FINANCIAL PLANNING

David M. Cordell

What Was the Situation Before?

The number of investment advisers subject to regulation at the federal level has grown significantly. This regulation derives primarily from the Investment Advisers Act of 1940 as administered by the Securities and Exchange Commission (SEC). Prior to the passage of the Investment Advisers Supervision Coordination Act (IASCA) in October 1996, financial planners were with few exceptions required to register as investment advisers with the SEC. Most states also required financial planners to register as investment advisers at the state level.

Congress passed the Investment Advisers Act in the post-Depression era primarily to police and control discretionary money managers. This act and subsequent regulations exempted the following entities from the definition of investment adviser:

• any bank or holding company as defined in the Bank Holding Company Act of 1956 that is not an investment company
• any lawyer, accountant, engineer, or teacher if the performance of advisory services is solely incidental to the practice of his or her profession
• any broker, dealer, or registered representative thereof whose performance of advisory services is solely incidental to the conduct of his or her business as a broker or dealer and who receives no "special compensation" for his or her services
• the publisher of any newspaper, news magazine, or business or financial publication of general or regular circulation
• any person whose advice, analyses, or reports relate only to securities that are direct obligations of or obligations guaranteed as to principal or interest by the United States of America
• such other persons not within the intent of the law as the SEC may designate by rules and regulations or by order

The Investment Advisers Act and subsequent regulations exempted five other groups from registration although they fall within the definition of investment adviser:

• advisers whose clients are all residents of the state within which the investment adviser maintains the principal office and place of business and who do not furnish advice or issue analyses or reports with respect to listed securities or securities admitted to unlisted trading privileges
• advisers whose only clients are insurance companies
• advisers who, during the preceding 12 months, have had fewer than 15 clients and who neither present themselves to the general public as investment advisers nor act as investment advisers to any investment company registered under the Investment Company Act of 1940
• advisers that are charitable organizations and that provide advice only to other charitable organizations
• advisers that provide advice solely to church plans

Although these advisers are not required to register, they are still required to comply with the act’s antifraud provisions.

In August 1981, the SEC’s Release No. IA-770 specified three tests to apply when determining if a financial planner was required to register with the SEC as an investment adviser. If the planner answered each of these tests affirmatively, he or she was required to register with the SEC.

The first test asked whether the planner provided clients with "advice or analyses" concerning securities. Although some planners believe that they do not provide such services, they are often surprised to learn that Sec. 80b-22(a)(18) of the Investment Advisers Act of 1940 defines security as

…any note, stock, Treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas or other mineral rights, or in general, any instrument or interest commonly known as a security, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or guarantee of, or warrant or right to subscribe to or purchase any of the foregoing.

Because of the breadth of this definition, almost all financial planners must answer the first test affirmatively.

The second test specified by Release No. IA-770 concerned whether the planner holds himself or herself out to the public as being "in the business" of providing advice or analyses about securities. Indications that the planner must answer affirmatively to this "holding out" provision can be inferred from such things as the planner’s business card, advertising, and letterhead as well as the way he or she describes his or her business activity.

The third test specified by Release No. IA-770 related to compensation. If the planner receives any compensation for services rendered, he or she must answer affirmatively to this test. Although commission-based planners often consider themselves excluded because of this test, the SEC makes no distinction between fee and commission compensation. The effect of this interpretation is that it is nearly impossible for a planner not to answer in the affirmative.

One effect of these inclusive definitions and the burgeoning financial planning field was the enormous growth in the number of registered investment advisers from 5,680 in 1980 to 22,500 in early 1997. The SEC’s budget was woefully inadequate to supervise or examine such a large group on a regular basis. Furthermore, as already noted, regulation of investment advisers was not the exclusive purview of the SEC. Forty-six states mandated registration of investment advisers at the state level, although with widely varying requirements. Many states specified qualifications and/or requirements that were much more stringent than federal requirements. For example, many states specified capital requirements, and most required National Association of Securities Dealers (NASD) registration, such as series 63 (uniform state securities exam) or series 65 (investment adviser).

Two important factors were at work. First, there was concern about the cost associated with overlapping and duplicative federal and state regulatory bodies. Second, there was concern about whether it was reasonable to require investment advisers and financial planners to be regulated at both the state and federal level.

What Is the Nature of the Change?

The relationship between state and federal regulation of investment advisers has changed. After years of dispute about the direction of regulation of investment markets and investment advisers, the Congress passed and the president signed the National Securities Markets Improvement Act in October 1996 with an effective date of April 9, 1997. Title III of that act is the Investment Advisers Supervision Coordination Act (IASCA). The most important aspects of IASCA concern allocating the jurisdiction of investment advisers between the SEC and state authorities based primarily on the level of assets under an adviser’s management. IASCA also authorizes appropriations for the SEC, prohibits felons from registering as investment advisers within 10 years of conviction, and mandates a consumer hotline (presumably via telephone and the Internet) for inquiry concerning disciplinary actions and proceedings against registered investment advisers and associated persons.

Under IASCA, investment advisers—and thus financial planners—need to register with either the SEC or state authorities, but not with both. The critical provisions of this law have the following effects:

• Amending the Investment Advisers Act of 1940 to exempt from SEC registration requirements investment advisers who are subject to a state securities regulator unless they (1) manage at least $25 million in assets, or (2) serve as advisers to certain federally registered investment companies. (Colorado, Iowa, Ohio, and Wyoming were the only states without securities regulations at the time this was written.)
• Exempting from state regulation advisers who are subject to SEC regulation or who are excepted from the SEC definition of investment adviser. IASCA permits states in such cases to (1) require the filing of documents for notice purposes, and (2) investigate fraud or deceit and bring enforcement actions.
• Prohibiting the enforcement of any state law or regulation that sets record-keeping or capital and bond requirements in addition to those of the state in which the adviser maintains its principal place of business as long as the adviser is in compliance with applicable requirements.
• Exempting from state registration, licensing, or qualification requirements certain investment advisers who (1) do not have a place of business located within the state, and (2) have had fewer than six clients who are residents of the state during the preceding 12-month period.
• Declaring that a state securities commission (or similar agency) can require the filing of any documents filed with the SEC pursuant to securities laws solely for notice purposes, together with consent to service of process and any required fee.
• Allowing states to continue collecting filing and registration fees that were in effect before the enactment of IASCA, until state law or regulation provides otherwise. For 3 years after IASCA’s enactment, state securities commissions may require the state registration of advisers who fail to pay such fees.

When Does this Change Affect Clients?

IASCA was supposed to take effect on April 9, 1997; however, Congress subsequently recognized that regulators and advisers needed more time to comply with the law. Both houses of Congress passed and the president signed legislation to postpone the effective date of IASCA to July 8, 1997. Meanwhile, on December 20, 1996, the SEC issued Release No. IA-1601, which contained proposed regulations for implementing IASCA and requested public comment during a period that expired February 10, 1997. Also on December 20, 1996, the SEC issued Release No. IA-1602, which stayed the requirement of filing Form ADV-S that investment advisers must file within 90 days of the end of their fiscal year.

What Should Be Done?

Of course, when governmental regulations change, the only appropriate response is compliance. Unfortunately, until the SEC finalizes the regulations, it is impossible to know exactly what to do. Although the proposed regulations are apt to change before reaching their final form, we can review some of the major points for guidance because it is likely that most will survive intact. The critical provisions of these proposed regulations would have the following effects:

• Requiring all registered investment advisers to file a new Form ADV-T, the instructions for which help determine whether the adviser meets the criteria for SEC registration. Under proposed transition rule 203A-5, all advisers registered with the SEC on July 8, 1997, are required to file a completed Form ADV-T by that date.
• Refining the definition of assets under management as used in the Investment Advisers Act of 1940 for the purpose of determining whether advisers must register at the state or federal level. (See the Author’s Note at the end of this topic section for the actual text used in instruction 7 of Form ADV-T.) Advisers would include only those accounts for which they provide "continuous and regular supervisory or management services" and 50 percent of the value of which consists of securities. Cash and cash equivalents must be excluded in the calculation of the percentage. If an account is determined to be a securities portfolio, the entire value of the account, including cash and other nonsecurities positions, must be included in calculating assets under management.
• Requiring that valuation of securities be calculated no more than 10 days prior to filing Form ADV-T.
• Creating a safe haven from SEC registration for an adviser that is registered with state securities authorities based on a reasonable belief that it is prohibited from registering with the SEC because it has insufficient assets under management.
• Increasing the level of assets under management for required SEC registration to $30 million, and making SEC registration optional for assets under management of $25 million to $30 million, thus lessening the likelihood that market volatility will force the adviser to move back and forth between state and federal registration.
• Requiring annual filing of a new Schedule I ("eye") to Form ADV to determine whether the adviser’s assets under management have fallen below $25 million, requiring de-registration. It also provides a 90-day grace period for registering at the state level after a schedule I filing that forces federal de-registration.
• Exempting four types of advisers from the prohibition on SEC registration:
  • Nationally recognized statistical rating organizations, often referred to as rating agencies. These entities do not have assets under management, but the SEC believes they are better regulated at the federal level.
  • Pension consultants, defined as investment advisers that provide investment advice to certain employee benefit plans with respect to assets having an aggregate value of at least $50 million during the adviser’s last fiscal year.
  • Certain affiliated investment advisers, primarily including firms that conduct their advisory activities through separately registered advisers, not all of which meet the criteria for SEC registration.
  • Newly formed investment advisers that reasonably expect that they will, within 90 days of formation, have assets under management that will qualify for SEC registration.
• Defining the terms principal office and place of business, supervised persons (of SEC-registered investment advisers), investment adviser representative, and solicitor to further delineate whether state or federal registration is appropriate.
• Amending the Investment Advisers Act to make state investment adviser statutes inapplicable to advisers that do not have a place of business in that state and have fewer than six clients who are residents of that state ("national de minimis standard"), and defining as a single client for this purpose (1) any natural person and any relative or spouse of the natural person sharing the same principal residence, and (2) all accounts of which such persons are the sole primary beneficiaries. The proposed rule also treats as a single client a corporation, general partnership, limited partnership (meeting the safe harbor definition in rule 203(b)(3)-1 of the Investment Advisers Act), trust, or other legal organization that receives investment advice based on its investment objectives rather than the investment objectives of its shareholders, partners, members, or beneficial owners.
• Limiting the applicability of the book- and record-keeping requirements of rule 204-2 only to advisers registered with the SEC and requiring advisers registered with the SEC to preserve any books and records the adviser was previously required to preserve under state law.
• Extending to advisers who are not required to register with the SEC the exemption from the prohibition against performance fee arrangements. This exemption allows advisers to charge performance fees (also called incentive fees), but only if the adviser is managing $500,000 of the client’s assets or reasonably believes that the client has a net worth of at least $1 million.
• Continuing to apply the antifraud provisions of the Investment Advisers Act to all advisers. However, four existing rules will no longer be applied to state-registered advisers because it is assumed that the states can more appropriately address these issues. These four rules prohibit certain abusive advertising practices, govern the adviser’s custody of funds and securities of clients, address the payment of cash to persons soliciting on behalf of the adviser, and require certain disclosure to clients regarding the adviser’s financial condition and disciplinary history.
• Continuing to apply the Investment Adviser Act’s prohibitions against advisory contracts that (1) contain certain performance fee arrangements, (2) permit an assignment of the advisory contract to be made without the consent of the client, and (3) fail to require an adviser that is a partnership to notify clients of a change in the membership of the partnership.
• Requiring advisers subject to state regulation to continue to be subject to the Investment Advisers Act’s requirement to establish, maintain, and enforce written procedures reasonably designed to prevent the misuse of material nonpublic information.

A review of the responses sent to the SEC via the Internet and posted on the SEC’s Web site suggests that respondents’ concerns are numerous. State regulators have expressed concern about definitions, being usurped by federal law, and losing revenue from investment advisers who will no longer need to register with states (although IASCA specifically allows states to charge fees). Advisers and their representatives have also expressed numerous concerns. For example, advisers with assets under management near the $25 million mark fear that they will need to switch back and forth between federal and state registration if market conditions are volatile, even with the SEC’s proposed $5 million buffer. Some small advisers with clients in several states complain that they must register in each state. Among the other controversial issues include the definitions of assets under management, client, place of business, and investment adviser representative and the registration of pension consultants at the federal level regardless of assets under management.

Despite all the uncertainty about the final form of the regulations, the effect on most advisers is clear. Instead of registering at both the state and federal level, relatively small advisers (with less than $25 million under management) will be regulated by the states while larger advisers will fall under SEC jurisdiction. Since SEC regulation may be easier and more predictable than state regulation, there is added reason to seek to increase the level of assets under management (as if there were not reason enough already).

Where Can I Find Out More?

• HS 318 Insurance and Financial Planning. The American College.
• HS 320 Fundamentals of Financial Planning. The American College.
• David M. Cordell, ed. Readings in Financial Planning, 2d ed., 1997. The American College. (This textbook is used in The American College’s HS 318 course. See chapter on SEC registration and compliance for investment advisers.)
• David M. Cordell, ed. Fundamentals of Financial Planning, 3d ed., 1996. The American College. (This textbook is used in The American College’s HS 320 course. See chapter on SEC registration and compliance for investment advisers.)
• For the most up-to-date information concerning regulatory requirements under the IASCA, contact the SEC’s Web site on the Internet (http://www.sec.gov) and click "Current SEC Rule Making." Review the sections "Proposed Rules" and "Final Rules." Electronically filed comments to proposed rules can be accessed from the "Proposed Rules" screen.

The full text of instruction 7 of proposed Form ADV-T is as follows:

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In determining the amount of assets the registrant has under management, include the total value of securities portfolios with respect to which the registrant provides continuous and regular supervisory or management services.

a. An account is a securities portfolio if at least 50% of the total value of the account (less cash and cash equivalents) consists of securities. Include securities portfolios that are: (i) family or proprietary accounts (unless the registrant is a sole proprietor, in which case the personal assets of the sole proprietor should be excluded); (ii) accounts for which the registrant receives no compensation for its services; and (iii) accounts of clients who are not U.S. residents.

b. Include the entire value of each securities portfolio for which the registrant provides "continuous and regular supervisory or management services."

c. A registrant provides continuous and regular supervisory or management services with respect to a securities portfolio if the registrant (i) has discretionary authority over and (ii) provides ongoing management or supervisory services with respect to the portfolio.

Whether a registrant that provides ongoing management or supervisory services on a non-discretionary basis provides continuous and regular supervisory or management services is a question of fact. The greater the registrant’s ongoing responsibilities, the more likely the adviser will be providing continuous and regular supervisory or management services.

To assist registrants, the Commission is providing examples of accounts that receive continuous and regular supervisory and management services. These examples are not exclusive.

Accounts that receive continuous and regular supervisory and management services:

• accounts for which the adviser provides traditional portfolio management services on a discretionary basis;
• accounts for which the adviser provides ongoing management services (i.e., is responsible for the selection of which securities to buy and sell and when to buy and sell them) without a grant of discretionary authority;
• accounts managed by other advisers (i) that the adviser has been given a grant of discretionary authority to hire and discharge on behalf of the client, and (ii) among which the adviser has the authority to allocate and reallocate account assets; and
• accounts for which the adviser provides asset allocation services by (i) continuously monitoring the needs of the clients and the markets in which account assets are invested, and (ii) allocating and reallocating account assets to meet client objectives under a grant of discretionary authority.

    Accounts that do not receive continuous and regular supervisory and management services:

• accounts for which the adviser provides only periodic advice (no matter how frequent), e.g., an account for which the adviser has prepared a financial plan which is periodically reviewed and updated;
• accounts for which the adviser provides advice only on a periodic basis or as a result of some market event or change in client circumstances (even if the adviser has discretionary authority), e.g., an account that is reviewed and adjusted on a quarterly basis or upon client request;
• accounts for which the adviser provides market timing recommendations (to buy or sell) but does not manage on an ongoing basis;
• accounts for which the adviser provides impersonal advice, e.g., market newsletters;
• accounts for which the adviser provides only an initial asset allocation, without continuous and regular monitoring and reallocation; and
• accounts for which the registrant undertakes to monitor the markets and apprise the client of any developments, or make recommendations as to the reallocation of client assets upon any developments.

d. Determine the total amount of assets under management based on the current market value as determined within 10 business days prior to the date of filing this Form. Current market value should be determined using the same methodology as the account value reported to clients or calculated to determine fees for investment advisory services.

e.    Include only those accounts for which registrant provides continuous and regular supervisory and management services as of the date of filing this Form.

Chapter 8

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