The Advisor's Professional Library

Regulatory Oversight of Investment Advisors

January 1, 2012

It is an interesting and challenging time to be a Registered Investment Advisor (RIA). The regulatory environment is in a state of flux. The Securities and Exchange Commission (SEC or Commission) continues to experience budget constraints that restrict its ability to carry out its mission of protecting investors. Carlo V. di Florio, director of the SEC’s Office of Compliance Inspections and Examinations (OCIE) told a Senate panel on November 16, 2011, that the Commission does not have the capacity to conduct effective and timely examinations of RIAs. This is in spite of the Commission’s newly instituted examiner training program. Mr. di Florio testified that OCIE only has 830 examiners to conduct thousands of registered entities examinations... Furthermore, di Florio stated that at current funding levels, the SEC will not be able to expand its oversight.

Although state securities regulators now have more responsibility for overseeing RIAs, they might not have the money to hire examiners. Many states are wrestling with drops in tax revenue and large budget shortfalls. Therefore, state securities agencies may not receive the funds needed to enforce rules and regulations that apply to RIAs.

Although the regulatory environment is in a state of flux, it is imperative that RIAs adhere to their compliance obligations. To ensure compliance, RIAs and Investment Advisor Representatives (IARs) must fully understand what those obligations are. To that end, it is important to explain some of the basics.

For instance, Registered Investment Advisor or RIA refers to the firm, not the individual. Quite often, financial professionals will incorrectly refer to themselves as “registered investment advisors,” which is the term that describes the firm itself. An IAR is the individual who is actually giving the advice. Adding to the confusion, the term Investment Advisor might apply to either the firm or the individual. As we will see in Advertising Advisor Services and Credentials, advisors should not use the initials, RIA, or IAR, after their names. Securities regulators take the position that investors will mistakenly believe those initials are a designation earned by the investment advisor, which is not the case.

Often, this book will use RIA to describe any advisory firm registered with either the SEC or state securities regulators. In reference to an investment advisor, it is spelled with an “or,” not an “er.” Nevertheless, the key statute governing RIAs is the Investment Advisers Act of 1940. In reference to the act itself or a rule that interprets this law, advisor will be spelled with an “er” as it appears in the legislation, speech, article, or quote.

Keep in mind that rules implement and interpret statutes such as the Investment Advisers Act. The language in a statute usually provides a broad framework for the act, and rules help to clarify what Congress’ intent was in passing the law. For example, the SEC passed rules to clarify Section 206 of the Investment Advisers Act. Rule 206(4)-1 the advertising rule delineates what types of advertisements are prohibited. Rule 206(4)-2 spells out an RIA’s obligations when the firm takes custody of a client’s funds or securities. These rules, and several others, bring clarity to an RIA’s obligations arising from Section 206.

Impact of the Dodd-Frank Act on RIAs

The regulatory climate for RIAs has been significantly impacted by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which was signed into law on July 21, 2010. The threshold for SEC jurisdiction over RIAs was increased to $100 million in regulatory assets under management.

Subject to certain exceptions, RIAs with regulatory assets under management of less than $100 million will be regulated by the states. Each state imposes different registration requirements on an RIA that conducts business there. As a result, an RIA may be required to register in many different states. Because these registration requirements may be unduly burdensome, the Dodd-Frank Act provides relief to an RIA that must register in at least fifteen states. A firm meeting that description has the option of being registered with the SEC. The SEC will additionally retain jurisdiction over mid-sized investment advisors in New York, since that state does not currently conduct examinations of RIAs. The Commission will also oversee all investment advisors in Wyoming.

The Dodd-Frank Act did not resolve the issue of financial services professionals being held to a fiduciary standard. The law authorized the SEC to impose a fiduciary duty on registered representatives who provide investment advice to clients. Although the SEC recommended that broker-dealers be subject to the same fiduciary standard as RIAs, it is not certain that this harmonization of regulation will occur anytime soon.

According to a December 9, 2011 posting on AdvisorOne written by Melanie Waddell, SEC chairman, Mary Schapiro said in an interview with Bloomberg that the Commission would issue a proposed fiduciary rule in 2012. The fiduciary rule, according to Schapiro, will be business-model neutral. Therefore, it is likely that brokers working with retail investors will be permitted to sell proprietary products and be allowed to charge commissions. Until that proposed rule is published, it will still be uncertain if broker-dealers are subject to a fiduciary standard. The Dodd-Frank Act made it clear that charging commissions and selling proprietary products do not by themselves breach the fiduciary standard.

As a result of the Dodd-Frank Act, the definition of “qualified client” has changed (Rule 205-3 under the Investment Advisers Act). Effective on September 19, 2011, the SEC issued an order raising two of the three thresholds that determine whether an RIA is permitted to charge its clients performance fees. As we will see in Dealings With Qualified Clients and Accredited Investors, an investment advisor registered with the SEC may not charge incentive or performance-based fees unless the person is a qualified client. State-registered investment advisors may face different restrictions if they intend to charge performance fees.

The Dodd-Frank Act gave the SEC the authority to pay financial rewards to whistleblowers that provide new and timely information about securities law violations. Among the many eligibility requirements, the whistleblower’s information must lead to a successful SEC enforcement action resulting in more than $1 million in monetary sanctions.

State Regulatory Activities

State securities regulators are gearing up for their expanded oversight of RIAs. States are pooling their resources to ensure that RIAs are satisfying their compliance obligations. Despite the increased volume of applications precipitated by the higher threshold to become or remain SEC-registered, state securities regulators are scrutinizing RIAs’ registration materials to find deficiencies. An RIA’s registration will not be approved until those deficiencies are resolved.

The North American Securities Administrators Association (NASAA) is an organization whose mission is investor protection. NASAA’s membership consists of securities administrators from all fifty states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada and Mexico. To provide more protection for investors, NASAA enhanced the Investment Adviser Public Disclosure (IAPD) website. The enhancements enable investors to electronically access information regarding individuals working for RIAs. The online system is similar to FINRA’s BrokerCheck® database, which discloses registered representatives’ disciplinary record.

Investors may now use the IAPD web site ( to obtain a great deal of information regarding IARs. The web site provides important information pertaining to an IAR’s background such as:

  • customer complaints;
  • criminal and regulatory disclosures;
  • employment history; and
  • professional qualifications.

With the old IAPD website, investors were only able to find out information about advisory firms, not the IARs who work there.

Definition of an Investment Advisor

Section 202 of the Investment Advisers Act defines an investment advisor as:

“any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”

The definition uses the word “person,” even though the “investment adviser” in the act refers to the firm and not the individual.

To satisfy the aforementioned definition, the person must receive compensation, which is interpreted broadly. Compensation does not need to be labeled as an advisory fee nor does it have to be received directly from a client. In addition, although the person must be engaged in the business of advising others, it does not need to be the individual’s sole or principal business activity.

The Investment Advisers Act and its rules govern the conduct of RIAs. Many states incorporate provisions of that federal statute and the related rules into their own laws governing RIAs. Blue Sky laws refer to state statutes regulating securities.

The Utah Department of Commerce Division of Securities provides a very simple explanation of what constitutes an investment advisor on its web site (

“What is an Investment Adviser?

An Investment Adviser is simply someone who provides advice on securities for compensation. However, Investment Advisers can render that advice in numerous ways, including:

  • issuing reports or analysis on securities;
  • making recommendations to buy or sell securities;
  • managing a client’s securities portfolio;
  • preparing financial plans that involve securities recommendations; or
  • managing an investment fund that allows for the investment in securities.”

Exemptions from Registering as an Investment Advisor

When Congress passed the Investment Advisers Act, it identified a number of specific groups that were exempted from complying with the statute. As a general rule, these groups are not required to register and are not subject to the regulations imposed by the Investment Advisers Act. The SEC’s Division of Investment Management summarized certain exemptions from registration in its publication, General Information on the Regulation of Investment Advisers:

  • “Domestic banks (defined in Section 202(a) (2) of the Advisers Act) and bank holding companies (defined in the Bank Holding Company Act of 1956). Savings and loan institutions, federal savings banks, foreign banks, and credit unions do not fall within this exclusion.
  • Lawyers, accountants, engineers, and teachers if their performance of advisory services is solely incidental to their professions.
  • Brokers and dealers if their performance of advisory services is solely incidental to the conduct of their business as brokers and dealers, and they do not receive any special compensation for their advisory services. This exclusion is not available to a registered representative acting as a financial planner outside the scope of his employment with the broker employer.
  • Publishers of bona fide newspapers, news magazines, and business or financial publications of general and regular circulation. Under a decision of the United States Supreme Court, to enable a publisher to qualify for this exclusion, a publication must satisfy three elements: (1) the publication must offer only impersonal advice, i.e., advice not tailored to the individual needs of a specific client, group of clients, or portfolio; (2) the publication must be “bona fide,” containing disinterested commentary and analysis rather than promotional material disseminated by someone touting particular securities, advertised lists of stocks “sure to go up,” or information distributed as an incident to personalized investment services; and (3) the publication must be of general and regular circulation rather than issued from time to time in response to episodic market activity or events affecting the securities industry. See Lowe v. Securities and Exchange Commission, 472 U.S. 181 (1985).
  • Persons and firms whose advice, analyses, or reports are related only to securities that are direct obligations of, or obligations guaranteed by, the United States, or by certain U.S. government-sponsored corporations designated by the Secretary of the Treasury (e.g., FNMA, GNMA).”

The above exclusions are found in 202(a) (11) (A)-(E) of the Investment Advisers Act.

Pursuant to the Dodd-Frank Act, the SEC recommended that broker-dealers and registered representatives who give investment advice be subject to the same fiduciary standard as RIAs. Nevertheless, the SEC did not eliminate the broker-dealer exclusion, which would have subjected brokers to the registration requirements of the Investment Advisers Act.

Family Offices

Family offices are entities that are set up by wealthy families to manage their wealth and to provide various services to family members. The family office assists with important services such as estate planning, charitable giving, and tax guidance. On June 22, 2011, the SEC approved a new rule defining which family offices are to be excluded from the Investment Advisers Act.

Until the passage of the Dodd-Frank Act, an investment advisor was not required to be registered if the firm had fewer than fifteen clients. The Dodd-Frank Act repealed the fifteen client exemption from registration. Historically, family offices were exempt from registration under the Investment Advisers Act because they fell within the exemption afforded to investment advisors with fewer than fifteen clients. Nevertheless, Dodd-Frank also required the SEC to define family offices, so they would still be exempt from regulation under the Investment Advisers Act.

Pursuant to the SEC’s definition, family offices are excluded from Investment Advisers Act regulation if:

  • they only provide advice to family clients;
  • the company providing the advice is owned by and exclusively controlled by family members; and
  • the family office does not hold itself out to the public as an investment advisor.

The new rule provided a full explanation of what is meant by family member and family client. If a family office does not meet the exclusion, it must register as an investment advisor by March 30, 2012.

The Big Picture

In any regulatory or economic environment, compliance is extremely important. Even if the threat of a compliance examination by securities regulators is unlikely, disobeying the rules can have serious implications. Lori A. Richards, the former director of OCIE, warned RIAs about the potential pitfalls of noncompliance in her December 2, 2009 open letter to CEOs of SEC-registered firms:

“During this time of financial and market turmoil, the Office of Compliance Inspections and Examinations of the Securities and Exchange Commission reminds leaders of SEC-registered firms, including broker-dealers, investment advisers, investment companies and transfer agents, of the critical role played by your firm’s compliance programs in helping to meet your obligations under the securities laws. Your firm’s compliance function is critical to assure that your operations comply with the law and rules for industry participation and to ensure that the interests of your customers, clients and shareholders are protected. Moreover, compliance is a vital control function that helps to protect the firm from conduct that could negatively impact the firm’s business and its reputation.

While many firms are considering reductions and cost-cutting measures, we remind you of your firm’s legal obligation to maintain an adequate compliance program reasonably designed to achieve compliance with the law.”

At the time of Richards’ speech, the United States was in the middle of the worst economic downturn since the Great Depression. RIAs found their income slashed as the value of portfolios plummeted. Most RIAs earn the bulk of their fees based on a percentage of clients’ assets under management. Because of this decline in their income, RIAs may have reacted by cutting their compliance budgets. As we will see in How to Avoid Sabotaging Your Compliance Exam, examiners may look at an RIA’s compliance budget to determine whether it is adequate.

Tough economic times are no excuse for an RIA being lax in fulfilling its compliance obligations. Failure to comply with rules and regulations may lead to misconduct that will severely damage a firm’s reputation and standing in the community. Many disciplinary events must be disclosed to existing and prospective clients in the RIA’s disclosure brochure. Furthermore, the SEC or state securities regulators may bring enforcement actions against RIAs that commit serious compliance violations. For example, on November 28, 2011, the SEC charged three RIAs with failing to put compliance procedures in place to prevent securities law violations. Aside from the fines and other penalties imposed on the RIAs, one firm was told to prominently post a copy of the SEC’s order on its web site.

Prospective clients are likely to avoid an RIA that has an SEC order rebuking the firm on its website. Few prospective clients will hire an RIA after conducting an Internet search of the firm and reading that order or seeing other negative publicity. Attracting new clients is difficult enough for RIAs without having to explain compliance violations and disciplinary action taken 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.