State investment advisor Exam Function
- What to expect if you are examined
- Common compliance issues
Table of Contents
The Divisions Securities Examiners
visit and review registered State Investment Advisors who reside in or
maintain offices in Alaska. The Securities conducts routine
as resources are available, but may also initiate examinations for cause.
A for cause examination is conducted where the division has reason
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
Securities 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 Investment Advisors are being followed.
These are some of the books and records
- 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 asset,
liability, reserve, capital, income and expense accounts
- Check books, bank statements, canceled checks
- 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
record keeping, outdated disclosures on Form ADV, inadequate supervisory
procedures, and outdated or incorrect account information. Another
compliance issues may arise because investment advisor regulation is
now divided between state and federal authorities. Our examiners will
the State investment advisor s operations to determine whether the
investment advisor is properly registered at the state level or whether
the Advisor should instead be registered with the Securities and Exchange
Commission. Generally, this depends on the value of the assets the investment advisor 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 advisor related activities without being licensed.
Discovery of such problems might result in
the State investment advisor 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 Advisors:
- Conflicts of Interest
- Advertisement and Performance Claims
- investment advisor Representative Registration
If you have further questions about these areas,
you can reach the Securities at (907) 465-2521.
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 State investment advisor .
What services are being provided and who is
providing the advisory services are questions that may arise where
investment advisor only introduces the clients to one or more other Advisors.
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 advisor 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.
Beginning with renewals for 2001, there is a newly crafted Form ADV Part
I which will become mandatory for use for the December 2001 renewals.
It can be filled out on the investment advisor Registration Depository
(IARD) over time and saved. The form can be submitted when one clicks
on the "send" button, after being satisfied that everything
on the form is complete and correct. A new Form ADV Part II will be ready
for use by the December 2001 renewal date. 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 being given adequate disclosure of any conflicts
of interest the State investment advisor may have. The examiners also
review investment advisory agreements to make sure they do not contain "hedge clauses" in which the State investment advisor disclaims liability
for losses occasioned by any negligence of the investment advisor . The
Securities and Exchange Commission has taken the position, to which the
Division agrees, that "hedge" clauses are unenforceable and
therefore their inclusion in an advisory agreement is misleading to clients.
Securities examiners look for conflicts of
interest when they exam State Investment Advisors. Different kinds of
conflicts of interest arise depending on the number of roles the investment advisor and its affiliates play with regard to the customer. The investment advisor is a fiduciary who must put the customers interest before
his own. These are some of the situations involving conflicts of interest
an examiner looks for:
- Conflicts where the investment advisor is also the broker-dealer or the broker-dealer is an affiliate of the
- Conflicts where the investment advisor or its representative has an ownership interest (or especially a controlling
interest) in an issuer whose securities the Advisor or representative
recommends to customers
- Conflicts relating to the payment
of finders fees
- Conflicts between the investment advisor s interest in trading for the investment Advisors
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
of the conflict? Has the customer consented to the transaction despite
the disclosed conflict? If the customer consented, was the customer
a position to evaluate the effect of the conflict on the customers
interest? The more vulnerable or unsophisticated the customer, the greater
the burden is on the investment advisor to show that the customer has
knowingly consented to the conflict. Disclosure and customer consent
not always be sufficient remedies for conflicts of interest.
An examiner will review any written policy
of the investment advisor 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 advisor 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 advisor 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 advisor is also an issuer or is an affiliate of an issuer.
If there is an apparent conflict of interest, the investment advisor has
a greater burden of showing that the investment recommendation was suitable
for the customer.
AND PERFORMANCE CLAIMS
The examiner will review the investment advisor s
advertising files containing a copy of all advertisements (pamphlets,
circulars, solicitation letters, etc.) the Advisor uses to solicit
business and maintain current clients. All advertisements should be dated
and initialed by a principal (or designated supervisor) of the Advisor
prior to or immediately after distribution to ensure that the advertisement
falls within applicable guidelines.
There is a new regulation 03 AAS 08.045 which
provides that all use of performance figures must comply
with guidelines adopted by the Association for Investment Management and
Research (AIMR). This regulation will become effective soon. It will be
announced on this page when it is effective.
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 Advisor appear superior to its competitors
- Money managers using simulated performance
- "Puffing" or exaggerating the services
and qualifications of the Advisor
During the review of advertisement files, the
examiner may examine software and other programming the Advisor uses to
record and retain client data and the examiner may verify performance
claims compliance with AIMR standards.
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 advisor ,
the state investment advisor 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 advisor is not considered as having constructive custody
of a clients 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 advisor 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 Advisor
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 SIA examinations. For instance, an investment advisor 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
Advisor. However, the SEC has established guidelines (no action positions)
that establish strict procedures to follow so that this situation would
not be considered constructive custody of client funds. The SEC
have allowed automatic payment of advisory fees where:
- The client authorizes the arrangement in
- The Advisor 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 on which the bill is based;
- The custodian notifies the client at least
quarterly of how much has been paid to the Advisor.
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
SIAs who are issuers
An Advisor 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 Advisor receives payment and withdraws funds (via an independent
Requirements for SIAs with "custody"
Additional financial and books and records
requirements ( 3 AAC 08.025 and .040(b)) are imposed on Advisors that
have custody or possession of client securities or funds, which include:
SIAs who have custody of clients
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 are 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, notifies the client
in writing of the place and the manner in which the funds and securities
will be maintained, and thereafter immediately notifies the client in
writing of any changes in the place or the manner in which the funds
or securities are maintained;
The SIA maintains a separate record
for each clients 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 clients beneficial interest in the account;
The SIA, at the end of every three
months, sends each client an itemized statement showing the funds
and securities in the state investment advisor s custody and all debits,
credits, and transactions in the clients account during the
at least once every calendar year,
an independent certified public accountant or public accountant verifies
all client funds and securities by actual examination at a time chosen
by the accountant without prior notice to the SIA, and the accountant
issues 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
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.
procedure for SIAs with custody
In addition to an examination of all the books
and records required of state investment Advisors (3 AAC 08.040) including
those listed above, additional tasks of the exam staff may include:
Determining whether the Advisor
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
Examiners review for suitability issues by
comparing customer new account information with the services contracted
for under investment advisory agreement and with the advice given to the
customer. State investment Advisors need to maintain adequate information
on their customers to document the suitability of the recommendations
made. At a minimum, the investment advisor should maintain information
on the customers annual income, net worth, and investment objectives.
If the customer has specific objectives (for example, to retire in the
year 2005 with a certain level of investment income, or to have funds
available for their childrens future education), those objectives
should be reflected in the customers file.
The examiner will pay special attention to
the suitability of recommendations where the investment advisor has discretion
over the customers account. However, the suitability of investment
recommendations is an issue relating to all investment advisory customers,
not only those who have given the investment advisor discretion over
or her account.
investment advisor Representative
During an exam, the issue of whether individuals,
working at or for the SIA, should be registered as investment advisor representatives may arise. SIAs shall register individuals who
meet the definition of an investment advisor representative under the
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 manger, investment manger,
investment planner or uses a designation such as CFP or ChFC to identify
- Receive a fee from a registered
investment advisor when the individual refers a prospective client to
the Advisor; or
- Prepares a financial plan for a
client and receives a fee.
Questions regarding registration can be directed
to the Divisions Securities at (907) 465-2521.
TOP TEN COMPLIANCE ISSUES FOUND ON investment advisor EXAMS
To assist you in meeting your compliance
responsibilities, we have compiled and identified the most common issues
and problem areas found during state review of investment Advisors:
Lack of a written customer contract. You
must have a written contract with each client (AS 45.55.023(a)(16)),
even if you are 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
the Advisor, and that the contract will not be assigned by the investment advisor 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 advisor to a lesser standard of care than is required by statute. You are allowed
to include an arbitration clause in the contract.
Outdated Form ADV or brochure. You are required
to update 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 Form 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, you must have reasonable grounds for believing the investment
transaction is suitable for the client. You 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 advisor ,
merely asking for estimated net worth and income, and checking a box
for investment objective probably is not sufficient to establish suitability,
particularly if 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.
You 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, you 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 advisor ." 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 advisor , and
persons employed by the entity and providing investment advice must
refer to themselves as "investment advisor representatives." Nor can
anyone call themselves "registered principals" of an investment advisor .
While the Division requires that each investment advisor 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, you should
have a copy of the client's agreement with any brokerage firm at which
you are authorized to trade on the client's behalf.
Problems with invoices for fees. You need
to keep a copy (electronic is ok) 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
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 you.
Misleading performance claims.
In general, because state experience has
found so many problems in this area, the Division strongly discourages
Advisors from attempting to provide overall portfolio numbers and comparing
them to indices. Be aware of the new regulation which provides that
all performance figures must comply with AIMR standards. When
effective this regulation will be found at 3 AAC 08.045.
- 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 Advisors 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 Advisors
portfolio, i.e., you 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.
Other books and records issues.
- You need to set up a complaint file,
even if you have never had any complaints.
- You need to keep all incoming correspondence
from clients, either in a correspondence file or in each client's
file. Similarly, you 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 you are managing money, you 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 advisor , 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. You are
required to maintain financial records for the business, such as
journals for cash receipts and disbursements, and ledgers reflecting
reserve, capital, income and expense accounts. These should be kept
in such a manner that you can produce financial statements on a timely
basis in accordance with generally accepted accounting principles (i.e.,
on an accrual basis). Some software programs, like "Quickbooks," are
generally sufficient to generate these statements. 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
to see a sole proprietor's personal account, however).
If you have 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. You have discretion
even if all you 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 advisor matters, please contact Sharla Kasper
at (907) 465-2521.