I am pleased to announce that an upgrade to the U.S. Compliance Consultants web site is just a few days away. Information on the registration requirements of all 49 states will be available for viewing (remember that Wyoming does not register state investment advisers). This upgrade will allow potential state registrants to see exactly what each state requires in order to register as an investment adviser. No other compliance consultant company maintains a web site with such comprehensive information.

Introduction

In this era of increased regulation of the financial industry in general and the investment advisory profession in particular, state-registered investment advisers have seen a dramatic increase in their compliance burden. Given the demands of this new compliance regime, it is truly a wonder that state-registered investment advisers have any time at all to devote to developing client relationships, pursuing new business opportunities or just tackling the everyday work that makes their advisory businesses run.

In light of the changes on the federal level, many states have also revised their investment adviser statutes to better reflect the new regulatory environment. In 2004, Ohio became the first state to require its state-registered investment advisers to adopt written compliance procedures and name a chief compliance officer. The following year, Massachusetts incorporated the requirements found in both the SEC Compliance Rule and the SEC Code of Ethics rule into its investment adviser regulations. Not to be outdone, the Texas State Securities Board has recently made the adoption of anti-money laundering provisions under the USA PATRIOT ACT a de facto requirement for advisers registered in that state. A rather interesting development when you consider that the U.S. Treasury Department has withdrawn its own proposed investment adviser anti-money laundering rule.

How long before other states follow suit? The consensus among state regulators and investment advisers is that the dominos are ready to tumble. No matter what the timetable, however, it is abundantly clear that the divide between federal and state regulation is shrinking rapidly. Gone are the days when a state-registered investment adviser could remain blissfully unaware of developments at the federal level. As a result, all state-registered investment advisers must now be keyed in to compliance developments on the federal level.

So where does a state-registered investment adviser turn to for help in deciphering all this information? We are certainly sympathetic to the fact that an investment adviser can read a state compliance statute, regulation or policy statement and still have absolutely no idea what is required of them. This is not a reflection on their intellectual capabilities, but rather, on the convoluted and counterintuitive way in which most state compliance regulations are written. While there has been a long-standing push in the securities world to communicate information in “plain English,” most state investment adviser compliance regulations appear to be written in a language more akin to Sanskrit.

The genesis of this quarterly column, therefore, is the lack of helpful compliance information available to state-registered investment advisers. Each quarter we will take a look at a different compliance issue that, based on our experience, should be of special concern to state-registered investment advisers. Its primary goal is to shed light on those areas where state advisers are most likely to run afoul of state compliance rules and regulations.

In this, our inaugural issue, we take a look at a state-registered investment adviser’s disclosure requirements. We are giving disclosures “top billing” simply because misleading and inconsistent disclosures are an area that state examiners report as the number one compliance deficiency. With many states now requiring their state-registered advisers to post their Form ADV, Part II and Schedule F online via the Investment Adviser Registration Depository (IARD) system, it has become even more important for all state-registered advisers to ensure that their disclosure documents are above reproach.

Disclosure Basics

“Disclosure” is really a catchall phrase for what an investment adviser reports on Parts 1 and II of Form ADV and describes in the Schedule F narrative (or equivalent disclosure brochure). It also includes the information an adviser sets forth in their advisory agreement, marketing material, due diligence questionnaire and just about any other document that makes into the public domain.

What Must Be Disclosed?

While the specifics of what must be disclosed is dependent on each adviser’s business, there are certain “absolutes” that all regulators will expect in an adviser’s disclosure documents. These include:

· What advisory services are being provided;

· Who is providing those services;

· What is the client being charged for the services; and

· What conflicts of interest might exist for the adviser.

Certainly, no surprises here and indeed, most advisers touch upon at least the first three categories (more on conflicts of interest below).

There are, however, two additional categories of additional disclosures of which advisers are not as readily aware. The first type of event requiring additional disclosure is when an investment adviser experiences a financial condition that is reasonably likely to impair the ability of the adviser to meet its contractual obligations (but only if the adviser has discretionary authority or if the adviser requires prepayment of advisory fees of more than $500, six months or more in advance). The second type of event requiring additional disclosure is when an adviser experiences a legal or disciplinary event that is material to an evaluation of the adviser’s integrity or ability to meet contractual conditions. A state-registered adviser should check the regulations in their home state for that state’s specific requirements.

When Must Disclosures Be Made?

There is (we hope) not an investment adviser in business today that does not know that they are required to provide their advisory clients and prospective clients with a written disclosure document. Most advisers also know that they may provide advisory clients and prospective clients with either Part II of Form ADV (including Schedule F) or with another document that contains, at a minimum, the information required to be disclosed in Part II of Form ADV (the so-called “disclosure brochure”). Most investment advisers are also aware that their disclosure document must be delivered to prospective clients at least 48 hours before entering into an advisory agreement with the client or, if it is delivered concurrently with the client’s execution of the advisory agreement, then the client must be given 5 business days to terminate the agreement without penalty. Finally, although some advisers seem to be a bit hazy on the details, each year they must deliver or offer in writing to deliver their disclosure document to each client without charge.

As to an event specifically involving financial distress or disciplinary action, disclosure must be made to an adviser’s existing clients promptly and to a prospective client at least 48 hours prior to entering into an advisory agreement or after the advisory agreement is executed; provided, however, that the client has 5 days to terminate the agreement. Such disclosure may be made by an adviser through the Form ADV or through a separate written communication to clients.

Conflicts of Interest

The most common disclosure issue that arises during an examination is the inadequate reporting of conflicts of interest. Specifically, the types of roles the adviser and/or its affiliates play with regard to a client may create conflicts of interest. Some of the situations involving conflicts of interest examiners often look for include:

1. Conflicts relating to the use of solicitors and finder’s fees;
2. Conflicts between the investment adviser’s interest in trading for the adviser own account and the interests of clients;
3. Conflicts where the adviser or its personnel participate in limited investment opportunities along with clients;
4. Conflicts relating to the allocation of investment opportunities among clients;
5. Conflicts relating to the aggregation and allocation of client trades;
6. Conflicts relating to the use of client commissions to obtain soft dollar items; and
7. Conflicts relating to side by side management of accounts that do and do not charge performance fees.

In order to determine whether a conflict exists, examiners will review client correspondences, complaints and statement of accounts or by operational review of the investment adviser itself and interviews with advisory personnel and clients. Once examiners determine that a conflict of interest does exist, they will expect that the adviser has disclosed any such conflict in the proper manner.

In all conflict situations the key issue is the effect of the conflict on the client. Has the client been told of the conflict? Has the client consented to the transaction despite the disclosed conflict? If the client consented, was the client in a position to evaluate the effect of the conflict on the client’s interest? Advisers must taken into account the client’s financial sophistication and investment experience as the more vulnerable or unsophisticated the client, the greater the burden is on the investment adviser to show that the client has knowingly consented to the conflict. Accordingly, disclosure and client consent may not always be sufficient remedies for conflicts of interest.

Filing and Updating

Advisers are required to promptly file an amended Part 1 of their Form ADV if information the adviser provided in response to Item 1 (Identifying Information); Item 3 (Form of Organization); or Item 11 (Disclosure Information) becomes inaccurate in any way or information the adviser provided in response to Item 4 (Successions); Item 8 (Interest in Client Transactions); or Item 10 (Control Persons) become materially inaccurate in any way. In addition, an adviser is required to amend Part II of the Form ADV if becomes materially inaccurate in any way.

Many states now require state-registered advisers to file all amendments to Form ADV Part II and Schedule F via the IARD system. Advisers should note that they will not be able to just “download” their existing Form ADV Part II or Schedule F and must go to the web site of the North American Securities Administrators Association (www.nasaa.org) to obtain the appropriate form. Advisers should be aware our experience has been that these forms are not exactly user friendly.

Record Keeping

Advisers must keep a copy of their disclosure document and each amendment or revision to such document that was given, or offered to be given, to any client or prospective client who subsequently becomes a client. An adviser must also keep a record of the dates that each disclosure document and each amendment or revision was offered or sent to clients. We suggest that advisers print out a list of clients to whom the Form ADV Part II was offered and staple a copy of that specific version of Part II to such list. There is no need for an adviser to save a copy of the annual offer in each separate client file.

Lessons Learned

Beyond lack of disclosures, beyond incomplete disclosures and even beyond failure to disclose conflicts of interest, the most problematic disclosure issue is when there are discrepancies between an adviser’s disclosure documents. State examiners take an especially harsh view of investment advisers that fail to reconcile their disclosure documents. In the words of one examiner, the presence of conflicting disclosure documents is evidence that an adviser lacks a commitment to the disclosure process. Examiners will not afford an adviser the benefit of the doubt when confronted with such an abject disregard for their disclosure obligations. Therefore, we suggest that at a minimum, every adviser pull out Parts 1 and II of their Form ADV, their Schedule F and their advisory contract and make sure it all adds up. If you report in Part 1 that you have investment or brokerage discretion, your Part II better report the same thing. It sounds obvious, but at least 60% of our audit clients had some form of inconsistent disclosures. While adviser should review their disclosure documents in their entirety, special attention should be paid in Part 1 of their Form ADV to Items 7 (Financial Industry Affiliations) and 8 (Interest in Client Transactions) and the corresponding Items in their Form ADV Part II (e.g., Items 8, 9, 12 and 13). This is typically where examiners find the most inconsistencies.

Disclose, Disclose, Disclose (and then disclose some more!)

If the three most important words in real estate are “location, location, location” then the three most important words in compliance are “disclose, disclose, disclose.” Any time an adviser comes across a questionable situation our advice is to thoroughly disclose the issue. After all, why give an examiner even the slightest opportunity to question whether a disclosure should have been made? Perhaps one of the key points to remember about most state statute is that short of fraud or other malfeasance, disclosure is the often the antidote to many of the issues that arise in the course of an investment adviser’s business.

Important Information

The information contained in this article is only a summary of the rules and regulations that apply to state-registered investment advisers. It is not intended to be a comprehensive analysis of the rules and regulations applicable to state-registered investment advisers. It is not intended to constitute legal or compliance consulting advice or apply to any one investment adviser’s particular situation. If you are in need of further information or have specific questions regarding the compliance obligations applicable to the conduct of your investment advisory business, please contact U.S. Compliance Consultants toll free at 888-798-2930.

Massachusetts is one of a handful of states that has expressly adopted the SEC Compliance Rule.  In a Policy Statement issued by the Massachusetts Securities Division, it was noted that existing state regulations require state-registered investment advisers to adopt and implement written compliance policies and procedures in accordance with the provisions of the Compliance Rule. As a result, investment advisers registered in Massachusetts face many of the same stringent compliance requirements as do their SEC-registered colleagues.

In keeping with the requirements of the Compliance Rule, all Massachusetts-registered investment advisers must: (i) adopt and implement policies and procedures reasonably designed to prevent violations of state and federal securities laws; (ii) review the policies and procedures at least annually to determine their adequacy and effectiveness of their implementation; and (iii) designate a chief compliance officer responsible for administering the policies and procedures.

At a minimum, an adviser must adopt and implement written policies and procedures that address the following areas of compliance concern:

• Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients’ investment objectives, disclosures by the adviser, and applicable regulatory restrictions;
• Trading practices, including procedures by which the adviser satisfies its best execution obligation, uses client brokerage to obtain research and other services (”soft dollar arrangements”), and allocates aggregated trades among clients;
• Proprietary trading of the adviser and personal trading activities of supervised persons;
• The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;
• Safeguarding of client assets from conversion or inappropriate use by advisory personnel;
• The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction
• Marketing advisory services, including the use of solicitors
• Processes to value client holdings and assess fees based on those valuations;
• Safeguards for the privacy protection of client records and information; and
• Business continuity plans.

An important point to remember is that the Compliance Rule requires only that the policies and procedures be reasonably designed to prevent violation of the Advisers Act, and thus, need only encompass compliance considerations relevant to the operations of the adviser. Accordingly, smaller advisory firms without conflicting business interests may have much simpler policies and procedures than larger firms that may have multiple potential conflicts as a result of their other lines of business or their affiliations with other financial service firms.

I suggest that when developing its compliance manual, the investment advisory firm review the conduct of its advisory business and, if appropriate, make note of its limited nature. This should be done in the manual’s introductory material to let regulators know right up front that certain of the policies and procedures mandated by the Compliance Rule are not applicable to your advisory firm. It has been my experience that the easier you make it for regulators to understand the thought process behind the development of your compliance polices and procedures, the more likely it is that the regulators will not challenge the sufficiency of those policies and procedures.

The Massachusetts Securities Division has strongly recommended that state-registered advisors adopt codes of ethics and generally comply with the Code of Ethics Rule adopted by the SEC. Pursuant to the Code of Ethics Rule, an investment adviser’s codes of ethics must, at a minimum:

• Set forth a standard of business conduct expected of advisory personnel. The standard chosen must reflect the adviser’s fiduciary obligations and those of its supervised persons, and must require compliance with the federal securities laws.
• Include provisions reasonably designed to prevent access to material non-public information about the adviser’s securities recommendations and client securities holdings and transactions.
• Require an adviser’s “access persons” to periodically report their personal securities transactions and holdings to the adviser’s chief compliance officer or other designated person.
• Require access persons to pre-clear investments in initial public offerings and private placements.
• Require prompt internal reporting of any violations of the code of ethics to the investment adviser’s chief compliance officer.

A question I often hear from single-member investment advisory firms is “do I need to pre-approve my own personal securities transactions”? The answer is no you do not. These advisers, however, should maintain careful records (e.g., brokerage account statements, trade confirmations) of their personal securities transactions and be prepared to explain any transactions that were either contrary to recommendations being given to the investment advisory firm’s clients or that were executed in advance of similar client trades. In addition, since it is typical in smaller investment advisory firms for all employees to have access to nonpublic information regarding clients’ purchase or sale of securities, I suggest that all employees be designated as “access persons” and brought under the umbrella of the firm’s personal trading policies and procedures.

Registration - inconsistencies between Parts I and II of Form ADV and failing to amend Form ADV in a timely manner.

Preparation and maintenance of books and records - not maintaining suitability information, not properly safeguarding records and not backing up data.

Unethical business practice deficiencies involved missing or no contracts and other contract-related issues, and misrepresenting qualifications, services and fees.

Supervision - most common deficiencies were a failure to have any written supervisory/compliance procedures or having inadequate procedures in place.

Financials - deficiencies included inaccurate financials, insufficient or inaccurate net worth, no bank reconciliations and poor financial conditions.

The Connecticut Department of Banking now requires all new investment adviser registrants to file their Form ADV Part II via the Investment Adviser Registration Depository (IARD) system. Previously, investment advisers registering in the State of Connecticut had the option, but were not required, to file via IARD. Existing registrants will have to transition their ADV Part II to the IARD system when they amend their disclosure documents.

State investment adviser compliance really does matter. So much so, in fact, that U.S. Compliance Consultants is preparing to launch a new newsletter devoted solely to state compliance issues. It will be a quarterly publication called “State Compliance Matters” and cover the state registration process and attendant compliance obligations. Despite its complexities, state compliance has been given scant attention by the major compliance consulting firms. Since dealing with state investment adviser registration and compliance is how U.S. Compliance Consultants actually got its start, we are, in a way, returning to our roots.  State compliance will receive short shrift no more!