Most of this chapter covers post-registration obligations for state-registered advisers. The rules are virtually identical for federal-covered advisers. There’s one exception related to brochure delivery requirements, noted below.
Once an investment adviser achieves effective registration, the adviser is legally permitted to operate. To maintain registration, the adviser must meet several ongoing (post-registration) obligations, including:
We previously covered that broker-dealers must maintain records of numerous business documents. The Uniform Securities Act (USA) imposes a similar requirement on investment advisers.
“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”
Because the general recordkeeping concept is the same, you can use the broker-dealer post-registration obligations chapter as a refresher.
One key difference is the retention period. Investment advisers must maintain required records for 5 years (rather than 3 years for broker-dealers), and records created within the most recent 2 years must be readily available.
We previously discussed Form ADV Part 2, which consists of the brochure (Part 2A) and the brochure supplement (Part 2B). This document contains key disclosures an adviser provides to clients, including:
Form ADV Part 2A (brochure)*
Form ADV Part 2B (brochure supplement)*
*We’ll refer to Form ADV Parts 2A and 2B simply as “the brochure” for the remainder of this chapter. While only Part 2A is technically the brochure, exam questions often use “the brochure” to mean both Parts 2A and 2B.
North American Securities Administrators Association (NASAA) rules require advisers to deliver the brochure in a specific way. The brochure-specific rule begins with this general requirement:
"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:
NASAA is also very specific about when delivery must occur:
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 an and rule. The adviser satisfies the brochure delivery requirement by meeting one of the two timing options.
Here’s an example.
Assume a prospective client comes to your office on Friday to ask about your advisory services. You discuss your firm’s services and provide the brochure at the end of the meeting.
The prospective client wants time to think and doesn’t sign a contract that day. On Monday, the client returns, agrees to hire your firm, and signs the advisory contract.
In this situation, the first delivery option is satisfied: the client had the brochure at least 48 hours before entering into the contract (brochure delivered Friday, contract signed Monday).
Now suppose the client wants to sign the contract on Friday. If the client can’t have the brochure for 48 hours before signing, the second option applies. The adviser must deliver the brochure at contract signing and give the client a five-business-day “free look” period. During that period, the client may terminate the contract without penalty. The adviser may charge for services already provided (for example, management fees), but may not impose a penalty for canceling within the five business days. After five business days, the adviser may charge surrender or cancellation fees.
The brochure and brochure supplement may be delivered physically or electronically. Electronic delivery requires client consent and verification that the client can access the document. The brochure is also publicly available through the regulators on the Investment Adviser Public Disclosure (IAPD) website.
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 the following:
- An investment company contract; or
- A contract for impersonal advisory services requiring a payment of less than [$500]*
*The original NASAA brochure rule referenced impersonal advisory services of less than $200, but that amount has since been updated to $500.
An adviser to a registered investment company (for example, a mutual fund or closed-end fund) does not need to deliver a brochure. Also note that an adviser hired to provide advice to an investment company would be federal-covered. Since federal-covered advisers are not subject to state regulation (and the SEC has its own brochure delivery requirement), this exception is effectively redundant in many situations. The practical takeaway is simple: there’s no need to deliver the brochure to an 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 don’t provide direct recommendations about specific securities to specific individuals. A common example is a market newsletter that provides general commentary about the securities markets. If an adviser sells subscriptions to a newsletter like this for less than $500, there’s no legal requirement to deliver the brochure to those customers.
Investment advisers must keep their brochure current. That means:
NASAA summarizes the timing requirements in this 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.
Here’s how to read that.
First, the firm must file an annual updating amendment within 90 days after the end of its fiscal year. That annual amendment includes changes made during the year (for example, new states where the adviser is registered or a change in investment philosophy). It also includes the adviser’s current assets under management, which helps determine whether the adviser should be registered with the state or the SEC (as a federal-covered adviser).
When the annual update is made, the brochure must be updated and delivered to clients. While the annual amendment must be filed with the administrator within 90 days of fiscal year-end, clients must receive the updated brochure within 120 days of fiscal year-end.
Second, the adviser must update Form ADV promptly (typically interpreted as within 30 days) when a material change occurs during the year. NASAA doesn’t provide a single, explicit definition of “material” (“state regulators can answer questions about whether a change is deemed material”), but the idea is that it’s a significant change that should be disclosed to regulators and/or clients. Examples include criminal or civil enforcements, regulatory actions by the SEC or a state administrator, or other substantial business changes.
We’ve discussed custody earlier. Here’s the definition again:
NASAA rules expand on that definition. 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 can arise if a client mistakenly sends a check, wires funds, or transfers securities to the adviser. For example, suppose the adviser recommends a Vanguard mutual fund and the client mistakenly sends the payment to the adviser instead of to Vanguard. If the adviser returns the payment to the client or forwards it to the proper destination within three business days, custody has not occurred.
If more than three business days pass, the adviser has taken custody. Later in this chapter, you’ll see the steps an adviser must take before taking custody. Those steps won’t be met if the adviser simply holds a check too long, which would put the adviser in violation of custody rules.
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
Having the authority to access client funds or securities is also custody. For example, the ability to pull funds directly from a client’s bank account would be custody.
Any capacity… that gives the investment adviser or its supervised person legal ownership of or access to client funds or securities.
Custody also includes legal ownership of, or legal authority over, client funds or securities. A common example is when an adviser is appointed trustee of a trust. Trusts are legal entities created to benefit a specific beneficiary (for example, a family trust). Trustees are legally appointed to manage the trust and have access to the trust’s assets. If an adviser is appointed trustee, the adviser has custody of the trust.
Investment advisers often use unaffiliated broker-dealers to maintain custody on their behalf. Although it’s less common, an adviser may take custody directly (or through an affiliated business). If the adviser takes custody, these obligations apply:
Confirm state administrator allows custody
While most states allow it, a number of states (roughly 13 at the time of this writing) prohibit investment advisers from taking custody. In those states, the adviser simply cannot take custody.
Notify state administrator
If the state allows custody, the investment adviser must disclose custody to the state administrator on Form ADV. This disclosure appears in multiple parts of the form, including the brochure (Form ADV Part 2A).
Place funds with qualified custodian
An investment adviser can’t simply “hold” client funds or securities. The assets must be placed with a qualified custodian - an organization that specializes in holding client assets. Banks, savings associations, broker-dealers*, and other financial institutions typically meet the definition. If an adviser wants to take custody itself, it must place the funds with an affiliated entity (another part of the organization) that is qualified to hold those assets.
*When we’ve discussed broker-dealers typically maintaining custody for investment advisers, we’re referring to unaffiliated broker-dealers (not part of the same organization). If an adviser wants to take custody itself, it may use an affiliated broker-dealer owned by the same parent company.
Provide quarterly statements
Clients must be able to track account balances and activity. Even though many accounts can be viewed online at any time, advisers that take custody must send statements showing balances and activity at least quarterly (every three months).
Balance sheet disclosure (state only)
State-registered advisers that maintain custody must also include a balance sheet in their brochure. This requirement applies only to state-registered advisers; the Investment Advisers Act of 1940 (which governs 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 confirm compliance with recordkeeping and custody requirements. Each year, an independent auditor (typically a CPA) arrives without prior notice. If the auditor finds something materially wrong with the adviser’s custody system, the auditor must notify the administrator within one business day. If nothing appears out of place, the auditor files 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 adviser.
Investment advisers often avoid taking custody because of the additional obligations listed above. In most cases, custody is handled by broker-dealers and other financial institutions whose business is built around custodial services. Advisers primarily provide investment advice and collect advisory fees.
Investment advisers may operate indefinitely as long as they maintain registration, follow applicable rules, and act ethically. However, advisers do shut down for many reasons (for example, retirement or a lack of clients). When an adviser withdraws, the adviser must notify the state administrator.
This disclosure is made on Form ADV-W. The withdrawal typically becomes effective 30 days after filing. Once registration is withdrawn, the business can no longer legally operate.
Even after withdrawal, the adviser remains subject to regulatory action for up to one year. If the adviser engaged in unethical or improper conduct before withdrawal, the administrator may suspend or revoke the adviser’s registration. This has two practical effects:
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