IAs and the SEC

UPDATED FOR CHANGES EFFECTIVE JANUARY 1, 2000

After July 8, 1997, generally only larger advisers that have $25 million or more of assets under management, that provide advice to investment company clients or who are required to be licensed in 30 or more states will be permitted to register with the SEC. Advisers with less than $25 million of assets under management and those advisers such as fee-only planners or those who give advice which is acted upon at the discretion of the client, are regulated solely by state securities agencies in 49 states. Only the following types of advisers are permitted to register with the SEC [and therefore must register with the SEC, unless exempt under section 203(b)] of the Act:

Advisers that have "assets under management" of $25 million or more. Advisers to registered investment companies. Advisers who would be required to be licensed in 30 or more states. Advisers that have their principal office and place of business in a state that has not enacted an investment adviser statute (currently, only Wyoming), or that have their principal office and place of business outside the United States. Advisers that are exempted from the prohibition by SEC rule or order.

The SEC has adopted a rule exempting four categories of investment advisers from the prohibition on registration:

Nationally recognized statistical rating organizations ("NRSROS"). [Rule 203a-2(a)] Pension consultants that provide investment advice with respect to $50 million or more of plan assets. [Rule 203a-2(b)] Certain investment advisers sharing the same principal office and place of business with an affiliated investment adviser that is registered with the SEC. [Rule 203a-2(c)] Certain newly-formed investment advisers that have a reasonable expectation of being eligible for SEC registration within 120 days of formation. [Rule 203a-2(d)]

For additional information on the prohibition on SEC registration, refer to Investment Advisers Act Release Nos. 1633 (May 15, 1997) and 1733 (July 17, 1998).

Should your business change such that you meet one of the criteria above, you may elect to change from state regulation to SEC regulation. Such a change should only be considered when you are sure your business will continue to meet the criteria for federal registration. For instance, if you have assets under management that grow beyond the $25 million mark, you should not immediately apply for SEC registration unless you are certain that the assets will not drop below that level.

To prevent problems with constantly fluctuating asset values forcing numerous changes between state and federal regulation, a $5 million window has been instituted whereby your assets can grow to $30 million before you must switch from state licensing to SEC registration. This provision allows you to voluntarily switch from state to SEC above $25 million but does not make it mandatory until your assets go above $30 million.

You may include assets in brokerage accounts as assets under management if you provide those accounts with continuous and regular supervisory or management services. The test for determining whether brokerage accounts receive continuous and regular supervisory or management services is the same as for all other types of client accounts. Accounts where the adviser regularly reviews the portfolio and makes independent investment decisions would meet the criteria. Likewise, certain types of "switch" activities where the adviser is constantly monitoring mutual funds to be switched on predetermined market indicators would qualify. Typically, only accounts over which a securities agent or broker-dealer has discretionary authority would receive continuous and regular supervisory or management services. Merely reviewing a monthly statement and telling a customer what the gain or loss was for the month is not continuous and regular supervision which would qualify as assets under management.

At the time of renewal of your state license, you will be required to file a completed Schedule I to Form ADV on which you will disclose your assets under management. If your assets under management remain over $30 million for 90 days beyond the filing of the Schedule I, you must register with the SEC within 90 days of filing that Schedule I.

If you do become eligible to be a federal covered adviser, you should not withdraw your state license until your SEC registration becomes effective. You should then file an amended Form ADV with the Division with Part I, Question 7 marked "4" for each state where you were previously licensed and "2" for the SEC. You will be required to pay a Notice Filing Fee of $200 for your new status as a federal covered adviser; previous licensing fees are not refunded or applied.

CONTINUED SEC AUTHORITY

Investment advisers who are now required to be state licensed are generally subject only to state investment adviser regulations. However, the SEC still retains jurisdiction over state licensed advisers in a number of areas. Perhaps foremost is Section 206 of the Act, the anti-fraud provision, which prohibits misstatements or misleading omissions of material facts and other fraudulent acts and practices in connection with the conduct of investment advisory business. As a fiduciary, an investment adviser owes its clients undivided loyalty, and may not engage in activity that conflicts with a client's interest without the client's consent. In S.E.C. v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), the United States Supreme Court held that, under Section 206, advisers have an affirmative obligation of utmost good faith and full and fair disclosure of all material facts to their clients, as well as a duty to avoid misleading them. Section 206 of the federal Statutes applies to all firms and persons meeting the Act's definition of investment adviser, whether registered with the SEC, a state securities authority, or not at all.

Other provisions of the Act that apply to state licensed advisers include:

Section 204a, which requires advisers to establish, maintain, and enforce written procedures reasonably designed to prevent the misuse of material nonpublic information. Section 205, which contains prohibitions on advisory contracts that (i) contain certain performance fee arrangements, (ii) permit an assignment of the advisory contract to be made without the consent of the client, and (iii) fail to require an adviser that is a partnership to notify clients of a change in the membership of the partnership. Section 206(3), which makes it unlawful for any investment adviser acting as principal for its own account to knowingly sell any security to, or purchase any security from, a client, without disclosing to the client in writing before the completion of the transaction the capacity in which the adviser is acting and obtaining the client's consent. (The exemption provided in rule 206(3)-2 from the prohibitions of section 206(3), however, is available to all advisers, including state licensed advisers.)