Similar to broker-dealers, investment advisers are subject to financial requirements to be granted registration with the state. While broker-dealers must meet minimum net capital requirements, investment advisers are subject to net worth requirements. Don’t worry about the differences or specifics, but it’s important to know the associations (BDs subject to net capital, IAs subject to net worth).
State-registered advisers are only registered with the state (obviously), and therefore aren’t concerned with SEC requirements (unlike broker-dealers, who register with the SEC and the states). Each state establishes its own net worth requirements, which presents a new challenge. What if an adviser is registered with multiple states, and all of them have different net worth requirements? North American Securities Administrators Association (NASAA) rules require investment advisers to abide by the financial requirements of the state where their principal place of business (headquarters) is located. Even if another state has a higher requirement, it’s only one state that determines the minimum net worth requirement.
While there are differences state-to-state, many states maintain the same requirements:
Advisers exercising discretion
Advisers maintaining custody
When an investment adviser takes a large prepayment of fees for services that will not be provided for at least 6 months, they may be required to make additional disclosures to their clients. State-registered advisers are considered subject to these additional disclosures if collecting:
If collecting what’s considered a large prepayment of fees, investment advisers must disclose a balance sheet* in their brochure. Balance sheets provide insight into the firm’s assets and liabilities, and most advisers want to avoid providing this information. If you run a business, would you want to disclose the inner workings of your company’s finances if you didn’t need to?
*A balance sheet must also be included in the brochure if a state-registered investment adviser maintains custody of client assets (discussed in a future chapter).
Investment advisers can be subject to surety bond requirements, similar to broker-dealers. The requirement depends on the state administrator’s policies, which can differ from state to state. Surety bond obligations for investment advisers are essentially the same for broker-dealers. If you need a refresher, click the link above to revisit the previous chapter that covered this topic.
It’s possible an investment adviser obtains registration with the appropriate net worth level, but then sees its net worth fall below minimum requirements. For example, an investment adviser not maintaining custody is granted effective registration when their net worth was $15,000, but several months later their net worth falls to $8,000. As a reminder, the minimum for advisers not taking custody is $10,000.
When this occurs, NASAA rules require investment advisers to notify the state administrator by the end of the next business day. Additionally, they must file a report regarding their financial situation by the end of the following business day. To put this in perspective, an adviser falling below minimum net worth requirements on Monday must notify the administrator by Tuesday, and file the financial report by Wednesday.
The financial report includes the following information*:
*The specifics of the financial information shared with the administrator are not important. Test questions tend to focus on what must be provided, not the characteristics.
**Segregated accounts are those that are stand-alone accounts owned by customers. Sometimes, investment advisers utilize omnibus accounts, where they place all their client’s funds and assets into one large account. The funds in this type of account are not considered segregated.
One additional item worth noting relates to “fixing” this problem. NASAA rules typically require advisers to post surety bonds in the amount of the shortfall, rounded up to the nearest $5,000 increment.
For example, let’s assume an adviser takes custody and is subject to the $35,000 minimum net worth requirement. The adviser’s net worth falls to $27,000. There’s an $8,000 shortfall ($35,000 requirement vs. $27,000 actual), but the surety bond requirement must be rounded up to the nearest $5,000 increment. After making the necessary disclosures to the administrator, the adviser will be required to take out a $10,000 surety bond.
Advisers that take custody or maintain discretion over clients’ accounts are also under an obligation to disclose their status if facing significant financial problems. In particular, this type of disclosure must be made if the adviser believes its financial condition may hinder its ability to fulfill its obligations to clients.
For example, an adviser with a significant number of liabilities and a small amount of assets may not be able to keep enough investment adviser representatives (IARs) on staff. Faced with these challenges, it’s possible the adviser fails to fulfill promises made to clients (e.g. the ability to contact an IAR regarding their account status). In this example and similar circumstances, the adviser must notify its clients promptly.
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