-dealers, investment advisers, and their agents/IARs. It helps to keep a little flow chart in your head, like the ones we published at http://www.passthe66.com/updates/.

For now, let's work through it with words. When you get a question about registration issues for "persons" in the securities business, the first question to ask is, "Do they have a place of business in the state?" If the answer is "yes," then the broker-dealer, agent, or investment adviser representative has to register in that state.
Period.
If the investment adviser has a place of business in the state, the adviser has to register with that state, unless they can claim eligibility for federal registration. If the adviser has $25 million or more under direct management, or if they manage investment company portfolios, or if they can click another of about a dozen reasons, they will register with the SEC. The state(s) where they have a place of business or more than 5 non-institutional clients will receive copies of the SEC paperwork, called "notice filings."
So, the first question is, "Do they have a place of business in the state?" If the answer is "no," the next question is, "Do they have non-institutional investors in that state?" If not, the agent, broker-dealer, investment adviser and investment adviser representative are excused from registration. If they want to start soliciting clients in the other state, they have to register, but if their only clients in the other states are institutional investors--pension funds, mutual funds, banks, insurance companies, advisers, broker-dealers--then they do not have to register in the other state. However, if the agent or broker-dealer have any non-institutional clients in the state, they have to register in that state, even if they don't have a place of business there. The adviser or IAR, on the other hand, can have up to 5 non-institutional clients in the other state without registering, as long as they're not soliciting new clients or "holding themselves out to the public as investment advisers."

Believe it or not, that's about as simple as we can make it. Although a picture may be clearer. Click that link above and check out the three Word Documents.

5 out-of-state clients

On the Series 65 or 66 exam there will likely be at least one question about registration issues for investment advisers with clients in other states. Maybe something like this:

Barry Mundy is a financial planner with a place of business in State A. Recently, three of his clients moved to State B. Barry has recently placed a billboard in State B offering a "total financial check-up, free of charge" with an 800-number and a link to a website. Therefore
A. Barry must register in State B because he is holding himself out to the public as an investment adviser in State B
B. Barry must register in State B because the clients who moved there were existing clients
C. Barry is exempt from registration requirements in State B because the number of clients there is 3
D. Barry is eligible for federal covered status due to the multi-state adviser exemption

You might have memorized the number 5 and decided that an out-of-state adviser with no more than 5 clients in State B is exempt from registration requirements there. And he is. Except when he isn't. See, that exemption is based on the fact that he is not holding himself out as an adviser in State B. Barry Mundy is definitely holding himself out as an investment adviser in State B, and right there he has to register in State B. He doesn't get to solicit clients and then stop when he gets to 5 . . . or solicit 5 clients. He's either soliciting clients in State B or he isn't. If he is, he has to register there. If he isn't, he can have 5 clients in that state without registering there. Most likely, they're existing clients or referrals . . . but if he wants to drum up business in State B, he needs to register there.

So the answer above is A.

Real World De Minimis

I just had a former client, who passed his Series 66 with an 80%, send me an email wondering if the de minimis exemption for out-of-state advisers with 5 clients actually applies in the real world, since he has 1 client in the state of Colorado but no place of business there.

Here is Question 8 and the answer from the Colorado Division of Securities website:

Q: Are there any exemptions from licensing for an IA located in another state, that are not FCAs?
A: The law contains a diminimus exemption from licensing for an IA that has no place of business in Colorado and has five or less clients in Colorado.

By "FCA" can you guess what they mean? Federal Covered Adviser. So, if I'm not a federal covered adviser, I have no place of business in Colorado, can I have 5 clients there without registering there? Yes. This saves you some time and money. Of course, if you defraud these Colorado residents, Colorado can come after you, and so can your state securities Administrator. But, you don't plan to do anything like that, of course.

And, of course, things change when the adviser employs an IAR with a place of business in Colorado, as # 9 on the website explains:

Q: What is required of an IA located in another state that is not a FCA, has five or less clients in Colorado and employs one or more IARs with a place of business in Colorado?
A: The difference between this question and the one immediately above is the IA employs IARs with a place of business in Colorado. It does not matter how many clients are located in Colorado. An IA should file a current Form ADV and pay the appropriate fee. For each IAR with a place of business in Colorado the IA shall file a Form U-4 for each individual and pay the IAR fee.

As you can see--and as I've written before--much of the information that you study for your exam is connected to the real world. It's just buried under a bunch of tricky exam questions filled with mumbo-jumbo. But the de minimis exemption is 5 on the test and 5 in the real world. Just thought you'd like to know that.