The Series 63 is a state-based exam primarily focused on the Uniform Securities Act (USA). The vast majority of the test will relate to state laws, rules, and regulations. However, you are likely to be questioned on certain aspects of federal laws. We already encountered some of these concepts with broker-dealers, which are required to register with both the Securities and Exchange Commission (SEC) and each relevant state administrator.
Investment advisers, which are financial firms in the business of providing advice, operate differently. Before we go into the specifics, we need to first discuss the federal law regulating investment advisers. The Investment Advisers Act of 1940 (IA40) was enacted to regulate entities that provide investment advice in a professional capacity. IA40 is a federal law, applicable only to investment advisers that register directly with the SEC.
In the mid-1990s, the National Securities Market Improvement Act of 1996 (NSMIA) was enacted to reduce over-regulation and promote efficiency in the securities markets. Prior to this legislation, investment advisers were required to register with both the SEC and each relevant state administrator (similar to how broker-dealers operate). In some circumstances, rules and regulations conflicted at the two different levels, causing confusion among investment advisers (who do you listen to - the state administrator or the SEC?). NSMIA effectively divided investment advisers into two different categories: state-registered and federal-covered.
NSMIA created the term federal-covered adviser, which is an investment adviser subject to SEC registration and regulation, and excluded from state registration and regulation. Although federal-covered advisers are not required to register with the state administrator, they are still obligated to provide a notice filing in every state they plan on doing business. We’ll discuss more about this type of filing in the next chapter.
The primary reason an investment adviser qualifies as a federal-covered adviser (or, sometimes referred to as simply a ‘covered’ or ‘SEC adviser’) relates to assets under management (AUM). This is a measurement of the value of the assets an adviser manages on behalf of its customers. The larger an adviser’s AUM, the more likely they’re considered federal-covered.
Another law defined these numbers specifically - the Dodd-Frank Wall Street Reform Act (usually referred to as Dodd-Frank). Dodd-Frank specifically defined three categories of investment advisers:
Large investment advisers
Advisory firms with at least $100 million of AUM are considered large investment advisers. Once a firm obtains $100 million of AUM, they are eligible to register with the SEC as a federal-covered adviser. If the firm exceeds $110 million of AUM, it must register with the SEC as a federal-covered adviser.
Advisers tend to register as federal-covered advisers once they reach $100 million of AUM. In fact, Dodd-Frank allows advisers that expect to reach at least $100 million of AUM within 120 days to register as a federal-covered adviser (meaning they’re eligible, but are not required to do so). Many advisers continue to grow their business by bringing in new clients and through capital appreciation (growth) of the assets they manage. However, what if an adviser’s AUM starts declining due to losing clients or investments losing value?
Federal-covered advisers that qualify for SEC registration may maintain their federal-covered status until they fall below $90 million AUM. At this point, the adviser is forced to withdraw their federal registration and register with all relevant states.
AUM fluctuates on a daily basis due to inflows and outflows of client assets, and market activity. So, what if an adviser drops below $90 million for a day, then bounces back above? Thankfully, these numbers are only looked at once per year. At the end of an adviser’s fiscal year, they are obligated to file paperwork (discussed in detail in the next chapter) updating the state administrator on changes made to the business over the past year. It is at this time the adviser will declare their current AUM level.
It’s possible to see a test question relating to how quickly an adviser must change their registration. A state-registered adviser that reaches $110 million of AUM has 90 days from filing their annual updates to register with the SEC. Conversely, a federal-covered adviser that falls below $90 million AUM has 180 days to de-register from the SEC and register with the appropriate state administrators.
Mid-size investment advisers
Advisory firms with at least $25 million of AUM, up to $100 million AUM, are considered mid-size investment advisers. Firms in these categories tend to register with relevant state administrators. There are a few circumstances where a mid-size adviser becomes eligible for SEC registration as a federal-covered adviser:
*Don’t worry about the specifics here. The language quoted above comes directly from SEC rules and refers to uncommon situations. Understanding that advisers in these situations could be considered federal-covered advisers is the important part. Don’t worry about the context.
Small investment advisers
Advisory firms with less than $25 million of AUM are considered small investment advisers. Similar to mid-size advisers, small advisers are typically state-registered. However, it’s still possible for a small adviser to be federal-covered. The only relevant exception for small advisers is the multi-state adviser rule (cited above). If operating in 15 or more states, the adviser qualifies for SEC registration as a federal-covered adviser.
In addition to AUM size, NSMIA defined two other circumstances an adviser would be considered federal-covered:
Investment companies offer various types of investment products. You’ve probably heard of a mutual fund, which is considered a type of investment company product. Investors buy shares in the fund, effectively placing their money in a pool with other investors’ money (basically a large account). A financial professional manages those assets according to a specific investment objective. For example, one of the largest mutual funds in the world is the Vanguard 500 Index Fund, which aims to provide its investors the same return as the S&P 500.
Most investment companies operate similarly. You don’t need to know the characteristics of investment companies, but you do need to know an investment company when you see one. Here are the categories and subcategories of investment companies:
Investment companies are registered and regulated under the Investment Company Act of 1940, which is a federal law enforced by the SEC. While you don’t need to know much about these types of securities, you must assume investment advisers are hired to manage these funds.
For example, the Vanguard fund discussed above is managed by a registered investment adviser known as Vanguard Equity Index Group. This firm (which is a subsidiary of Vanguard) is a federal-covered adviser, registered and regulated by the SEC. The same would go for any other investment adviser hired to manage an investment company.
The IA40 explicitly excludes several persons in various circumstances from the definition of an investment adviser. Many of these exclusions overlap with the state, and we’ll cover those in depth later in this unit. There’s one specific exclusion that does not exist in the USA.
A person who provides advice solely on US Government securities is excluded from the definition of an investment adviser according to federal laws. There’s no mention of this exclusion in the USA. Regardless, the state administrator has no power to enforce registration and regulation on a person the SEC and IA40 exclude from registration. If federal laws and regulators exclude a specific person or circumstance, the states have no power to enforce regulation themselves. Therefore, this rule also applies at the state level.
In case you’re wondering, here are the most commonly referenced US Government securities:
You don’t need to know the characteristics of these securities for the Series 63 exam. Be aware these are safe securities, are backed by the US Government, and persons that only provide advice on these securities are excluded from the definition of an investment adviser.
The way this rule is enforced can be attributed to NSMIA. One of the components of this law states that federal rules and regulations supersede state rules and regulations. If there’s common jurisdiction, federal laws will always prevail. This is why state administrators can’t enforce higher financial requirements on broker-dealers than the SEC.
It’s different with investment advisers because they register with either the SEC or the states (not both). One of the purposes of NSMIA was to reduce conflicting laws between federal and state regulators, and it successfully accomplishes this for the most part. With the “line in the sand” drawn between state-registered and federal-covered advisers, compliance with relevant laws is easier. State-registered advisers generally are subject to the laws of the USA, while federal-covered advisers are subject to the laws of the IA40.
The following video summarizes the key points from this chapter:
Sign up for free to take 7 quiz questions on this topic