Securities

Compliance for State Investment Advisers

The Division's State Investment Adviser Exam Function

  • What to expect if you are examined
  • Common compliance issues

Table of Contents

 

The State Investment Adviser (SIA) Exam Function

The Division’s Securities Examiners visit and review state registered investment advisers who reside in or maintain offices in Alaska. The Division conducts routine exams and may also initiate examinations for cause. A for cause examination is conducted where the division has reason to believe a firm may have violated securities laws. Most exams are conducted on a routine basis.

If you or your firm are to be examined, the Division will generally schedule a date and time with you prior to the exam. The exam may last a day or longer, and the examiner will review books and records to determine if the rules and regulations pertaining to state registered Investment Advisers are being followed.

These are some of the books and records we review:

  • Journals, including cash/check receipts and disbursements, and any other records of original entry forming the basis of entries in any ledger
  • General and auxiliary ledgers showing assets, liabilities, reserves, capital, income and expense accounts
  • Check books, bank statements, canceled checks and reconciliations
  • Bills and documents pertaining to the expenses of the firm
  • Trial balances, financial statements and internal working papers
  • Correspondence and complaints
  • Account information including contracts, disclosures and transaction activities
  • Documents pertaining to discretion and custody of customer securities and cash

Record keeping compliance issues may be uncovered during our exam. Potential compliance issues include incomplete record keeping, outdated disclosures on Form ADV, inadequate supervisory procedures, and outdated or incorrect account information. Other potential compliance issues may arise because investment adviser regulations are now divided between state and federal authorities. Our examiners will review the State investment adviser’s operations to determine whether the investment adviser is properly registered at the state level or whether the adviser should instead be registered with the Securities and Exchange Commission. Generally, this depends on the value of the assets the investment adviser has under management.

The exam may also uncover sales practice compliance issues such as misrepresentation to clients, inflated performance claims, lack of suitability of investments offered to clients, inadvertent custody of client funds and securities, and engaging in investment adviser related activities without being licensed.

Discovery of such problems might result in the State Investment Adviser receiving a warning letter, a follow-up exam, an administrative order, or monetary penalties.

The following information covers the most common compliance issues found in examinations of State Investment Advisers:

  • Disclosure
  • Conflicts of Interest
  • Advertisement and Performance Claims
  • Custody
  • Suitability
  • Investment Adviser Representative Registration

If you have further questions about these areas, you can reach the Division at (907) 465-2521.

 

Disclosure

Securities examiners review records for the purpose of determining whether there is adequate disclosure to investment advisory clients on the following topics:

  • what investment advisory services are being provided,
  • who is providing those services,
  • what is the client being charged for the services, and
  • what conflicts of interest, if any, might be involved for the investment adviser.

What services are being provided and who is providing the advisory services are questions that may arise where the investment adviser only introduces the clients to one or more other advisers. These questions also arise in connection with wrap fee programs, where a third party firm may provide advisory services.  The investment advisory agreement should answer these questions, as should the State investment adviser ’s brochure and/or Part II of Form ADV. Securities examiners review the investment advisory contract and compares the contract with the activity conducted at the firm and with the contents of Form ADV.  After 2001, all new and renewal filings by investment advisers registered or notice filed in Alaska are required to submit filings through the Investment Adviser Registration Depository (IARD), which includes the form ADV Parts I and II.  The IARD is an electronic gateway that investment advisers use to update filing information, add or delete investment adviser representatives they employee, and provide disclosure information to existing and potential clients.  To check on continuing information on the IARD and Form ADV, go to www.sec.gov/iard/.

Securities examiners also check to see if investment advisory clients are given adequate disclosure of any conflicts of interest the state investment adviser may have.  The examiners also review investment advisory agreements to make sure they do not contain "hedge" clauses in which the state investment adviser disclaims liability for losses occasioned by any negligence of the investment adviser. The Securities and Exchange Commission has taken the position, and the Division agrees, that "hedge" clauses are unenforceable and therefore their inclusion in an advisory agreement is misleading to clients.

 

Conflicts of Interest

Securities examiners look for conflicts of interest when they examine state investment advisers. Different kinds of conflicts of interest arise depending on the number of roles the investment adviser and its affiliates play with regard to the customer. The investment adviser is a fiduciary who must put the customer’s interest before his own. These are some of the situations involving conflicts of interest an examiner looks for:

  • Conflicts where the investment adviser is also the broker-dealer or the broker-dealer is an affiliate of the investment adviser
  • Conflicts where the investment adviser or its representative has an ownership interest (especially a controlling interest) in an issuer whose securities the adviser or representative recommends to customers
  • Conflicts relating to the payment of finder’s fees
  • Conflicts between the investment adviser’s interest in trading for the investment advisers account and the interests of customers

In all conflicts situations, the key issue is the effect of the conflict on the customer. Has the customer been told of the conflict?  Has the customer consented to the transaction despite the disclosed conflict?  If the customer consented, was the customer in a position to evaluate the effect of the conflict on the customer’s interest?  The more vulnerable or unsophisticated the customer, the greater the burden is on the investment adviser to show that the customer has knowingly consented to the conflict.  Disclosure and customer consent may not always be sufficient remedies for conflicts of interest.

An examiner will review any written policy of the investment adviser on conflicts of interest and will consider conflicts issues throughout the review of books and records. An examiner might spot a conflict through review of customer correspondence, complaints, and statement of accounts or by operational review of the investment adviser itself and interviews of its employees or customers. Once an examiner has spotted a conflict, the examiner will generally ask the principals of the investment adviser for an explanation and may seek further evidence to confirm the extent of the conflict of interest.

Conflicts of interest may involve serious securities law violations, such as sale of unregistered securities, fraud in connection with the purchase or sale of securities, and unlawful acts of a person advising another. Some of the most serious conflict problems arise when the investment adviser is also an issuer or is an affiliate of an issuer. If there is an apparent conflict of interest, the investment adviser has a greater burden of showing that the investment recommendation was suitable for the customer.

 

Advertisement and Performance Claims

The examiner will review the investment adviser’s advertising files containing a copy of all advertisements (pamphlets, circulars, solicitation letters, etc.) the adviser uses to solicit new business and maintain current clients.  All advertisements should be dated and initialed by a principal (or designated supervisor) of the adviser prior to or immediately after distribution to ensure that the advertisement falls within applicable guidelines.      

Common compliance issues include:

  • The use of testimonials by clients or other individuals (which are not allowed)
  • Using advertising of previous performance that does not comply with AIMR standards
  • Use of inappropriate indices which make the adviser appear superior to its competitors
  • Money managers using simulated performance figures
  • "Puffing" or exaggerating the services and qualifications of the adviser

During the review of advertisement files, the examiner may examine software and other programs the adviser uses to record and retain client data and the examiner may verify performance claims compliance with AIMR standards.

 

Custody

Definition of custody

On October 1, 1999, Alaska adopted a definition of "custody of client funds or securities" at 3 AAC 08.950 (22) which states that custody, "means for a state investment adviser, the state investment adviser directly or indirectly holds client funds or securities, has authority to obtain possession of client funds or securities, or has the ability to appropriate the client funds or securities, except a state investment adviser is not considered as having constructive custody of a client’s funds or securities, if such possession is for the sole purpose of immediately forwarding those funds or securities to a third party at the request of the client;"[.]

However, until the recent adoption of this definition, the term "custody" had not been defined under most State Securities laws or the Investment Adviser’s Act of 1940. As a result, court cases involving custody, along with SEC interpretations and no-action letters, have established fairly broad parameters and deem an adviser to have "custody" of client assets if it has any direct or indirect access to them.  This body of interpretive information will still be applicable in the course of our examinations.  For instance, an investment adviser may be deemed to have custody of client funds if it sends the bills for its services directly to the custodian, who then automatically pays the adviser. However, the SEC has established guidelines that establish strict procedures to follow so that this situation would not be considered constructive custody of client funds. The SEC has allowed automatic payment of advisory fees where:

  • The client authorizes the arrangement in writing;
  • The adviser sends the bill to both the client and the custodian at the same time;
  • The bill shows the amount of the fee, how it was calculated and the value of the assets upon which the bill is based; and 
  • The custodian notifies the client at least quarterly of how much has been paid to the adviser.

The Division also holds to this position regarding automatic payment of advisory fees and, in general, rules consistently with the established SEC "no action" positions on matters of custody.

IAs who are issuers of securities

An adviser who is also an issuer of securities is deemed to have custody unless an independent custodian is utilized and the custodial agreement(s) include provisions that define the method by which the adviser receives payment and withdraws funds (via an independent representative).

Requirements for IAs with "custody"

Additional financial and books and records requirements (3 AAC 08.025 and .040(b)) are imposed on advisers that have custody or possession of client securities or funds, which include:

IAs having custody of client funds or securities must have a $35,000 surety bond and maintain a positive net worth at all times;

Securities of each client must be segregated, marked to identify the particular client having the beneficial interest in the security, and held in safekeeping in a place reasonably free from risk of destruction or other loss;

The SIA must deposit all client funds in one or more bank accounts that contain only client funds and the account or accounts must be maintained in the name of the SIA as agent or trustee for the clients;

The SIA, immediately after accepting custody of funds or securities from any client, must notify the client in writing of the place and the manner in which the funds and securities will be maintained, and thereafter immediately notify the client in writing of any changes in the place or the manner in which the funds or securities are maintained;

The SIA must maintain a separate record for each client’s bank account that shows the name and address of the bank where the account is maintained, the dates and amounts of deposits to and withdrawals from the account, and the exact amount of each client’s beneficial interest in the account;

The SIA, at the end of every three months, must send each client an itemized statement showing the funds and securities in the state investment adviser's custody and all debits, credits, and transactions in the client’s account during the period; and

At least once every calendar year, an independent certified public accountant or public accountant must verify all client funds and securities by actual examination at a time chosen by the accountant without prior notice to the SIA, and the accountant must issue a report stating that the accountant has made an examination of all client funds and securities and describing the nature and extent of the examination, and the report is filed with the administrator promptly after each examination.

The SIA shall maintain a journal or other record showing all purchases, sales, receipts and deliveries of securities for all accounts and all other debits and credits to the accounts;

The SIA shall maintain a separate ledger account for each client showing all purchases, sales, receipts and deliveries of securities, the date and price of each purchase and sale, and all debits and credits;

The SIA shall keep copies of confirmations of all transactions effected by or for the account of any client; and

The SIA shall maintain a record for each security in which a client has a position showing the name of each client having an interest in the security, the amount or interest of each client, and the location of the security.

Exam procedure for SIAs with custody

In addition to an examination of all the books and records required of state investment advisers (3 AAC 08.040) including those listed above, additional tasks of the exam staff may include:

Determining whether the adviser has any affiliation with the custodian; and

Obtaining information regarding how instructions are conveyed to a custodian, who determines where the client funds or securities are maintained, and, if the custodian is a person other than a broker-dealer (such as a bank) how the transactions are settled.

 

Suitability

Examiners review accounts for suitability issues by comparing account information with the services contracted for under the investment advisory agreement and with the advice given to the customer. State investment advisers need to maintain adequate information on their customers to document the suitability of the recommendations made. At a minimum, the investment adviser should maintain information on the customer’s annual income, net worth, and investment objectives. If the customer has specific objectives, for example, to retire in the year 2020 with a certain level of investment income, or to have funds available for their children’s future education, those objectives should be reflected in the customer’s file.

The examiner will pay special attention to the suitability of recommendations where the investment adviser has discretion over the customer’s account.  However, the suitability of investment recommendations is an issue relating to all investment advisory customers, not only those who have given the investment adviser discretion over his or her account.

Investment Adviser Representative (IAR) Registration

During an exam, the issue of whether individuals, working at or for the SIA, should be registered as investment adviser representatives may arise. SIAs shall register individuals who meet the definition of an investment adviser representative under the Alaska Securities Act.

As a rule of thumb, the SIA should register individuals associated with the firm who:

  • Use terms such as investment counselor, financial planner, financial consultant, money manager, investment manager, investment planner or uses a designation such as CFP or ChFC to identify themselves;
  • Receive a fee from a registered investment adviser when the individual refers a prospective client to the adviser; or
  • Prepares a financial plan for a client and receives a fee.

Questions regarding registration can be directed to the Division at (907) 465-2521.

 

Top Ten Compliance Issues Found on Investment Adviser Exams

To assist advisers in meeting your compliance responsibilities, we have compiled and identified the most common issues and problem areas found during state review of investment advisers:

Lack of a written customer contract. Advisers must have a written contract with each client (AS 45.55.023(a)(16)), even if the adviser is a fee only financial planner. The contract must disclose: the services to be provided, the term of the contract, the advisory fee, the formula for computing the fee, whether the fee is negotiable, the amount of prepaid fee to be returned in the event of contract termination or nonperformance, whether the contract grants discretionary power to the adviser, and that the contract will not be assigned by the investment adviser without the consent of the client. The contract may not include a so-called "hold harmless" or "hedge" clause, which purports to require clients to waive potential claims they may be entitled to bring under state or federal statutes, or which seeks to hold the investment adviser to a lesser standard of care than is required by statute.  Advisers are allowed to include an arbitration clause in the contract.

Outdated Form ADV or brochure. Advisers are required to update the Form ADV (and file the amendment with the Securities Division) whenever information disclosed in the form changes in any material respect. If brochures are used for providing required disclosures to clients, they should be updated as required (at the same time the Form ADV is updated) and filed with the Division.  Part II of the qForm ADV or the brochure must be furnished to prospective clients 48 hours before they sign a contract, or at the time of signing the contract if the client can cancel without penalty within five days after signing. In addition, every year you must deliver to each client, or offer to deliver, a copy of the updated ADV Part II or brochure. As always, a brochure must include at least all information required by Part II of Form ADV.  You need to keep records of to whom the disclosure was offered or sent, and which clients requested the update.

Inadequate or outdated client information. Before recommending or executing an investment transaction on behalf of a client, advisers must have reasonable grounds for believing the investment transaction is suitable for the client. Advisers are required to make reasonable efforts to obtain information concerning the client's financial status, tax status, investment objectives, and other information necessary to make a reasonable suitability determination. For an investment adviser, merely asking for estimated net worth and income, and checking a box for investment objective probably is not sufficient to establish suitability, particularly if it must be established you have to establish it in an arbitration or court action. A better practice is to obtain detailed information such as a client's: assets, liabilities, income and expenses; existing investments, financial goals and risk tolerance; marital status, dependents, family obligations, age, health, and mortality issues; and insurance coverage. Advisers may need to obtain documents such as tax returns, company benefit (e.g., 401k) booklets, will and trust documents, and stock option agreements. Since suitability will change over time as a client's family and financial circumstances change, advisers need to update this information periodically. The best practice is to update this information annually, and the Division considers three year old information to be stale.

Misleading business cards, letterhead and advertising. There can be some confusion about who can use the term "Registered (State) Investment Adviser. "If on Form ADV Part I, No. 8, the box for "A. Corporation," "B. Partnership," or "D. Other" has been checked, then an entity is the registered investment adviser, and persons employed by the entity and providing investment advice must refer to themselves as "investment adviser representatives." While the Division requires that each investment adviser have a principal, we do not technically "register" them.

Lack of documentation regarding discretionary authority over client accounts.  As stated in No. 1 above, this information needs to be included in the client contract. In addition, advisers should have a copy of the client's agreement with any brokerage firm at which advisers are authorized to trade on the client's behalf.

Problems with invoices for fees.  Advisers need to keep a copy (electronic is okay) of each invoice sent to a client. The invoice should show how the fee was calculated. In addition, if fees are to be deducted directly from a client's brokerage account, in order to avoid "inadvertent custody" of client funds:  (1) the client must authorize the arrangement in writing; (2) the invoice must be sent to both the client and the custodian at the same time; (3) the invoice must show the amount of the fee, how it was calculated, and the value of the assets on which it is based; and (4) the custodian must notify the client at least quarterly how much it has paid the adviser.

Misleading performance claims.

  • Annualized rate of return. Rates of return should be shown only for the period being actually measured, i.e., rates should not be annualized. In other words, if the return being shown is for three months, then it should not be multiplied by four and an annual rate shown, since there is no assurance that the rate of return will be sustained for a 12-month period.
  • Rate of return incorrectly calculated. Rates of return should be disclosed net of all fees. Also, various states have come across instances where Advisers did not have adequate knowledge of the software they were using to calculate rates of return and therefore made errors.
  • Inconsistent methods of calculating performance. The method of calculating performance (e.g., AIMR time-weighted rate of return) should be consistent from period to period. Methods should not be switched to whatever method shows the largest gain for a particular time period.
  • Inaccurate comparisons to indices. If comparisons are going to be made to indices, then (1) the securities making up the particular index should be of like kind to the adviser’s portfolio, e.g,, do not compare an equity portfolio to a bond fund; (2) rates of return must be shown net of fees; and (3) comparisons to the S&P 500 and Dow Jones may be misleading because those indices do not factor in reinvested dividends.
  • Failure to include disclaimer. A disclaimer to the effect that past performance is no guarantee of future performance needs to be included.
In general, because state experience has found so many problems in this area, the Division strongly discourages advisers from attempting to provide overall portfolio numbers and comparing
them to indices. Be aware of the3 AAC 08.045 provides thatall performance figures must comply with AIMR standards.

Other books and records issues.

  • Advisers need to set up a complaint file, even if you have never had any complaints.
  • Advisers need to keep all incoming correspondence from clients, either in a correspondence file or in each client's file. Similarly, advisers need to keep copies of all outgoing correspondence, and any documents sent to clients. This can be done by a central file or in each client's file. This can also be kept electronically, so long as an item can be easily retrieved for an examiner to review, and it can be determined to whom it was sent (and do not forget to back up your computer on a regular basis).
  • Files should be maintained for paid bills and bills payable.
  • Bank statements should be reconciled on a monthly basis.
  • If managing money, advisers must maintain: (1) documentation on each investment in a client's portfolio and each purchase and sale (including date and price) on behalf of the client; and (2) for each security, a record of which clients hold it and the amount held, and purchases and sales.

Inadequate documentation of supervision.   If more than one person is employed by the investment adviser , then the principal will have supervisory responsibilities. A compliance manual (which even a sole proprietor should have) should be established and maintained. There should be evidence that the principal is providing supervision, such as reviewing and initialing incoming and outgoing correspondence, order tickets, new client forms, and advertising.

Inadequate financial statements.  Advisers are required to maintain financial records for the business, such as journals for cash receipts and disbursements, and ledgers reflecting asset, liability, reserve, capital, income and expense accounts. These should be kept in such a manner that the adviser can produce financial statements on a timely basis in accordance with generally accepted accounting principles (i.e., on an accrual basis). The examiners will also want to review your check register, so sole proprietors may want to set up a separate business checking account so that business income and expenses are segregated from personal (the examiners may still request to see a sole proprietor's personal account, however).

If the adviser has custody of, or discretion over, client funds or securities, then you will need to have a surety bond of $35,000 for custody and $10,000 for discretion. The adviser have discretion even if all they can do is trade among a family of mutual funds. If needed, a surety bond form can be obtained from the Division (see forms page). A positive net worth must be maintained at all times, not just at quarter or year end.

If you need assistance regarding these compliance issues or other investment adviser matters, please contact the Division of Banking & Securities at (907) 465-2521.