Disclosures

In addition to making disclosures to the state administrator during the registration process, broker-dealers and investment advisers must also make ongoing disclosures to their clients. This chapter covers three categories of client disclosures:

• Broker-dealer disclosures
• Investment adviser disclosures
• General disclosures

Broker-dealer disclosures

In the previous chapter, we covered the various fees broker-dealers may charge outside of commissions, markups, and markdowns. Those fees are disclosed in fee schedules that must be made available to customers.

The North American Securities Administrators Association (NASAA) offers a model fee disclosure template that many broker-dealers use. Broker-dealers typically provide this information in account applications and on their websites.

Investment adviser disclosures

An investment adviser’s most important disclosures are typically presented in the brochure. Here are the three key parts of that disclosure package:

• Form ADV Part 2A - The brochure
• Form ADV Part 2A Appendix 1 - The wrap fee program brochure
• Form ADV Part 2B - The brochure supplement

The main purpose of these documents is to help clients understand the person they’re trusting with their money. They describe the products and services offered and provide background on the firm and its investment adviser representatives (IARs). If the adviser (or an IAR) has a disciplinary or criminal history, that information can be found in the brochure.

Solicitors for state-registered advisers

NASAA disclosure-related rules also regulate solicitors, sometimes called promoters. NASAA defines a solicitor as follows:

“Solicitor” means any individual, person, or entity who, directly or indirectly, receives a cash fee or any other economic benefit for soliciting, referring, offering or otherwise negotiating for the sale or selling of investment advisory services to clients on behalf of an investment adviser.

In practical terms, a solicitor is anyone who is compensated for connecting potential clients with an adviser. A solicitor might be an employee of the adviser, or an independent third party. For example, a marketing professional might network locally and refer prospective clients to an adviser.

Definitions

Prospective client

A person a financial professional aims to sign as a client

This arrangement is permitted as long as required procedures are followed and disclosures are made. Under the rules for solicitors of state-registered advisers, the solicitor must:

• Be registered as an IAR
• Not be subject to a statutory disqualification
• Maintains a written agreement with the adviser
• Must deliver brochures
• Obtains signed receipt of brochures from a prospective client

Be registered as an IAR
The solicitor must be registered as an IAR of the firm for which they are soliciting business.

Not be subject to a statutory disqualification
Solicitors are treated like other securities professionals. If a solicitor is subject to a statutory disqualification, they can’t solicit on behalf of an adviser. Statutory disqualifications are past actions or sanctions that prevent a person from becoming registered (effectively barring them from the industry). We covered these in a previous chapter. A person is statutorily disqualified if they are:

• Subject to denial, suspension, or revocation by any securities regulator
• Any felony or securities-related misdemeanor conviction in the past 10 years
• Subject to any injunction or other court-related order prohibiting work in the securities industry
• Has filed a registration application with inaccurate or false information
• Has willfully violated a securities act (e.g. Uniform Securities Act, Investment Advisers Act of 1940)

Maintains a written agreement with the adviser
Solicitor rules require a written agreement between the adviser and the promoter. The adviser must keep this agreement in its records, and the state administrator may request it. The agreement must describe:

• The solicitation activities the solicitor will be engaged in
• How the adviser will ensure all applicable laws and regulations will be followed

Must deliver brochures
When soliciting a prospective client, the solicitor must deliver two brochures.

• The adviser must provide Form ADV Part 2A (the adviser’s brochure) in writing.
• The solicitor must also provide a separate solicitor’s brochure in writing.

The solicitor’s brochure must disclose:

• Name of the solicitor and the adviser they’re soliciting for
• Nature of the relationship between the solicitor and the adviser
• A statement confirming the solicitor is being compensated for their services
• Terms and description of the compensation to be received by the solicitor
• Disclosure if the client will be charged a higher fee than normal to compensate the solicitor

Obtains signed receipt of brochures from a prospective client
After delivering both brochures, the solicitor must obtain a signed receipt from the prospective client confirming that both disclosures were received. The investment adviser must keep the signed receipt in its records.

Sidenote

Solicitation of impersonal advisory services

The promoter is not required to register as an IAR if they only solicit impersonal advisory services. For example, a solicitor attempts to sell an adviser’s newsletter that includes market commentary and general recommendations (nothing specific to any one client).

Sidenote

Nominal fees

A third party may refer clients to an adviser and still not be treated as a solicitor if the compensation is a nominal fee (generally no more than a few hundred dollars). This often happens when professionals in other industries recommend an adviser’s services. For example, an accountant may recommend an adviser in return for a $200 finder’s fee. In that case, the accountant would not be required to follow the solicitor rules above (although general ethical guidelines still apply).

Regulators pay close attention to arrangements where a third party shares in asset under management (AUM) fees. If AUM-based compensation is shared with the third party, it would not be considered a nominal fee, and the normal solicitor rules would apply.

Solicitors for federal-covered advisers

Before 2020, solicitor rules for federal-covered advisers were largely similar to state rules. In 2020, the Securities and Exchange Commission (SEC) adopted a new rule that simplified how solicitors are regulated.

The solicitor must disclose the following:

• If they’re a client of the adviser
• If they’re being compensated and, if so, how much
• Any conflicts of interest related to their relationship with the adviser

Additionally, these rules must be followed:

• A written agreement must exist between the adviser and solicitor*
• The solicitor may not be subject to any statutory disqualification

*Essentially the same items that must be in the agreement between a state-registered adviser and their solicitor (discussed above) are the same here.

Last, the solicitor may not*:

• Make an untrue, inaccurate, or misleading statement
• Discuss potential benefits without discussing potential risks
• Reference the adviser’s recommendations in a way that is not fair and balanced
• Present the adviser’s performance in a way that is not fair and balanced

*Although these prohibitions are specifically for solicitors of federal-covered advisers, you can assume the same applies at the state level.

Compared with the state solicitor rule, there are two major omissions for federal-covered advisers. First, federal-covered solicitors are not required to be registered as IARs. Second, there is no brochure delivery requirement for promoters. Because the adviser must provide the brochure to the client, the SEC viewed a separate delivery requirement for the solicitor as redundant.

Instead, the promoter must make the required disclosures at the time of solicitation. The SEC rule says the disclosures must be made “clearly and prominently,” but it does not explicitly require that they be in writing.

Sidenote

De minimis fees

If a promoter is collecting a “de minimis” (small) fee for their services, the SEC does not require a written agreement to be in place between the adviser and solicitor. De minimis fees are defined specifically as $1,000 or less.

Access person disclosures

Securities rules have increasingly emphasized transparency around investment advice. One key concern is whether an IAR’s personal holdings could influence recommendations to clients.

For example, suppose an IAR owns stock in a thinly traded company. Because additional demand could push up the market price, the IAR recommends the stock to multiple clients - even if it isn’t fully suitable. That conflict is exactly what regulators want firms to detect and prevent.

Rules for both federal-covered and state-registered advisers require certain employees to disclose personal securities holdings and transactions to their firm’s compliance department. This helps compliance staff compare client recommendations with the employee’s personal trading activity.

These disclosure rules apply only to access persons.

Definitions

Access person

Any supervised person of an investment advisor who:

• Has access to non-public information regarding any client’s purchase or sale of securities
• Has access to non-public information regarding the portfolio holdings of any reportable fund (e.g. a mutual fund)
• Is involved in making securities recommendations to clients, or who has access to such recommendations that are non-public

In practice, most (if not all) IARs of a registered adviser qualify as access persons because they can view client accounts, portfolio holdings, and nonpublic recommendation details.

Access persons must regularly file two types of reports with their firm:

• Holdings reports
• Transaction reports

Holdings reports
A holdings report provides a snapshot of an access person’s personal portfolio. It must include:

• Securities owned by the access person
• Name of broker, dealer, or bank where the portfolio is held
• The date the holdings report is submitted

Holdings reports must be filed:

• No later than 10 days after the person becomes an access person, and the information must be current as of a date no more than 45 days prior to the date the person becomes an access person
• At least once each 12-month period thereafter on a date selected by the investment adviser, and the information must be current as of a date no more than 45 days prior to the date the report was submitted

Transaction reports
Transaction reports disclose personal securities transactions. They must include:

• Date of the transaction
• Security traded and any relevant details (e.g. number of shares)
• Nature of the transaction (e.g. buy, sale, short sale)
• Price the security was traded at
• Name of the broker, dealer, or bank performing the transaction
• The date the transaction report was filed

Transaction reports must be filed no later than 30 days after the end of the quarter in which the transactions occurred.

There are three exceptions to the holdings and transaction report requirements. No filing is required for:

• Activity in which the access person had no direct or indirect control over
  • For example, the access person is a beneficiary of a trust account owning and trading securities, which is managed by a separate third-party trustee
• Transactions related to an automatic investment plan
  • For example, dividends received from a mutual fund that are automatically reinvested
• Transactions the adviser has direct access to
  • For example, an IAR maintains an account with their employing adviser’s affiliated broker-dealer (the adviser can access this account at any time)

Key points

Solicitor (promoter)

• Any person compensated for connecting prospective clients with an adviser

Requirements for solicitors of state-registered advisers

• Must be registered as an IAR
• May not be subject to statutory disqualification
• Must maintain written agreement with the adviser
• Must deliver adviser’s and solicitor’s brochures to prospective clients
• Must obtain signed receipt of brochures

Requirements for solicitors of federal-covered advisers

• Must disclose if they’re a client
• Must disclose if being paid and, if so, how much
• Must maintain written agreement with the adviser
  • Unless the solicitor is paid $1,000 or less
• May not be subject to statutory disqualification

Solicitors may not:

• Make untrue, inaccurate, or misleading statements
• Discuss benefits without potential risks
• Reference adviser’s recommendations in an unfair or unbalanced way
• Present the adviser’s performance in an unfair or unbalanced way

Access person

• Any supervised person of an investment advisor who:
  • Has access to client accounts
  • Has access to fund portfolios
  • Provides recommendations

Holdings reports

• Disclose securities personally owned by access persons
• Must be:
  • Filed no later than 10 days after becoming an access person
  • Filed annually thereafter
  • Current within 45 days of filing

Transaction reports

• Disclose securities transactions personally performed by access persons
• Must be filed no later than 30 days after the end of the quarter

Exceptions to access person filing requirements

• Activity in which the access person had no direct or indirect control over
• Transactions related to an automatic investment plan
• Transactions the adviser has direct access to