Financial requirements
Net worth requirements
Federal-covered advisers are not required by the Investment Advisers Act of 1940 to maintain minimum financial levels. However, covered advisers may still be subject to certain disclosure requirements depending on their financial status. These details will be discussed.*
Similar to broker-dealers, state-registered investment advisers must meet financial requirements to obtain and keep registration 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 calculations here, but you do need the association:
- Broker-dealers (BDs) → net capital
- Investment advisers (IAs) → net worth
State-registered advisers register only with the state, so they don’t follow SEC financial requirements (unlike broker-dealers, which register with both the SEC and the states). Each state sets its own net worth requirements, which raises a practical question: what if an adviser is registered in multiple states with different requirements?
Under North American Securities Administrators Association (NASAA) rules, an investment 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 determines the minimum net worth requirement.
While requirements can vary by state, many states use the same standards:
Advisers exercising discretion
- $10,000 net worth requirement
Advisers maintaining custody
- $35,000 net worth requirement
Large prepayment of fees
When an investment adviser accepts a large prepayment of fees for services that won’t be provided for at least 6 months, additional disclosures to clients may be required. There are two sets of rules: one for state-registered advisers and one for federal-covered advisers.
State-registered advisers
- More than $500 received
- For services to be provided at least 6 months later
Federal-covered advisers
- More than $1,200 received
- For services to be provided at least 6 months later
If an adviser collects what’s considered a large prepayment of fees, it must disclose 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).
Surety bonds
Investment advisers may 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, surety bond obligations for investment advisers follow the same approach used for broker-dealers.
Falling below minimum net worth requirements
An investment adviser might meet the net worth requirement when registration becomes effective, but later fall below the minimum.
For example, an adviser that does not maintain custody is registered when its net worth is $15,000. Several months later, its net worth drops to $8,000. The minimum net worth requirement in this case is $10,000.
When this happens, NASAA rules require the adviser to notify the state administrator by the end of the next business day. It must then file a report about its financial condition by the end of the business day following that notification.
To make the timing concrete: if the adviser falls below the minimum on Monday, it must notify the administrator by Tuesday and file the financial report by Wednesday.
The financial report includes the following information*:
- Trial balance of all ledger accounts
- Statement of all client funds or securities which are not segregated**
- Computation of the aggregate amount of client ledger debit balances
- Statement as to the number of client accounts
*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 how this shortfall is typically addressed. NASAA rules generally require advisers 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. The shortfall is $8,000 ($35,000 required vs. $27,000 actual), but the bond amount must be rounded up to the nearest $5,000 increment. After making the required disclosures to the administrator, the adviser would be required to obtain a $10,000 surety bond.
Disclosure of financial problems
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 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 promised to clients (such as being able to reach an IAR about account status). In situations like this, the adviser must notify clients promptly.