Series 66
Textbook
5.3.3.6 Exemptions & exclusions
Now that we’ve thoroughly discussed the registration process for investment advisers, let’s go through the circumstances that allow a person to avoid registration. The rules and regulations covered in the previous five chapters do not apply if an exemption or exclusion exists. Click the previous link if you need a full refresher, but here are the definitions:
The examples listed above relate to securities, but the same concept applies to investment advisers. Both exemptions and exclusions are exceptions to the rules, but for different reasons.
In this chapter, we’ll discuss exemptions and exclusions applicable to persons potentially subject to registration with the Securities and Exchange Commission (SEC) or state administrator.
A person exempt from investment adviser registration technically meets the definition of an investment adviser. However, they’re not subject to registration requirements due to a specific mention in the Investment Advisers Act of 1940. These exemptions only apply to advisers subject to registration as federal-covered advisers:
Only providing services to insurance companies
Investment advisers only offering their services to insurance companies are exempt from registration with the SEC. When we cover state-based exemptions, we’ll discuss a similar rule at the state level that applies to all types of institutions (not just insurance companies). Keep in mind the difference between the rules as it may be a test point on your exam.
Intrastate advisers
The federal government tends to get involved only when a situation or circumstance crosses state lines. If someone commits a serious crime and hides out at home, the local or state police may go after them. But, if the person gets in a car and drives across state lines, the FBI typically gets involved.
The same application of jurisdiction relates to this exemption. If an adviser is only operating in one state, they are exempt from SEC registration. In order to register as a federal-covered adviser, the firm’s operations must be taking place in more than one state.
In addition to only providing advice to clients within one state, advisers seeking the intrastate exemption may not provide advice on securities listed on a national exchange (e.g. the NYSE, NASDAQ). If an adviser does, the federal exemption is no longer available and registration with the SEC may be required (if no other exclusion or exemption exists and is considered mandatorily required to register as a federal-covered adviser).
As we stated above, a person exempt from investment adviser registration technically meets the definition of an investment adviser. In this section, we’ll specifically cover state exemptions mentioned in the Uniform Securities Act (USA) and/or North American Securities Administrators Association (NASAA) rules. These exemptions only apply to advisers subject to state registration.
These are the relevant exemptions to be aware of for the exam:
Snowbird/vacation rule
If an adviser has no place of business in a state and only engages existing clients that are temporarily in that state (non-resident), no registration is required. We originally discussed this rule in a previous broker-dealer chapter, and the same applies to investment advisers*. Click the previous link if you need a full refresher.
*The vacation rule and the institution rule (discussed below) were both referred to as exclusions for broker-dealers. Although the rules are essentially the same for investment advisers, it’s referred to as an exemption here. The difference is purely based on how the USA is written and is generally not an important test point.
Institution rule
If an adviser has no place of business in a state and only engages institutions in that state, they are exempt from registration. This is another example of a rule discussed in a previous broker-dealer chapter that also applies to investment advisers. Click the previous link if you need a full refresher.
Keep in mind the difference between the state-based rule and the federal rule discussed above. While an adviser subject to state registration is exempt when dealing with institutions when no place of business exists, an adviser subject to federal registration is exempt if only dealing with insurance companies.
De minimis rule
Investment advisers can avoid registration in a state if these two conditions are met:
Known as the de minimis rule*, this exemption allows an adviser to obtain a small group of retail clients (investors) in a state without registering in that state. As long as the adviser doesn’t maintain an office in the state and keeps the group to a maximum of five retail investors, the exemption applies. Keep in mind there’s no limit to the number of institutional clients, as discussed above.
*De minimis is Latin for “of minimal things.”
The de minimis rule is applicable to both investment advisers and investment adviser representatives (IARs), but not broker-dealers or agents. Even if a broker-dealer and/or agent has one retail client permanently located in a state, registration is required.
Private fund advisers
A private fund is similar to a mutual fund, but is generally only available to a small group of wealthy investors. Additionally, it’s private and not available to the general public. Hedge funds are very similar, and are even sometimes lumped into the category of private funds. The exam tends to avoid the specific characteristics of these funds, so don’t get too caught up in the details.
Prior to 2011, private fund advisers (investment advisers that manage private funds) largely avoided regulatory oversight, including registration. Securities regulators don’t pay too much concern to protecting larger and wealthier investors, even though these investment opportunities can be subject to high levels of risk. It’s assumed these investors have access to significant resources and are sophisticated enough to understand and withstand the risks of such investments.
We discussed the impact of the Dodd-Frank Wall Street Reform Act (usually referred to as Dodd-Frank) in a previous chapter. In addition to defining different types of investment advisers, Dodd-Frank removed a long-standing exemption for private fund advisers. Instead of virtually ignoring these advisers, federal regulations now subjected them to registration and disclosure requirements. Soon after the federal rules were updated, the North American Securities Administrators Association (NASAA) adopted their own version of the rule.
Private fund advisers overseeing less than $150 million of assets under management (AUM) still maintain a registration exemption, but are required to make periodic reports to the Securities and Exchange Commission (SEC). Those with $150 million or more of AUM must register with the SEC as a federal-covered adviser. Regardless of the situation, state registration is never involved. At the very most, a larger private fund adviser may be required to provide a notice filing to the state administrator (assuming they’re subject to registration as a federal-covered adviser). Therefore, it’s safe to say private fund advisers are generally exempt* from state registration.
*You’ll also see federal-covered advisers listed as a ‘state-only exclusion’ below. However, the private fund adviser exemption may result in an adviser being federal-covered. Federal-covered advisers are referred to as an exclusion in one rule, and an exemption in another. It seems like a contradiction, but this is how the law is written. Don’t worry about it, though! It’s not an important distinction for the exam.
A person excluded from a legal definition of an investment adviser is not subject to registration, rules, or regulations typically applicable to advisory firms. We’ll break down investment adviser exclusions into three separate categories:
The only exclusion unique to the Investment Advisers Act is:
Advisers only providing advice on US Government securities
Most investment advisers provide guidance on numerous security types, those that only provide services related to US Government securities (e.g. Treasury bonds) are excluded from the definition of an adviser. Therefore, those meeting this definition that are subject to federal jurisdiction are not required to register as federal-covered advisers.
There are three exclusions unique to the USA:
Investment adviser representatives (IARs)
We learned how agents are excluded from the definition of a broker-dealer in a previous chapter. Agents are the registered employees of a broker-dealer, not the broker-dealer themselves. The same concept applies here. IARs are not the firms (investment advisers) they work for. A natural person (human being) representing a business is not the business itself!
Federal-covered advisers
When an adviser is registered with the SEC, they are excluded from the definition of an adviser according to state laws. Federal-covered advisers are still subject to some state-specific rules and obligations, including notice filing requirements and investigations related to fraud. Regardless, they are not required to register with the administrator and largely avoid regulation at the state level.
Any person designated by the administrator
The USA gives state administrators broad powers when enforcing securities laws. Several times throughout the law, language like this appears:
“Such other persons not within the intent of this subsection as the [Administrator] may by rule or order designate.”
This legal language loosely translates to “the state administrator can do what they want.” If they want to recognize an entity as being excluded from the definition of an investment adviser, they have the power to do so (even if the entity isn’t mentioned anywhere in the USA). The same concept applies to institutional investors; the state administrator may recognize any person as an institution.
The following exclusions exist at both the federal level under the Investment Advisers Act of 1940 and the state level under the USA:
Although most of the quoted language is pulled from the USA, similar language exists in the Investment Advisers Act of 1940.
Certain professionals providing incidental advice
This is the specific language from the USA regarding this exclusion:
A lawyer, accountant, engineer, or teacher whose performance of these services is solely incidental to the practice of his profession [is excluded from the definition of an investment adviser]
When the USA was written, there were four distinct professions named for this exclusion. Most test takers remember this as the LATE exclusion - Lawyers, Accountants, Teachers, and Engineers. These professionals can give “incidental” investment advice and still avoid being considered an investment adviser. What exactly is incidental? Let’s first start with the dictionary definition:
Let’s assume a lawyer is hired to file suit against another party and wins the lawsuit, resulting in their client receiving a significant sum of money. They advise their client to invest that money into a safe, short-term security until they find some long-term use for it.
On the surface, it certainly seems the lawyer meets the definition of an investment adviser. They gave advice related to securities while being compensated by their client. However, is the client hiring them for their investment advice or for their legal expertise? If the argument can be made the securities advice is “on the side” and not what the client is paying for, this exclusion can be applied (only to LATE professionals).
It is absolutely possible a lawyer, accountant, teacher, or engineer could be considered as an investment adviser. If the securities advice isn’t incidental, they meet the definition. For example, what if the lawyer we discussed above started offering financial plans involving securities as a separate service? If the client is paying directly for investment advice, the product or service is no longer incidental.
Broker-dealers and agents
A similar exclusion to the LATE rule exists for broker-dealers and agents. According to the USA:
A broker-dealer or its agent whose performance of these services is solely incidental to the conduct of its business as a broker-dealer and who receives no special compensation for them [is excluded from the definition of an investment adviser].
It’s not uncommon for advice to be provided while executing securities transactions. For example, assume a customer calls their registered agent to buy a security. They mention a specific stock and ask the agent if the investment should be made given their financial situation. The agent states the security is suitable and recommends the trade. The customer buys the stock through the agent and pays a commission.
This should feel familiar - the agent is providing investment advice while being compensated by the client. But, what exactly is a commission? It’s payment for executing a transaction. Commissions typically exist regardless of whether the trade was based on a recommendation (known as a solicited trade) or not (known as an unsolicited trade). It’s considered the cost of fulfilling a transaction request, not payment for securities advice.
This doesn’t mean broker-dealers and/or agents are never considered investment advisers. If an advisory fee is charged on top of the commission, the exclusion doesn’t apply. To be legally compliant in this scenario, the broker-dealer and agent should be dual-registered as an investment adviser and IAR (respectively).
Media programs
According to the USA:
A publisher of any bona fide newspaper, news column, newsletter, news magazine, or business or financial publication or service, whether communicated in hard copy form, or by electronic means, or otherwise, that does not consist of the rendering of advice on the basis of the specific investment situation of each client [is excluded from the definition of an investment adviser]
A number of media programs that discuss securities exist today, especially in the digital age. This could include everything from a newspaper to a financial blog. The USA further adds “radio, television programs, or other electronic communications” to the same exclusion, which additionally includes everything from TV and radio shows to YouTube and TikTok channels. As long as the advice provided on the media program is general in nature, the distributor and/or author are not considered investment advisers.
What exactly does ‘general in nature’ mean? In basic terms, the advice provided is not specific to a particular client’s situation. For example:
“I recommend senior citizens invest a significant amount of their portfolio in Treasury bonds”
While there’s mention of a specific security, a specific client is not involved. The media program exclusion can be applied when generalizations (e.g. senior citizens) are used. However, the following would not qualify:
“I’m speaking with Jade today, who is 40 years old and has two children. She works full time, and makes a combined annual income of $125,000 with her spouse. Her current portfolio is invested entirely in very safe debt securities, and I recommend she invest 50% of her portfolio in the Fidelity Large Cap Stock Fund.”
Do you see the difference? The more specific the recommendation, the more likely the exclusion no longer applies*.
*You’ve probably seen some real-world examples that seem to contradict this. For example, Dave Ramsey and Suze Orman provide financial advice (many times involving securities) to specific people. Neither is currently registered; Ramsey has no history of registration and Orman hasn’t been registered since 1991. Try to separate the “real world” from the exam. There are a lot of “gray areas” the exam doesn’t cover that may apply to these types of media programs.
Banks and savings institutions
Generally speaking, banks and savings institutions are excluded from most securities laws and regulations. The USA makes it clear the bank must be US-based, resulting in the exclusion not being applicable to foreign banks. Generally speaking, if it sounds like a US-based bank, it’s probably excluded. However, this exclusion does not apply to bank holding companies, (as we discussed in a previous chapter). If you need a refresher on this topic, follow the previous link.
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