Nine Key Compliance Items for New SEC-Registered Investment Advisers

Main Contributor: Samuel Carralejo, Compliance Manager

Introduction

Financial advisors who start their own advisory firms have several things to consider and implement. To name a few, they must create a legal entity, select a custodian, formulate service offerings, create numerous regulatory documents, and execute a plan to transition clients to the new firm. These tasks take time to complete, which can cause new advisers to overlook certain key compliance requirements. But regulatory requirements don’t wait for advisers to settle in. Rather, an adviser’s duty to comply begins upon registration approval, and failure to comply can have significant consequences. Accordingly, we lay out nine essential compliance items that new advisers mustn’t overlook.

1. Identify and Disclose Conflicts of Interest

Advisers owe their clients a duty of loyalty, requiring them to disclose all conflicts of interest that might hinder their impartiality. Come exam time, new advisers that neglected to disclose certain conflicts may be required to send clients a separate written notice explicitly highlighting them. Not only does this bring the conflict centerfold, but it also leaves a negative impression on clients and regulators, which can be damaging for a new adviser trying to build its reputation. Accordingly, it is crucial for new advisers to identify potential conflicts and ensure they are disclosed on the Form ADV before delivering it to clients. Common conflicts of interest requiring disclosure include: advisers receiving financial transition assistance or soft or hard dollar benefits from custodians, broker-dealers, or other third parties; employees who are also registered representatives or licensed insurance agents receiving commissions for securities or insurance sales; advisers paying referral fees to clients or third parties; advisers recommending proprietary products; and advisers or their representatives investing in the same securities as clients and trading at similar times.

2.   Deliver Disclosures . . . and Do So Timely

Investment advisers must provide clients with a host of disclosure documents, including the Form ADV Part 2A, Form ADV Part 2B(s), Privacy Policy, and, if offering a wrap fee program, Appendix 1 to the Form ADV Part 2A. Advisers must also provide a Form CRS to any “retail investors”—those seeking services primarily for personal, family, or household purposes. Importantly, these disclosures must be provided timely: advisers must provide their Form CRS and Form ADV documents before or at the time they enter into an investment advisory contract with the client; similarly, the Privacy Policy must be provided at the time of establishing the customer relationship. Failure to provide these disclosures on time can subject advisers to significant penalties, so it is imperative advisers provide these documents before servicing the client. Advisers should also keep adequate records to substantiate delivery, such as a delivery log or a copy of the email, if sent electronically. Additionally, advisers must post the Form CRS prominently on their website.

3.   Finalize Compliance Policies and Procedures

Advisers must adopt and implement written policies and procedures reasonably designed to prevent violating the Investment Advisers Act of 1940 and rules adopted thereunder. However, unlike the Form ADV documents, registration approval is not contingent on the adviser finalizing its compliance policies and procedures. For this reason, new advisers will often save the creation of these documents for last. But this can lead advisers to put off finalizing their written policies until several months after their registration has been approved, exposing them to regulatory violations for lack of timely implementation. Accordingly, advisers should ensure they finalize their written policies and procedures before receiving registration approval. Also, once approved, advisers must also obtain from each employee a written acknowledgment that they received and will comply with the compliance policies.  

4.   Complete Code of Ethics Reporting Obligations

Advisers are required to adopt a Code of Ethics that, in part, addresses conflicts of interest arising from employee personal trading. To this end, the adviser’s “access persons”—those with access to nonpublic information about client securities recommendations or transactions or those involved in recommending securities—must submit initial and annual holdings reports and quarterly transaction reports. Notably, an access person’s initial holdings report is due within ten (10) days of their becoming an access person, meaning that a newly registered adviser generally must collect its access persons’ initial holdings reports within ten (10) days of the adviser’s registration approval. Quarterly transaction reports are due within thirty (30) days after each calendar quarter-end beginning as of the quarter in which the adviser’s registration was approved. As with the compliance policies, advisers must obtain from each employee a written acknowledgment that the employee received and will comply with the Code of Ethics.

5.   Ensure Proper Firm Notice Filings and Investment Adviser Representative Registrations

Investment advisers and their representatives are subject to state notice filing and registration requirements. Generally, investment adviser firms must notice file in each state where (i) they have a place of business or (ii) more than five (5) of their clients reside. Exceptions to this general rule include Louisiana, Nebraska, New Hampshire, and Texas, which require notice filing before the adviser accepts a single client in that state.

The registration requirements for investment adviser representatives—those who provide investment advice on behalf of the firm—vary more widely among states. Often, states only require registration from investment adviser representatives who operate from that particular state. But some states, like Texas, may require registration even if the representative does not maintain a place of business there. It is also important to note that each state may define “investment adviser representative” differently. Most states defer to the SEC’s definition, which defines investment adviser representative to include only those with “more than five (5) clients who are natural persons.” A minority, however, define the term more broadly to include anyone who: makes or determines any securities recommendations; manages accounts; solicits, offers, or negotiates advisory services; or supervises employees who perform these activities.

To ensure compliance with state notice filing and registration requirements, new advisers should—before registration approval—identify and tally the state locations of their client base and determine which state notice filings and registrations are needed. Though it may take several months to transition clients to the new advisory firm, advisers would be prudent to notice file and register in the applicable states in conjunction with the firm’s initial SEC registration rather than apply a wait-and-see approach.

6.   Be Mindful of the Marketing Rule

Though new advisers may be enthusiastic about promoting their brand, they should be careful not to violate the Marketing Rule. The Marketing Rule sets forth certain restrictions as well as disclosure, substantiation, due diligence, and other requirements for advertisements. Of significance is that the term “advertisement” is defined broadly and encompasses two prongs. First, advertisements generally include any communications an adviser makes to more than one person that offers advisory services. These can include pamphlets, newsletters, presentations, email blasts, websites, blog and social media posts, media appearances, requests for proposals, due diligence questionnaires, as well as other communications. Second, advertisements include testimonials and endorsements, meaning that communications by clients or third parties that promote the adviser are also subject to the Marketing Rule. Testimonials and endorsements can encompass not only traditional solicitor relationships but also more subtle activities, such as clients referring friends and family to the adviser. Accordingly, advisers should carefully review their communications to ensure compliance with the Marketing Rule.

7.   Understand Custody and its Implications

“Custody” means holding client funds or securities or having authority to obtain them. Understanding custody is important because advisers with custody generally must undergo an annual surprise examination, which can cost tens of thousands of dollars. Due to these expenses, many advisers forego accepting custody, especially since having it is generally not critical to an adviser’s ability to service its clients. But custody is more than simply holding a client’s securities, a responsibility left with the custodian. Indeed, an adviser can trigger custody in ways it did not consider, including by acting as trustee to client accounts, possessing client account login credentials or credit card information, or failing to forward checks or return physical stock or bond certificates within three (3) days of receipt. New advisers seeking to avoid undergoing an annual surprise exam should thus ensure they do not engage in these activities. That said, there are two (2) forms of custody that do not trigger the surprise exam requirement, provided the adviser complies with other safeguards. These include fee deduction capability and third-party money movement ability (SLOAs). In all cases, advisers must disclose each form of custody on the Form ADV.

8.   Conduct Vendor Due Diligence

An adviser’s fiduciary duty includes ensuring it adequately vets its service providers, especially those with access to client-sensitive information. Hence, it is important that advisers conduct due diligence before selecting a particular vendor, which, for new advisers, likely means doing so before the advisory firm is fully operational. The specific due diligence process needed will vary based on the services provided and information shared but may nevertheless include collecting and reviewing the vendor’s service agreement, privacy and information security policies, business continuity plan, and internal control reports. Advisers should also document their due diligence process to evidence the review was conducted.

9.   Maintain Compliance Logs

When—not if—the adviser is audited, they will be required to produce numerous records. Common among these requested records are compliance logs for trade errors, client complaints, gifts and entertainment, political contributions, checks received and forwarded, and funds received and returned. These records can accumulate quickly after registration approval, so new advisers should diligently monitor and log them.

Conclusion

Navigating the complex regulatory landscape as a newly minted investment adviser can be daunting. But by proactively addressing these key compliance items, new advisers can set themselves up for long-term success. Of course, these items represent only a fraction of an adviser’s regulatory obligations, so new advisers should consider partnering with dedicated compliance professionals to ensure compliance with all relevant rules. At SEC Compliance Solutions, we offer tailored support for new advisers, enabling them to embark on their journey confidently, knowing they have a reliable partner to help meet and exceed regulatory expectations.