The Advisor's Professional Library

Differences Between State and SEC Regulation of Investment Advisors

January 1, 2012

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According to the SEC’s study of investment advisors and broker-dealers released in January 2011, there were 11,888 firms registered with the Commission as of September 30, 2010. At that time, there were over 15,000 state-registered advisory firms. Those figures will change dramatically as many investment advisors make the transition from SEC to state registration. According to Carlo V. di Florio’s remarks at the IA Watch Annual IA Compliance Best Practices Seminar on March 21, 2011, approximately 4,100 RIAs will switch from SEC to state registration. Assuming these predictions are accurate, approximately 19,000 RIAs will be state registered.

Section 410 of the Dodd-Frank Act raised the asset under management threshold from $25 million to $100 million. As we saw in Regulatory Oversight of Investment Advisors, RIAs managing less than 100 million may choose to become or remain SEC-registered if they are required to register with fifteen or more states. Prior to the Dodd-Frank Act, this option was not available unless an advisor had to register in at least thirty states.

The Switch from SEC to State Registration

The North American Securities Administrators Association (NASAA) launched a coordinated review program on November 29, 2011, for RIAs switching from federal to state securities regulatory oversight. According to Jack E. Herstein, NASAA President and Assistant Director of the Nebraska Department of Banking and Finance Bureau of Securities, “This initiative provides investment advisers registering in multiple states with an easier way to navigate the switch to state registration and gives states an opportunity to coordinate and resolve issues about potential problems with applicants.” The program is available to advisors who are currently registered with the SEC and now required to register in four to fourteen states. In the press release, Herstein observed that advisors registered in fifteen or more states can retain their SEC registrations.

The new rules implementing the Dodd-Frank Act create a buffer zone for mid-sized advisors who have regulatory assets under management that fluctuate around the $100 million threshold. The new rules also permit advisors to wait until their assets hit $110 million before the firm must register with the Commission. Once registered, however, RIAs need not withdraw registration until the firm’s regulatory assets under management fall below $90 million. The term “regulatory assets under management” replaces the old term, which was simply “assets under management.”

Now that more RIAs are transitioning from SEC to state registration, these firms may be subject to different regulations. Each state is likely to have specific rules that must be followed, which sometimes apply to both SEC and state-registered investment advisors.

How the Transition Impacts SEC-Registered Advisors

The National Securities Markets Improvement Act of 1996 (NSMIA) established the parameters for regulatory oversight, so the SEC and the states would not infringe on each other’s jurisdictions. Until the Dodd-Frank Act, the SEC was usually responsible for overseeing RIAs with assets under management that exceeded $25 million. Now that the assets under management threshold has increased to $100 million, the SEC has jurisdiction over large advisory firms while states oversee most small and mid-sized advisors.

Despite NSMIA, SEC-registered investment advisors may be required to provide state securities regulators with copies of documents filed with the Commission, a process referred to as notice-filing. An SEC-registered investment advisor must notice-file in the state where its principal office is located and in other states where the firm has an office. An SEC-registered firm must also notice-file where it exceeds the cap on clients established by the state, even though it has no office there.

SEC-registered firms that transition to state registration are facing new compliance rules. In an article in Compliance Insights/2011 entitled “Changes Loom for RIAs Under State Supervision,” TD Ameritrade Institutional pointed out certain pitfalls that RIAs under state regulation might face. An RIA that was previously SEC-registered might need to:

  • be ready for more frequent examinations if the state securities agency is adequately staffed;
  • send out client invoices, because states typically require firms to send invoice statements directly to clients;
  • pay higher fees and penalties, because states will be under pressure to raise revenue;
  • amend their advisory agreements and other documents to conform with state requirements; and
  • adjust to net capital requirements.

Generally, advisory firms that take custody of clients’ assets, or have discretion over their accounts, are expected to maintain a capital cushion and must typically provide a balance sheet when registering. As we will see in Do’s and Don’ts of Advisory Contracts, RIAs with discretion solely assume investment authority over clients’ accounts and are not required to seek approval before making trades.

State Registration Requirements

Suppose a Pittsburgh-based RIA is registered in Pennsylvania but one of its biggest clients moves to Florida. Because there is a national de minimis standard established by Section 222 of the Investment Advisers Act, the RIA may not need to register in Florida. Based upon the de minimis standard, a state may not require registration, licensing, or qualification of an investment advisor if the firm:

  • does not have a place of business in the state; and
  • has had fewer than six clients who are residents of the state during the preceding twelve month period.

If that Pittsburgh-based RIA does open a Florida office or has six clients in the state, the firm must register there. It is important to note that this is a rolling twelve-month period, not a calendar year.

An RIA that has six or more clients in several states must register in each of them. To facilitate the registration process, the Self-Regulatory Organization for Independent Investment Advisers created a web tool to guide RIAs. The organization launched a website in December, 2011, that provides the registration requirements for each state (

In certain states such as Texas, registration is required before an RIA takes on its first client. If the RIA does not have an office in Texas and has fewer than six clients, however, a full registration is not required and the RIA must make a special notice filing. In the Frequently Asked Questions (FAQ) section of the Texas State Securities Board’s web site, registration staff addressed the de minimis issue:

“22.2.A.9 Q: Didn’t NSMIA create a national de minimis exemption from investment adviser registration?

23.A: Yes. If an investment adviser does not have a place of business (See FAQ 2.A.10) located in Texas and, during the preceding 12-month period, had no more than 5 clients (See FAQ 2.A.11) who are Texas residents, the investment adviser is not required to register with the Texas Securities Commissioner. See Rule 116.1(b)(2)(A). However, a notice filing and fee is required. See Rule 116.1(b)(2)(C) and FAQ 2.A.12. This is satisfied by filing Form ADV through the IARD system for the firm as well as filing Form U-4 for each investment adviser representative through the CRD system.”

Which Securities Regulator Oversees an RIA Registered in Several States

Typically, examinations of state-registered investment advisors are conducted by the state where the RIA’s principal office is located. Section 222 stipulates that an RIA may not enforce a higher minimum net capital requirement or any bond in excess of the amount required by the state in which the firm maintains its principal place of business. An RIA’s home state net capital requirement preempts that of another jurisdiction where the advisor is registered. This applies even if an RIA’s home state does not impose a minimum net capital or bonding requirement. Furthermore, an RIA is only obligated to comply with its home state’s books and records rule.

Surprisingly, a state-registered investment advisor in Florida recently received notification that a desk audit would be conducted by Michigan. A desk audit is conducted remotely by securities examiners instead of visiting the RIA’s offices. Although a desk audit is not unusual, it is out-of-the-ordinary for an RIA to be examined by a regulator in a state where the firm is registered but does not have a place of business.

An examination of an RIA with its principal office in another state might be less surprising if it was scheduled in response to a complaint. It is also more common where there is a coordinated examination of an RIA by several states in which the firm is registered. In this particular case, the examination was part of Michigan’s efforts to examine all RIAs registered in the state. Michigan requested numerous documents and files, including copies of the RIA’s most recent financial statements. The RIA was required to send a balance sheet, trial balance, and income statements for the last three years. The advisor was also required to send copies of all bank statements relating to the advisory business for the last twelve months. If other states adopt the same practice, state-registered RIAs will face a significant compliance burden by being subjected to multiple examinations.

NASAA View on RIA’s Fiduciary Obligations

In the Investment Adviser Guide published by NASAA, the organization pointed out that some prohibited practices should be obvious and others are not. For example, it should be obvious that RIAs may not engage in any activity that acts as a fraud or deceit on clients.

According to NASAA’s Investment Adviser Guide, RIAs should avoid the following practices:

  • Acting as an issuer or affiliate of a securities issuer
  • Recommending unregistered, non-exempt securities or the use of unlicensed broker-dealers
  • Charging unreasonable fees
  • Using contracts and contractual language, like hedge clauses, which seek to limit or negate an advisor’s legal liability
  • Limiting a client’s ability to pursue a civil case or arbitration
  • Borrowing from or lending money to clients
  • Failing to disclose to all clients, not just a select few, that fee discounts are available

An RIA may offer fee discounts, such as charging a lower rate to clients with a larger amount to invest. These discounts must be disclosed to every client in the RIA’s Form ADV disclosure brochure, which we will discuss in The New and Improved Form ADV.

When state examiners review an RIA’s books and records, they will be on the lookout for these kinds of prohibited practices. Examiners will also be scrutinizing the firm’s books and records for undisclosed or misrepresented conflicts of interest. Furthermore, examiners will be on the lookout for unethical business practices committed by RIAs.

Unethical Business Practices

Among its other responsibilities, NASAA formulates model rules that are used by state legislators in drafting securities legislation. While some states will adopt NASAA’s model rules in their entirety, others tweak them and pass their own version of a particular regulation. RIAs facing the prospect of state oversight should familiarize themselves with NASAA’s model rule entitled, “Unethical Business Practices Of Investment Advisers, Investment Adviser Representatives, And Federal Covered Advisers.” NASAA’s model rule lists a number of unethical business practices (Table 1-1).

Table 2-1
Model Rule 102(a)(4)-1 Adopted 4/27/97, amended 4/18/04, 9/11/05

NASAA Unethical Business Practices of Investment Advisers, Investment Adviser Representatives, and Federal Covered Advisers


While the extent and nature of this duty varies according to the nature of the relationship between an investment adviser or an investment adviser representative and its clients and the circumstances of each case, an investment adviser, an investment adviser representative or a federal covered adviser shall not engage in unethical business practices, including the following:

        Recommending unsuitable investments;
     Exercising any discretionary power without obtaining written discretionary authority from the client;
      Trading excessively;
        Placing an order to purchase or sell a security for a client’s account without authority to do so;
        Placing an order to purchase or sell a security for a client’s account based on the instruction of a third party without first having obtained a written third-party trading authorization from the client;
        Borrowing money or securities from a client unless the client is a broker-dealer, an affiliate of the RIA, or a financial institution engaged in the business of loaning funds;
        Loaning money to a client unless the RIA is a financial institution engaged in the business of loaning funds or the client is an affiliate of the RIA;
        Misrepresenting the advisor’s qualifications, fees, or services to clients and prospective clients;
        Providing a report or recommendation to any advisory client prepared by someone other than the advisor without disclosing that fact;
        Charging an unreasonable fee to a client;
        Failing to disclose in writing any material conflict of interest to clients;
        Guaranteeing a specific result;
        Publishing non-compliant advertising;
        Disclosing a client’s identity, affairs, or investments unless required by law to do so or the client consents to that disclosure;
        Violating the Custody Rule;
        Entering into, extending or renewing an advisory contract that is not in writing or does not disclose the services to be provided, the term, the advisory fee, the formula for computing the fee, the amount of prepaid fee to be returned in the event of termination or non-performance, whether it grants discretionary power, and that no assignment shall be made without the consent of the other party;
        Failing to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material nonpublic information;
        Entering into, extending, or renewing any advisory contract that is contrary to the provisions of Section 205 of the Investment Advisers Act;
        Using an advisory contract that forces any person to waive compliance with the Investment Advisers Act or a rule prohibiting unethical business practices;
        Engaging in any act, practice, or course of business which is fraudulent, deceptive, or manipulative; and
        Engaging in any act or conduct, indirectly or through another person, which would be unlawful for that person to do directly.

States may add to the list of unethical business practices to prevent misconduct they believe will hurt investors. It is now an unethical business practice in states such as Washington to use any term or abbreviation in a misleading manner, such as stating or implying that a person has special expertise, certification, or training in financial planning. This unethical business practice includes the misleading use of a senior-specific certification or designation.

NASAA’s model rule also emphasizes the importance of full disclosure. In addition to the lengthy list of unethical business practices, the model rule states that, “Engaging in other conduct such as non-disclosure, incomplete disclosure, or deceptive practices shall be deemed an unethical business practice.”

Disclosure of Risks and Conflicts of Interest

An important component of an RIA’s fiduciary duty is the firm’s obligation to provide full disclosure of risks and conflicts of interest. NASAA’s Investment Adviser Guide points out a number of areas where full disclosure is imperative, such as when the:

  • RIA or its employees are also acting as a broker-dealer;
  • RIA is receiving compensation for transactions, including 12b-1 fees;
  • RIA receives any type of compensation from any source for soliciting or referring clients to another adviser or a broker-dealer; and
  • RIA receives hidden service charges, wrap fees, or expenses reimbursed by other parties.

According to NASAA, state securities examiners view these issues from the client’s perspective. The burden of proof is on the RIA to demonstrate that the firm has made full disclosure.

Lending or Borrowing Money

As noted in NASAA’s model rule and its Investment Adviser Guide, RIAs should not lend money to a client or borrow money or securities from that person. The SEC will also look harshly upon RIAs who borrow or lend money to clients.

Borrowing or lending money to a client is a breach of the fiduciary obligations that RIAs owe to their clients, and neither should clients loan money to their RIA. Unfortunately, an advisor may rationalize that a loan benefits both parties if the RIA is willing to pay a higher interest rate than the client is earning from certain investments. In truth, however, the advisor is exploiting confidential information regarding the client’s finances gained from the advisory relationship. To secure the loan, the RIA might not disclose all of the reasons why the transaction is inadvisable. The advisor may not be a credit-worthy borrower and might encounter problems in paying the money back, which would adversely affect the client.

The RIA might manage the client’s funds differently in view of the loan, and the situation would make it very difficult to give totally objective advice. Similarly, if an RIA lends money to a client, the firm might manage the portfolio differently knowing that its own funds are at risk.

The Big Picture

As we will see in Registration Requirements for Investment Advisor Representatives (IARs), states may impose licensing or registration requirements on IARs doing business in their jurisdictions. Those requirements usually apply, even if the IAR works for an SEC-registered firm. Nevertheless, states may investigate and prosecute fraud committed by any IAR in their jurisdictions, even if the individual works for an SEC-registered firm. Normally, however, oversight of an IAR working for an SEC-registered firm is the Commission’s responsibility. The state will typically notify the Commission if it learns about misconduct by an IAR for an SEC-registered firm.

State securities regulators are likely to take harsh action against RIAs and IARs involved in unethical business practices, such as borrowing money from or lending money to clients. These violations may result in fines or other sanctions. In some cases, it may be grounds for denial, suspension, or revocation of an IAR’s registration.

Section 206 of the Investment Advisers Act is the general anti-fraud provision governing RIAs. It gives rise to the fiduciary duties owed to advisory clients. Whether an RIA is state or SEC-registered, the firm owes a fiduciary obligation to put clients’ interests ahead of its own. An RIA or IAR may not engage in any act, practice, or course of business, which is fraudulent, deceptive, or manipulative.

The line between unethical and ethical business practices may not always be clear. Nevertheless, RIAs and IARs can avoid misconduct if they focus on their fiduciary duties at all times. One helpful tool is to implement and enforce thorough policies and procedures that establish ethical business practices. Whether required to do so or not, firms should implement a code of ethics to ensure that IARs and associated persons live up to the standards expected by securities regulators.

Les Abromovitz

Les Abromovitz

Les Abromovitz is the author of The Investment Advisor’s Compliance Guide, published by The National Underwriter Company/ALM Media.

An attorney and member of the Pennsylvania bar, Les has handled hundreds of consulting and publishing projects for National Compliance Services,, a leading compliance and regulatory services firm. He has conducted a number of seminars and training sessions dealing with compliance subjects. Les is also the author of several white papers that analyze compliance issues impacting Registered Investment Advisors (RIAs)‎.

To contact Mr. Abromovitz, email or call 561-330-7645 Ext. 213‎.