Post-registration obligations
Once an investment adviser achieves effective registration, they are legally permitted to operate in a state. The adviser must fulfill a number of post-registration obligations to maintain their registration, including:
- Record retention
- Brochure delivery
- Brochure updates
- Custody rules
- Registration withdrawal
Record retention
We learned that broker-dealers are required to maintain records of numerous business documents in a previous chapter. The Uniform Securities Act (USA) requires investment advisers to do the same.
”Every registered broker-dealer and investment adviser shall make and keep such accounts, correspondence, memoranda, papers, books, and other records as the [Administrator] prescribes by rule or order”
Given the requirements are essentially the same, use the broker-dealer post-registration obligations chapter if you need a refresh.
There is one area where post-registration obligations are different for investment advisers. The length of time documents must be maintained is 5 years (instead of 3 years for broker-dealers), with the records created within the past 2 years being readily available.
Brochure delivery
We previously discussed Form ADV Part 2, also known as combination of the brochure (Part 2A) and brochure supplement (Part 2B). As a reminder, this document provides much of the important information an adviser should disclose to its clients, including:
Form ADV Part 2A (brochure)*
- General business characteristics
- Fees and compensation
- Types of clients (the adviser usually handles)
- Investment philosophy
- Disciplinary information
- Conflicts of interest
Form ADV Part 2B (brochure supplement)*
- Personnel-related information, including:
- Business history
- Education history
- Disciplinary history
*We’ll refer Form ADV Parts 2A and 2B simply as “the brochure” for the remainder of this chapter. While only one part is technically considered the brochure (2A), test questions tend to refer to both simply as “the brochure.”
North American Securities Administrators Association (NASAA) rules require advisers deliver the brochure to clients in a very particular manner. The brochure-specific rule starts out with this generality:
“Unless otherwise provided in this rule, an investment adviser… shall… furnish each advisory client and prospective advisory client with a written disclosure statement which may be a copy of Part II of its Form ADV or written documents containing at least the information then so required by Part II of Form ADV, or such other information as the [Administrator] may require.
In other words, advisers must deliver the brochure and brochure supplement to every client and prospective client. A prospective client is a person the adviser is attempting to bring on as a client. Not only does the NASAA rule require delivery of the brochure, but it is very explicit on the timing of that delivery. In their own words:
An investment adviser… shall deliver the [brochure]… to an advisory client or prospective advisory client:
- Not less than 48 hours prior to entering into any investment advisory contract with such client or prospective client; or
- At the time of entering into any such contract, if the advisory client has a right to terminate the contract without penalty within five business days after entering into the contract.
This is an ‘either/or rule,’ not ‘and.’ Meaning, the adviser meets brochure delivery requirements by fulfilling one of the two obligations above (never both). Let’s go through an example to better understand this rule.
Let’s assume a prospective client shows up at your office on a Friday to inquire about your firm’s advisory services. You give them your “elevator pitch” and discuss some of the products and services your firm offers. As you conclude your discussion, you provide the client with the brochure.
The prospective client loves all the information you discussed, but says they’ll need some time to think it over before signing a contract. On Monday, they return and agree to have your firm manage their account. They sign a contract and effectively become a client of the adviser. In this situation, the first delivery requirement was fulfilled. Prior to entering into the contract, the client was provided access to the brochure for at least 48 hours (provided on Friday, contract signed on Monday). Therefore, the advisor met their delivery obligation.
What if the client wanted to sign the contract on Friday instead of waiting? This is possible, but the situation must be handled differently. If having access to the brochure for 48 hours prior to contract signing isn’t possible, the second delivery rule kicks in. The adviser must now give the client a five business day “free look window,” meaning they can terminate the contract without penalty within that period of time. The adviser may charge the client for services rendered (e.g. management fees), but cannot penalize the investor for canceling the contract. Outside of five business days, they may charge surrender or cancellation fees.
The brochure and brochure supplement may be delivered physically or electronically. Electronic delivery requires client consent and verification the client is able to access the document. Additionally, the brochure is made publicly available by the regulators on a site called the Investment Adviser Public Disclosure (IAPD).
While Form ADV Part 2 must be delivered to most clients, there are two exceptions.
The delivery of the [brochure and brochure supplement] need not be made in connection with entering into:
- An investment company contract; or
- A contract for impersonal advisory services requiring a payment of less than [$500]*
*The original NASAA brochure rule made reference to impersonal advisory services of less than $200, but the number has since been updated to $500.
An adviser to a registered investment company (e.g. mutual fund, closed-end fund) does not need to deliver a brochure. Also, a quick reminder - the adviser would be considered federal-covered if hired to provide advice to an investment company. Therefore, it’s kind of a redundant rule; federal-covered advisers are not subject to state regulation (the SEC has its own brochure delivery requirement). Bottom line - there’s no need to deliver the brochure to any investment company client.
Impersonal advisory services are defined as:
- Statements which do not purport to meet the objectives or needs of specific individuals or accounts
- Through the issuance of statistical information containing no expression of opinion as to the investment merits of a particular security
- Any combination of the foregoing services.
In plain English, impersonal advisory services are products or services that do not offer direct recommendations on specific securities to specific individuals. An example of this would be a market newsletter that provides general commentary on the securities markets. While the information provided in the newsletter contains specific information related to securities, many times it’s informational and styled similarly to news and other media programs. If an adviser sold subscriptions to a newsletter like this for less than $500, there would be no legal requirement to deliver the brochure to those customers.
Brochure updates
Investment advisers must continually update their brochure when material changes occur, and are additionally obligated to provide an annual update to the regulators and clients. The following is made available on a NASAA FAQ (frequently asked question) page:
When must Form ADV be amended?
A firm should file the annual updating amendment within 90 days of the close of its fiscal year (e.g., by March 31st for firms on a calendar-year basis). The firm should update information that has changed, including recalculating regulatory assets under management. During the year, if there are material changes to the information on the Form ADV, the firm should do an “other-than-annual” amendment within 30 days of the change. State regulators can answer questions about whether a change is deemed material.
Let’s analyze this statement. First, firms are required to submit an updated amendment within 90 days of the close of their fiscal year. The amendment will include any changes made to the business over the course of the year, including new states the adviser is registered in or a change to the adviser’s investment philosophy. Additionally, the adviser must disclose their current assets under management, which will determine if the adviser should be registered with the state or the SEC (as a federal-covered adviser).
When those updates are made, the brochure is updated and must be sent to clients as well. While the updates must be filed with the administrator within 90 days of fiscal year end, clients must be sent the updated brochure within 120 days of fiscal year end.
Advisers must also update their Form ADV promptly (within 30 days) if a material change occurs during the year. While NASAA doesn’t explicitly define a material change (“state regulators can answer questions about whether a change is deemed material”), it’s considered any significant change worthy of updating the state administrator(s) and/or the adviser’s clients. This would include items such as any criminal or civil enforcements, regulatory actions by the state administrator, or any substantial changes to the business.
Custody
We’ve already discussed custody at a few points in this material. Let’s define what it is again:
NASAA rules go on to define custody further. Custody also includes:
Possession of client funds or securities unless the investment adviser receives them inadvertently and returns them to the sender within three business days of receiving them and the investment adviser maintains the records
Custody could exist if a client mistakenly sends a check, wires funds, or transfers securities into the possession of the adviser. For example, what if the investment adviser recommends the purchase of a Vanguard mutual fund, and the client mistakenly sends the payment to the adviser instead of their Vanguard account? As long as payment is returned to the client or forwarded to the proper destination in three business days, custody has not occurred.
If more than three business days elapse, the adviser has taken custody. Later in this chapter, we’ll learn all the steps an adviser must take prior to taking custody. Obviously, these obligations will not take place if a check or payment is held too long, resulting in the adviser breaking custody laws.
Any arrangement… under which the investment adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the investment adviser’s instruction to the custodian
Merely having access to client funds or securities is considered custody. For example, this would include the ability to pull funds directly from a client’s bank account.
Any capacity… that gives the investment adviser or its supervised person legal ownership of or access to client funds or securities.
Custody also includes giving an adviser ownership over funds or securities, or legal authority over those funds or securities. The most common example of this involves appointing an adviser as the trustee of a trust. Trusts are legal entities set up to benefit a specific beneficiary (e.g. a family trust). Trustees are legally appointed to manage the trust, giving them full access to any securities or funds owned by the trust. If an adviser is appointed as trustee of a trust, they legally have custody of that trust.
Investment advisers often have unaffiliated broker-dealers maintain custody on their behalf. Although uncommon, it is possible an adviser takes custody themselves (or has an affiliated business do it). In order to do so, these obligations must be fulfilled:
- Confirm state administrator allows custody
- Notify the state administrator
- Place funds with a qualified custodian
- Provide quarterly statements
- Annual surprise audit
Confirm state administrator allows custody
While most states allow it, there’s a considerable number of states (roughly 13 at the time of this writing) that outright prohibit investment advisers from taking custody. If an adviser is operating in any of these states, they simply cannot take custody. There’s no need for the adviser to obtain permission; a state either allows it, or they don’t.
Notify state administrator
If operating in a state that allows custody, the investment adviser must notify the state administrator on Form ADV. There are multiple parts of the form that require this disclosure, including the brochure (Form ADV Part 2A).
Place funds with qualified custodian
An investment adviser can’t simply “hold” their clients’ funds or securities. They must have the assets placed with a qualified custodian, which is an organization that specializes in holding these assets. Banks, savings associations, broker-dealers*, and other financial institutions typically meet the definition of a qualified custodian. If an adviser wants to take custody itself, it must place those funds with an affiliated entity (another part of the company) that is qualified to take those deposits.
*When we’ve discussed broker-dealers typically maintaining custody for investment advisers, we’re referring to unaffiliated broker-dealers (meaning they’re not part of the same organization or company). If an adviser wants to take custody themselves, they may have an affiliated broker-dealer that’s owned by the same parent company do it for them.
Provide quarterly statements
It’s important for investors to keep track of activity in their accounts. Nowadays, account information can typically be checked at any time online. Regardless, investment advisers must send their client statements with balances and account activity at least once a quarter (every three months).
Balance sheet disclosure (state only)
Investment advisers that maintain custody of client assets must additionally disclose a balance sheet in their brochure. This rule only applies to state-registered advisers, as the Investment Advisers Act of 1940 (the law governing federal-covered advisers) does not require this additional disclosure.
Annual surprise audit
NASAA rules also require an annual surprise audit of the adviser’s books and records to ensure their compliance with proper recordkeeping and custodial guidelines. Every year, an independent auditor (typically a CPA) will show up at the investment adviser’s place of business without prior notice (surprise!). If the auditor notices something materially wrong with the adviser’s custody system, they must notify the administrator within one business day. If nothing seems out of place, the auditor will file Form ADV-E (E stands for ‘examination’) with the state administrator within 120 days of the audit. This is the only relevant version of Form ADV that is not filed by the investment advisers.
Investment advisers tend to avoid taking custody in order to avoid the long list of obligations listed above. In most scenarios, custodial services are “farmed out” to broker-dealers and other financial institutions whose business is built around custodial services. Remember - advisers primarily offer securities advice and collect advisory fees.
Registration withdrawal
All good things eventually come to an end. Investment advisers can operate indefinitely as long as they maintain their registration status, operate ethically in the industry, and follow applicable rules & regulations. Regardless, numerous investment advisers shut down their businesses annually. Whether it’s due to a lack of clients, retirement, or any other reason, a disclosure must be made to the state administrator when this occurs.
The disclosure is made through Form ADV-W, which typically takes effect 30 days after filing. After registration is withdrawn, the business can no longer legally operate. Regardless, the adviser is still subject to regulatory actions for a period of up to a year after withdrawal. If the adviser was engaged in an unethical or improper action prior to their withdrawal, the administrator may suspend or revoke their registration. This would accomplish two things - first, the punishment would be disclosed publicly. Second, it would make it difficult for the adviser to re-enter the industry in the future.
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