Similar to broker-dealers, investment advisers must meet certain financial requirements to register with a state. Broker-dealers must meet minimum net capital requirements, while investment advisers are subject to net worth requirements. You don’t need the detailed differences here - just remember the association:
State-registered advisers register only with the state, so they aren’t subject to SEC financial requirements. (This differs from broker-dealers, which register with both the SEC and the states.)
Because each state can set its own net worth requirement, a practical question comes up: what if an adviser is registered in multiple states with different requirements? Under North American Securities Administrators Association (NASAA) rules, the adviser follows the financial requirements of the state where its principal place of business (headquarters) is located. Even if another state has a higher requirement, only the home state’s requirement determines the minimum net worth standard.
While requirements can vary by state, many states use these common minimums:
Advisers exercising discretion
Advisers maintaining custody
If an investment adviser accepts a large prepayment of fees for services that won’t be provided for at least 6 months, the adviser may have to make additional disclosures to clients. For state-registered advisers, this threshold is met when the adviser collects:
If the adviser collects a large prepayment of fees, it must include a balance sheet* in its brochure. A balance sheet shows the firm’s assets and liabilities, which is why many advisers prefer to avoid triggering this disclosure.
*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 may also be subject to surety bond requirements, similar to broker-dealers. Whether a bond is required depends on the state administrator’s policies, which can vary from state to state. In general, the surety bond concept for investment advisers works the same way it does for broker-dealers.
An investment adviser might meet the net worth requirement at the time of registration, but later fall below the minimum.
For example, an adviser that does not maintain custody is granted effective registration when its net worth is $15,000. Several months later, its net worth drops to $8,000. The minimum for advisers not taking custody is $10,000.
When this happens, NASAA rules require the adviser to:
So, if the adviser falls below the minimum on Monday, it must notify the administrator by Tuesday and file the 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 is how the adviser typically addresses the shortfall. NASAA rules generally require the adviser to post a surety bond equal to the shortfall, rounded up to the nearest $5,000 increment.
For example, 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. That’s an $8,000 shortfall ($35,000 required vs. $27,000 actual). Because the bond amount must be rounded up to the nearest $5,000 increment, the adviser would be required to obtain a $10,000 surety bond after making the required disclosures to the administrator.
Advisers that take custody or maintain discretion over client accounts must also disclose significant financial problems when those problems could affect the adviser’s ability to meet its obligations to clients. Specifically, disclosure is required if the adviser believes its financial condition may hinder its ability to fulfill its obligations.
For example, an adviser with substantial liabilities and limited assets may not be able to keep enough investment adviser representatives (IARs) on staff. That could interfere with services the adviser has promised clients (such as being able to reach an IAR about account status). In situations like this, the adviser must notify clients promptly.
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