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This article is reprinted with permission from the July 30, 1997 edition of New York Law Journal. ©1997 NLP IP Company.

In October 1996, President Clinton signed into law the Investment Advisers Supervision Coordination Act (Coordination Act). 1 The Coordination Act (and rules promulgated under it) became effective on July 8, 1997, and operate to reallocate federal and state regulation of investment advisers. This reallocation of responsibility is designed to make the states primarily responsible for smaller advisers and the Securities and Exchange Commission (SEC or Commission) primarily responsible for larger investment advisers, thereby allowing “the regulatory resources of the Commission and the states [to] be put to better, more efficient use.” 2 The SEC estimates that approximately two-thirds of the more than 23,000 advisers currently registered with the SEC will be ineligible for federal registration once the Coordination Act goes into effect. Essentially, the Coordination Act requires investment advisers with less than $30 million of assets under management to register (if at all) with their home states. Advisers with more than $30 million of assets under management (or those falling into specific categories) must register with the SEC. Advisers registering with the SEC will be exempt from state registration or licensing requirements; however, some state authority, such as the authority to investigate and prosecute fraud, is preserved in all cases by the Coordination Act. Some advisers not qualifying for federal registration will likewise be exempt from state registration requirements, since the Coordination Act also establishes a national de minimis standard prohibiting states from requiring the registration of certain small investment advisers. Generally, however, investment advisers not registered with the SEC will have to comply with their home states’ registration requirements. This article explains the new two-tiered registration scheme and examines the impact the new rules will likely have on investment advisers.

One departure from the text of the Coordination Act, implemented by Rule 203A-1, is an increase in the SEC’s registration threshold from $25 to $30 million of assets under management. Concurrently with this change, the SEC also gives advisers who are “registered or required to be registered” by their home states, and who have between $25 and $30 million of assets under management, the option to remain registered with the Commission should they so desire. This accommodation is apparently intended to ease the transition for those advisers otherwise caught unaware by the changing “assets under management” requirement.

The SEC defines “assets under management” as securities portfolios with respect to which an investment adviser provides “continuous and regular supervisory or management services.” While securities portfolios are defined by Instruction 8(a) to Form ADV-T 3 as accounts having at least 50 percent of their value in securities, the meaning of “continuous and regular supervisory or management services” is not as clearly delineated. The SEC explains that most accounts over which an investment adviser has discretionary control (i.e., for which the adviser is authorized to buy and sell securities) will receive “continuous and regular services within the meaning of the Coordination Act.”

In addition, the SEC states that a “limited number” of non-discretionary arrangements may receive continuous and regular supervisory or management services, “but only if the adviser ‘has an ongoing responsibility to select or make recommendations, based upon the needs of the client, as to specific securities or other investments the account may purchase or sell and, if such recommendations are accepted by the client, is responsible for arranging or effecting the purchase or sale.'” 4

The SEC will look to three factors to determine whether such nondiscretionary advisory arrangements receive continuous and regular supervisory or management services: (i) the terms of the advisory contract; (ii) the form of compensation; and (iii) the management practices of the adviser.

Once it is determined that a securities portfolio receives continuous supervisory or management services, the entire value of the account (not just the securities portion) is included in determining the amount of the adviser’s assets under management.

An adviser to a registered investment company, regardless of the amount of assets the adviser has under management, is required to register with the SEC. A registered investment company generally refers to a company primarily in the business of investing or trading in securities, such as a mutual fund.

Instruction 4 to Form ADV-T provides further guidance. Instruction 4 explains that registration is required only if the adviser “currently provides advisory services pursuant to an investment advisory contract” and the investment company is “operational” at the time of the adviser’s registration.

When initially drafting regulations under the Coordination Act, the Commission read the word “regulated” in §203(A)(a) to mean “registered.” Under this interpretation, however, advisers small enough to be exempt from registration in their home states would have been required to register with the SEC. Such a result obviously ran counter to Congress’s objective to purge from the SEC’s jurisdiction small, local financial advisers.

In order to avoid frustrating Congress’s purpose, the SEC has chosen to regard advisers as “regulated or required to be regulated” by the states in which they have their principal offices and places of business, if those states have enacted investment adviser statutes of any type. According to the SEC, such states have asserted an “interest in regulating investment advisers,” and, while the state may thereafter exempt certain advisers from its registration requirements, it may not “thereby delegate regulatory responsibility for such advisers to the Commission.” 5

This final interpretation of “regulated” has resulted in a regulatory gap. For example, an investment adviser with only $15 million of assets is not required to register with the SEC. Such an adviser may also be exempt from registration in any state if, for example, the adviser has only a small number of clients or does not fall within a state’s definition of an investment adviser.

The SEC, although recognizing the “gap” created by its interpretation, has stated that “to the extent there is a ‘gap,’ … it is more consistent with the Coordination Act for the gap to be closed by the states, which are given primary responsibility for regulating advisers … not eligible for Commission registration.” 6

Additionally, investment advisers whose home states are Colorado, Iowa, Ohio or Wyoming must register with the SEC. While 46 states and three U.S. territories have enacted statutes regulating advisers to some degree, no such statutes exist in these four states, and advisers headquartered there are consequently entirely unregulated.

While actively purging advisers from SEC jurisdiction, Congress provided the SEC with fairly broad general authority to permit federal registration whenever the Coordination Act’s prohibition on registration would be a burden on interstate commerce or otherwise inconsistent with the purposes of the Coordination Act.

In Rule 203A-2, the SEC identifies four categories of investment advisers which shall be exempted from the prohibition on SEC registration: (i) national statistical rating organizations; (ii) pension consultants to plans having an aggregate value of at least $50 million; (iii) investment advisers controlling, controlled by, or under common control with an investment adviser registered with the Commission, provided that their principal offices and places of business are the same; and (iv) investment advisers which are currently neither registered nor required to be registered with either the SEC or their home states, and which reasonably expect to be eligible for SEC registration in the immediate future.

Even before the passage of the Coordination Act, the Advisers Act had carved a few exceptions out of its registration requirements. Investment advisers were exempt from SEC registration if they: (i) had only in-state clients and gave no advice concerning national exchange-traded securities; (ii) advised only insurance companies; (iii) in the previous year had fewer than 15 clients and neither held themselves out generally as advisers nor advised either investment companies or business development companies; (iv) were either charitable organizations or employees or officials thereof; or (v) were either church plans or employees or officials thereof. 7

The Coordination Act has not altered these exceptions, and any adviser fitting within one of these categories is not required to register with the SEC.

As noted above, one of the leading objectives of the Coordination Act is to reduce the amount of SEC resources dedicated to regulating locally operated financial planning firms. Consequently, the Coordination Act puts on the states’ shoulders sole responsibility for the regulation – if any – of a large class of investment advisers. In addition to promoting more efficient use of SEC resources, such jurisdictional mutual exclusivity allows advisers to avoid the difficulties of maintaining both federal and state registration.

This mutual exclusivity notwithstanding, the Coordination Act also states that “[n]othing in this subsection [203A(b)] shall prohibit the securities commission … of any State from investigating and bringing enforcement actions with respect to fraud or deceit against an investment adviser or person associated with an investment adviser.” 8 Such a reservation of power to the states provides all investment advisers with an increased incentive for compliance without subjecting them to the overlapping and duplicative regulation the Coordination Act was designed to eliminate.

Similarly, §222(a) preserves more generally state regulatory authority that does not conflict with the provisions of the Advisers Act or its rules and regulations.

Particularly noteworthy is the operation of §203A(b)(1)(B). Congress has decided that those advisers not meeting the federal definition of “investment adviser” set out in §202(a)(11) – which advisers are already not required to register with the SEC – are nevertheless also outside the general regulatory purview of the states. The Coordination Act also sets a national de minimis standard, beneath the threshold of which investment advisers are mandatorily out of reach of the states’ securities regulators.

Section 222(d) prohibits the states from requiring an investment adviser to register with the state or to comply with any but anti-fraud laws where that adviser: (i) does not have a place of business within the state; and (ii) has had fewer than six clients who were residents of the state within the previous 12 months. For the sake of national uniformity, the SEC has defined “place of business” as any office or other location “held out … as a location at which the … adviser provides investment advisory services [to], solicits, meets with, or otherwise communicates with clients.” 9

The enactment of the Coordination Act obviously entails a dramatic shift away from the previous status quo of adviser registration. Consequently, a number of the sections of the Coordination Act and the rules promulgated by the Commission are specifically designed to govern the transition process. The Coordination Act allows the SEC to cancel the registrations of advisers prohibited from SEC registration under §203A. The Commission is enabled to purge from its rolls those current registrants which, while once eligible for SEC registration, now meet the conditions of prohibition set out in §203A(a).

The workhorse of the transition is Form ADV-T. The form is designed to aid the SEC in determining which federally registered advisers will continue to be eligible for SEC registration following the Coordination Act’s effective date. Those SEC-registered advisers which are now ineligible to register with the SEC must use Form ADV-T to withdraw from federal registration.

ENDNOTES

1. The Act was included as Title III of the National Securities Markets Improvement Act of 1996. Unless otherwise noted, all section citations refer to the Investment Advisers Act of 1940 (Advisers Act), as amended by the Coordination Act. All rule citations refer to 17 CFR Part 275, as amended by 62 Fed. Reg. 28112 et seq. (May 22, 1997).

2. S. Rep. No. 293, 104th Cong., 2d Sess. 3-4 (1996).

3. Form ADV-T is the SEC form used for determining eligibility for SEC registration.

4. 62 Fed. Reg. 28115.

5. 62 Fed. Reg. 28119-20.

6. 62 Fed. Reg. 28120.

7. Section 203(b)(1)-(5).

8. Section 203A(b)(2).

9. Rule 22-1(a).