The following is an edited transcript of an Oct. 9 webcast, “The Switch: Surviving, and Even Thriving, in the New Regulatory Landscape,” moderated by InvestmentNews deputy editor Greg Crawford and senior reporter Dan Jamieson.
InvestmentNews: Linda Cena is going to give us an overview of how the switch process went, where it is and a little bit on what the Securities and Exchange Commission might do with stragglers who haven't yet registered with a state, and a little background on what state examiners have found through a number of different audits.
Linda?
Ms. Cena: The switch went much smoother than we could ever have anticipated. A lot of things went really well. One of the things that jumps out at me that went well was the coordinated review. If you were going to register in four or more states, you could opt to participate in the Coordinator Review Program, which meant the states worked together on that application.
The firms that went through it went through much quicker and much smoother. The registration staff from the states that worked on those applications had a real learning experience, and the big theme you are going to hear from [the North American Securities Administrators Association Inc.] and the states in the coming year is uniformity.
There are also two things that came out of that I want to make everyone aware of. We have two new pieces. One is called the most common deficiencies. We actually tracked the deficiencies we found in the Coordinator Review Program, and those are on the NASAA website. If you go on NASAA's website, it is under IA Switch Resources/Most Common Deficiencies; that would be an excellent piece for a registration department to have in an investment adviser firm.
The second is, we created a Guide to Registration. That will also walk you through a lot of the problems firms were having with registration and how to get through them much easier. So I would highly recommend that firms look at those.
I have learned through the switch process that there are three areas that would help a firm if they were registering in a state: consistency with forms, contracts and fees.
COMPARE THE ADV FORMS
One of the biggest things I told firms when they applied for registration in a state is to pull your ADV 1, your ADV 2 and your contracts out and look. Make sure there are no inconsistencies between those forms.
Make sure you have a contract for each service and describe the services provided.
Make sure that there are consistent fees throughout and that there is a complete description of the fees. For example, how is [the fee] calculated? When is it calculated? How is it collected? When is it collected?
We did have a rush of applications. They came in late June and July, and most of those have been gone through. We don't have an exact date when the SEC will begin its deregistration process, but it will be soon. So it is very important that those IA applications that are still pending get worked on quickly.
Basically, who will be involved in this deregistration process? It is going to be investment advisers who haven't completed the process — in other words, those that are still registered with the SEC and still pending with the states. The second category we are going to see there are those that are registered with the SEC still, [and] registered with the states but have failed to file their ADV-W. I had to call two firms just last week in Michigan that had gone through, completed their registration process with Michigan — everything was fine — but they didn't realize they had not done the last step, which was doing the ADV-W.
Now, how is the SEC going to take action to cancel those registrations? They will publish this list in the Federal Register and then after the time listed on the notice, they will start deregistering those firms. So to get registered, the next steps that we have to work on are curing deficiencies, verifying the state has approved your registration, and you need your ADV-W. You need to avoid being on the deregistration list. There are a couple of consequences that are big.
One, it is a disclosable event. Equally important is that you are going to leave your clients in a lurch if you are not an adviser and you are not registered, and it comes to the beginning of the year, because that is usually a big time for investment advisers. If you have questions and you are still one of these pending, contact your appropriate jurisdiction and they will help you through this.THE EXAM PROCESS
The second part would be exams. Our goal is to examine every state-registered investment adviser. We have three basic types of exams. We have random, which are just lucky. We have cause, which means we are there for a reason. Or we have a desk audit, which means we do not physically visit the office.
We have something called an exam sweep. Some of you may be familiar with this, and some of you may not. Every two years, NASAA conducts an exam sweep. The last exam sweep was in 2011, which means that we are due for one in 2013. We typically start these in January, and I thought it was important to bring this up because we will be targeting the switch firms in the 2013 sweep.
Michigan participated along with 45 other jurisdictions in the last one. Basically, about 19% of [examined firms] were affiliated with a [broker-dealer]; 72% had only one [investment adviser representative]. I would expect we are going to see some changes in those numbers in the 2013 sweep.
The average adviser that was examined had two IARs, $14 million in [assets under management] and 57 accounts. So I definitely think we will see some changes in that in the next set of sweeps. But when we finish our sweeps and we compare what we find on our exams to what the SEC has found on their exams, our deficiencies are very similar. So even though we haven't done one with the larger firms yet, I would expect some of the deficiencies to stay the same.COMMON DEFICIENCIES
Moving on to the common deficiencies, the top category is registration. You have already heard me talk about that a little bit. The main part is the inconsistencies between Parts 1 and 2, and failing to amend the ADV in a timely fashion. Also, books and records — not maintaining suitability information. Unethical business practices; contract deficiencies. Supervisory and compliance: not having any written supervisory procedures, inadequate WSPs, failure to follow WSPs; advertising; privacy; financials and inaccurate financials; insufficient or inaccurate net worth; fees: inconsistency with ADV or contract; billing and calculation errors; and custody.
At the end of the sweeps, we always issue a best-practices directive. I think those are very important for the firms to have. Revise and review your Form ADV and disclosure brochure annually. Review and update all of your contracts. Prepare and maintain all required records, including financial records. Prepare and maintain client files. Prepare a written compliance and supervisory- procedures manual that is relevant to your type of business. Prepare and distribute a privacy policy. Keep accurate financials. Calculate and document fees correctly in accordance with the contracts in the ADV. Review all advertisements. Implement appropriate custody safeguards. Review solicitor agreements.
The biggest thing we try and tell the firms is, you are a fiduciary. Always act in your customer's best interests. Lastly, the states have something new: the NASAA Examination Modules. Nemo is a database version of [broker-dealer] and [investment adviser] modules. [After] the exams, we come back to our office and we sync [the findings] up, and it goes into a main database. Up till now, I could only see the information for Michigan. Illinois, for example, could only see Illinois. Indiana could only see Indiana.MULTISTATE EXAM DATABASE
But what that means is, I can't see the actual exam, but I will be able to see the deficiencies. So if we have firms that are registered in more than one state, I can go in and look and see if a firm has been examined by another state, and the deficiencies that have been noted. So that will really help us as states to be a little bit more uniform and to work with examining the other firms. So it is a great tool. We are very excited to get it started. It gives us a lot of intelligence and a lot of reporting features.
InvestmentNews: Let's turn it over to Brian.
Mr. Hamburger: Our biggest concerns lay with those states that didn't necessarily participate in the conversation. So as you will see, there is some inconsistency that exists among the states, and that is where advisers are really going to be tripped up.
Linda started off by talking about consistency among the forms. We preach to advisers day in and day out that if a regulator can take a look at your documents and, never having spoken to you, identify that there must be a regulatory compliance violation or disclosure violation simply because [ADV] Parts 1 and 2 don't speak to each other, or you have contracts for services that you don't disclose in your Form ADV, or your marketing materials promote services that you are not otherwise prepared to handle within your policies and procedures, therein lies a problem.
So if you can't get through that Tier 1 review, we have significant problems.
Review, for example, your Form ADV, including all of the disclosures. Take a look at your client agreements. Look through your compliance manual and your third-party agreements, including the agreement that you have with the RIA custodian or any broker-dealers that you are utilizing, or third-party money managers. Look through your marketing materials. If you are sponsoring a fund or participating in a private fund, make sure all of these documents are speaking to one another.
At the very baseline, we are imploring folks to pay attention to compliance. Compliance nowadays is a standard of care. For those firms that are registered at the state level, it is not a separate silo. It is not a separate area, compartment or department in the firm. It is a standard of care that exists within the firm.
The fact that you are attending this call means that you are giving compliance some priority. I'd like to focus the rest of my time on where you are likely to get tripped up be-tween federal and state standards, and where some of those differences lie.CONFLICTING STATE REGS
Our biggest concern is conflicting state regulations. If you are registered in more than one state, you need to deal with more than one state's laws, rules and regulations. There are a number of factors that you want to look toward. You want to look toward where you have a place of business which may be more compelling. You can choose to address this as the lowest common denominator, meaning that you are going to figure out where the most stringent standards exist and simply adopt that as the method upon which your firm is going to handle regulatory compliance.
Or you are going to put in place strong controls that treat each client based upon the laws that may impact them, because some laws may apply to the investment adviser based upon their principal place of business, some may apply to wherever the adviser is conducting business, and others may apply to you based upon simply your registration status or even where a particular client may reside. So you have to take a look at those laws, rules and regulations, and you need to make that determination for yourself.
States may require you to maintain a certain net worth. That net worth may vary depending upon your custody practices or whether or not you have discretionary authority over investment decisions in the client accounts. Some states may require that you post a surety bond. Others are going to require that you notify them if you are either in a precarious financial situation, which I know is a rather vague term, or more specifically, if you fall under certain levels in the reports, you have to furnish them whether they are net capital reports or net worth reports.
Then finally, many of those states are going to require an annual financial submission — whether it be audited or unaudited financial reports — they are going to require you to submit those based upon your practices.
Use of solicitors is another common hot topic that trips up advisers that are used to dealing with federal regulations and are now dealing with regulations in one or more states. State-specific disclosures regarding conflicts of interest are something you want to watch out for. Many states are not satisfied with the level of disclosure required by the SEC for use of solicitors and require some very specific language regarding the conflict of interest. So you want to pay some particular attention to that.
There are states that are going to require the adviser to ensure that the solicitor is properly listed, so there is an undertaking in certain states that if you are going to use solicitors, that you actually supervise at the very least the business activity that overlaps with their solicitation activities, and you undertake to [inform] the state that they are in compliance with the state's rules and regulations. In other words, you need to supervise that activity in those states. So if you are using solicitors and you were SEC-registered and now state-registered, you want to look carefully at how that may change here.
Advertising is a final area. Again, each state is going to have its own take on the regulations. Social media has become more of a business necessity for many investment advisers, and state regulators have taken notice of that more quickly that federal regulators have.
Massachusetts, for example, has published significant guidance on the use of social media. At least three states now have regulations on employers' requiring passwords from employees. In California, Maryland and Illinois, employers are not going to be permitted to require their employees to furnish them with passwords.
This makes supervision and oversight of their social-media activities very cumbersome, very difficult, if not near impossible. A state examiner is going to be much more likely to check compliance with social media [regulations] than a federal examiner.
InvestmentNews: Steve?
Mr. Thomas: With the change in the ADV Part 1 filing to the new term Regulatory Assets Under Man- agement, we have discovered that quite a few folks are geting caught up with the difference between assets under management versus assets under advisement.
By far, our largest finding with the majority of our clients is they really do not understand the difference, and we have had some rather interesting situations where we had an individual hire us after they had some discussion with the SEC. And it turned out they went from a firm that was recording $900 million assets under management to virtually having no assets under management — they were all classified as assets under advisement — which, of course, then required them to transfer to the state.
We are finding that a lot of regulators are starting to pay more and more attention to the differences here, and I think it is only going to get worse.
As we move forward, it is going to be interesting to see how many people have to go back to the states or forward to the states, depending on which side of the fence you are on, as far as assets under management are being reported. We will look at a couple of specifics here.
There is a division the SEC has created that simply just informed a review of filings between ADV Parts 1, 2 and 3. We always tell our clients that one of the things we used to learn in the sales business is, you never get a second chance to get a first impression. The first impression that you make on a regulator is your filing documents. You need to make sure that your documents match and make a good impression on that regulator the first time around.
Understanding the difference between assets under management and assets under advisement is critically important nowadays. The term that always has been bandied about when it comes to assets under management is “continuous and regular supervision or management services.” From their point of view, obviously, you have that if you have discretionary authority over a client's account.
You may have it if you are [serving] on a nondiscretionary basis but your advice is typically followed and the securities and other investments you are recommending are accepted by the client and, ultimately, if you are responsible for arranging or effecting the purchase or sale of your recommendations. That last sentence is a big one in the recent determination of these two different types of assets.
For example, you may be providing continuous and regular supervision if you have discretionary authority, as we just talked about, [or] if you do not have discretionary authority but you go through the steps we talked about. One of the things a lot of our clients are using are third-party money managers or subadvisers. You may still have continuous and regularly supervised assets if you not only have the discretionary authority to choose third-party money managers but also if you have the authority to allocate assets among them.
So just because you use all third-party money managers in your practice does not mean you cannot count those assets under management. There are cases where you cannot, but it does not necessarily preclude that example.
You do not have continuous and regular supervisory management services for an account if you provide a market-timing service, if you provide only impersonal investment advice such as anything after that, or if a client calls you and you get paid to do it on a periodic basis or whenever they want you to.PRECISE REASONING
The issue of assets under management, we are finding out, is being reviewed more closely. You need to make sure you are doing it properly and that you have an accurate and precise reasoning for why you are reporting what you are reporting. You can expect Linda and all of her associates are going to be paying close attention to this in the future.
For some firms, it is a very simple thing. You have discretionary authority over a client's account. You simply run a custodian report, and that gives you your assets under management. In other cases where you have off-the-book assets or you simply provide advice, where a lot of people get caught up in this is when they advise 401(k) plans or other types of qualified plans. Those may very well not be assets under management, technically.
Mr. Hamburger: There is no reason to lie about your assets under management. The confusion issue that Steve raised — where the adviser thinks they have those assets under management, but those assets actually don't qualify — continues to exist to this day.
There has also been a real strong motivation to lie about assets under management in bringing in new business. There are a lot of cases that the SEC has pursued over the years where advisers trying to grab some additional business or secure some legitimacy in the marketplace said they were going to be managing over $1 billion when they actually were managing $10 million.ADVISERS STRETCHING AUM
The only thing new here is that lately we have seen some advisers wanting to form-shop, if you will — select their own regulator. So they are coming up with justifications on how to re-categorize their assets in order to qualify for SEC registration. They do this when they think that the climate is favorable in their particular situation to report to the SEC as opposed to their state regulator.
InvestmentNews: Brian, you used the word “solicitor.” There was a question from the audience as to whether you were using the term in the British sense, meaning an attorney.
Mr. Hamburger: No. Within this industry, “solicitor” refers to one who is effectively paid a referral fee for soliciting — going out and securing those assets and referring them to an investment adviser.
Under SEC purview, solicitors are permitted to operate simply by disclosure, and the investment adviser has to have a solicitor's agreement in place. When SEC advisers who are already using solicitors move over to state regulation, it may be a different ballgame — depending upon the state they are in.
InvestmentNews: One of our participants is wondering what state regulators are looking for in a com- pliance manual for a one-advisor shop with no other employees. Linda?
Ms. Cena: What we are not looking for when we walk into the firms is a compliance manual with a generic name that is still completely sealed in plastic wrap. We would like something that is specific to the firm — which, if it is a one-person firm, is going to be much different than it would be at a large firm. I don't see the need to purchase a very expensive compliance program if you are a one-person shop and you have a really simple business. I want to know who does what, how often is it done and how is it documented. I think that would be kind of a simplistic compliance program.
Mr. Thomas: Someone is asking, “With regard to assets under management, should you include values for assets that, while technically under discretionary management, cannot be managed?” The example given is, a client requests a minimum cash cushion be maintained or a specific equity that cannot be sold. How does one account for that kind of an asset or that value of asset?
Mr. Hamburger: While we are talking about specific calculations that have to be made, investment advisers are best served to really create larger buckets. So for a client who engages them for this service, those assets are counted toward the AUM, whereas that may not be the case when the client has engaged the adviser for another service.UNMANAGEABLE ASSETS
The good thing about those particular positions is that the SEC asks you to count the assets in what are called securities portfolios. Securities portfolios are those comprising at least 50% securities. So if there are assets within those securities portfolios that on their own wouldn't count as AUM but are within the overall management of the portfolio, they actually can still be counted. So it becomes a less specific exercise than going dollar-for-dollar through each client's portfolio.
InvestmentNews: There is a very basic question from one of our audience members. What is the AUM cutoff between filing for state versus SEC registration, and what are the requirements here?
Ms. Cena: If they're asking, “Is anywhere between zero and $100 million going to be a state registration; anything over $100 million an SEC registration?” that is the basis. It used to be that $25 million and under were the state registrants, but now under Dodd-Frank, if your AUM are between zero and $100 million, you would file with the state; over $100 million, you would file with the SEC.
InvestmentNews: There is a question about examiners' sending out a list of items to gather for the exam. Is there any sort of preliminary information?
Ms. Cena: We don't always give advanced notice, but when we do, we generally fax or e-mail a list of documents that we would like the firm to have ready. That makes it much easier for us when we get there. The examinations can last one day at a very small IA firm to a couple of weeks if it is a larger firm.
InvestmentNews: What are the consequences if an adviser hasn't switched its registration yet?
Ms. Cena: If they don't do anything and they don't speak to anyone and they don't make any money, we wouldn't have a problem. But they have to realize if they missed this deadline and they are deregistered by the SEC, they will be an unregistered investment adviser. They have to realize that. If they are not registered, they can't work.
