SEC Jurisdiction Over Investment Advice

What every CPA should know.
BY BRIAN CARROLL

EXECUTIVE SUMMARY
MANY CPAs HAVE RESPONDED TO INCREASED client interest in financial products by formally offering investment advisory services. This generally requires them to register as investment advisers with either a state agency or with the SEC, based primarily on the amount of assets under management.

CPAs CAN PROVIDE LIMITED INVESTMENT ADVICE to clients without registering. The key question is whether a CPA’s investment advice brings him or her under the definition of “investment adviser” in the Investment Advisers Act of 1940. Even if the answer is yes, a CPA may still be excepted under the professional’s safe harbor.

THE ACT DEFINES AN INVESTMENT ADVISER as anyone who, for compensation, engages in the business of advising others about the value of securities or the advisability of investing in, purchasing or selling securities. While this three-part definition appears simple, there are nuances CPAs should understand in deciding if they need to register.

THE ACT’S SAFE HARBOR EXCLUDES FROM the investment adviser definition any “lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession.” The exception is not available to an accountant who acts as a financial planner.

CPAs THINKING ABOUT PROVIDING INVESTMENT advice should proceed with caution. The best approach is to consult with legal counsel to make sure the CPA is not unintentionally providing investment advice without registering.

BRIAN CARROLL, CPA, JD, is an attorney and special counsel with the Securities and Exchange Commission in Philadelphia. He is co-chair of the securities regulation committee of the American Association of Attorney-CPAs. The SEC, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the commission or of the author’s colleagues on the SEC staff.

ith the explosion of financial information and interest in financial markets, clients of all types are turning to their CPAs for advice on investing in stocks, bonds, mutual funds, limited partnerships and other financial products. Many CPAs have responded by formally offering investment advisory services, which generally requires them to register as investment advisers with either a state agency or the SEC.

SEC vs. State Registration

CPA meeting the definition of investment adviser in the Investment Advisers Act of 1940 and not excepted under the professional’s safe harbor must determine whether he or she must register with a state agency or with the SEC itself. The commission’s criterion is based in part on a minimum amount of assets under management and whether the investment adviser provides investment supervisory services. However, several registration exemptions exist. To determine where you should register, consult with the North American Securities Administrators Association, 10 G Street, N.E., Suite 710, Washington, D.C. 20002; 202-737-0900; www.nasaa.org , or the Office of Filings and Information Services, U.S. Securities and Exchange Commission, 6432 General Greenway Drive, Alexandra, Virginia, 22312; 202-942-7820; www.sec.gov .

Short of staking a claim as an investment adviser, CPAs can provide limited investment advice to clients without registering. The key question is whether a CPA’s investment advice brings him or her under the definition of “investment adviser” in the Investment Advisers Act of 1940. Even if the answer is yes, the CPA may still be excepted from the definition under the “professionals” safe harbor. If he or she is not excepted, the CPA must determine whether to register with a state agency or the SEC (see “SEC vs. State Registration,” above). Regardless, CPAs are subject to the act’s anti-fraud provisions.

This article provides guidance to every CPA who has ever wondered whether or not providing investment advice triggers the act’s registration requirements and its anti-fraud rules.

Internet Isn’t Replacing Planners

Financial planners remain important in the Internet age. A survey of investors who go online showed they were not abandoning their financial advisers but rather were using the Internet to complement the information and advice they provided.

While 71% of investors who used both a financial adviser and the Internet conducted some financial activities online, only 15% used the Internet to buy or sell stocks in the last year. Most used the Internet to access financial news (73%), monitor their portfolios (63%), do financial research (58%) or get quotes (54%). They turned to a professional for more specific buy/sell recommendations, asset allocation and financial planning.

Investors who used the Internet more than once a month said that while they expect their online activity to increase over the next three years, they would continue to consult their financial advisers. Only 11% anticipated decreasing their use of an adviser in the future.

Among Internet users, 68% were very satisfied and 29% were somewhat satisfied with their primary financial adviser. Of the 3% who were somewhat dissatisfied, most were young, male and not yet affluent. This group anticipated it would turn more to the Internet for investing in the next three years and use advisers less.

Source: Forum for Investor Advice, Bethesda, Maryland, www.investoradvice.org .

WHO IS, WHO ISN’T

The act defines an investment adviser as “any person who, for compensation, engages in the business of advising others…as to the value of securities or as to the advisability of investing in, purchasing, or selling securities….” [Section 202(a)(11)]. Moreover, if you fall under this definition and are not excepted, use any means of interstate commerce (mail, e-mail, telephone) as part of your investment advisory business and are required to register with the SEC and fail to do so, you may have violated the act, subjecting you to criminal and civil prosecution.

At first glance, the three-part, statutory definition of an investment adviser appears to cover only those who intend to be compensated for operating a business providing investment advice. The SEC may, however, interpret the definition in ways that are not self evident. In addition, the act has a broad reach. For example, the term “person” in the investment adviser definition includes both people and a company, which, in turn, includes not only corporations, partnerships, trusts and the like, but “any organized group of persons, whether incorporated or not…” [Sections 202(16) & (5)]. This inclusiveness runs throughout the act and interpretations by the staff of the SEC division of investment management.

1. Investment advice. This element of the definition is deceptively simple. Many CPAs read it and immediately think, “I don’t advise clients to buy or sell a particular stock, so I’m not an investment adviser.” Nothing could be further from the truth. While the act defines a “security” by listing traditional items, such as a note, stock, bond, debenture and, in general, “any instrument commonly known as a ‘security,’” it doesn’t stop there. Less obvious investments, such as a “certificate of interest or participation in any profit-sharing agreement,… preorganization certificate or subscription,…investment contract,…a certificate of deposit,” are also included [Section 202(18)]. Consistent with this approach, in a no-action letter (see “Ask the SEC: No-Action Letters,” below), the staff of the SEC division of investment management viewed limited partnership shares in a real estate venture as securities.

Ask the SEC: No-Action Letters

The SEC, through the division of investment management, will provide informal written advice—in the form of no-action letters—on whether a CPA falls within the definition of an investment adviser and qualifies for the professional’s exception. In a no-action letter the division states that it will or will not recommend any enforcement action (civil prosecution) against a CPA if he or she acts in accordance with specific facts and representations made in its letter.

Requesting a no-action letter gives CPAs an opportunity to explain to the SEC prospectively a course of conduct and learn whether following through would trigger an enforcement action. CPAs must identify themselves in the letter, which is made available to the public.

For more information see “Procedures Applicable to Requests for No-Action and Interpretative Letters,” Securities Act of 1933, Release no. 5127, etc. 1971 SEC LEXIS 446, 36 FR 2600 (Jan. 25, 1971). No-action letters should be addressed to the U.S. Securities and Exchange Commission, Division of Investment Management, Chief Counsel’s Office, 450 Fifth Street, N.W., Washington, D.C. 20549. General information about the SEC and its activities is also available on its Web site, www.sec.gov.

More important, a CPA may provide investment advice without ever mentioning a specific security. According to the SEC division of investment management staff, a CPA is offering investment advice if he or she advises a client “concerning the relative advantages and disadvantages of investing in securities in general as compared to other investments” (Release 1092). For example, if a CPA provides advice on the benefits of investing in securities as opposed to coins (not a security), this would constitute investment advice. Similarly, advice on what type of security to choose—bonds, stocks or mutual funds—would satisfy this element, as would advice on allocating certain percentages of assets among securities. Even a CPA’s advice to a client on selecting or retaining a particular investment adviser may constitute investment advice.

2. In the business. This element is also tricky. The division of investment management staff set broad principles supplemented with specific guidelines. Generally, a CPA would be in the business even if providing investment advice did not constitute his or her principal business. Indeed, no particular percentage of investment advisory services is required. However, to be considered in the business, a CPA must give investment advice with some regularity. Although it is considered a factor, the frequency of advice is not determinative. Investment advice furnished by a CPA but communicated to the client by a third party is another factor.

More specifically, a CPA will be considered to be in the business by satisfying one of the following three factors.

Holding out. A CPA does this by presenting him- or herself to the public as an investment adviser. This happens when he or she promotes investment advisory services by general advertising or mailings, or uses the term investment adviser—or a similar title—on a business card, stationary, in a telephone, business or building directory or generally makes it known—even by word of mouth—that he or she provides investment advice.

Compensation. If a CPA receives compensation as a clearly definable charge for providing investment advice, regardless of whether the payment is part of or separate from an overall charge for more than one service, he or she is considered to be in the business. Any transaction-based fees the CPA earns when a client implements the investment advice are considered covered compensation.

Specific investment advice. If a CPA provides “specific” investment advice more often than in “rare, isolated or non-periodic instances” (Release 1092), he or she would be in the business. Specific investment advice is narrower than the definition of investment advice because it includes recommending specific securities and categories of securities and allocating certain percentages of assets among securities, but excludes general recommendations on asset allocation.

3. Compensation . This final element of the three-part investment adviser definition is independent of the factors used to decide if someone is in the business. To be considered an investment adviser, a CPA must receive compensation, including any economic benefit. Hence, any fee, whether charged for a single or multiple service, commission or payment would suffice. Also, a fee could be paid by someone other than the client and still constitute compensation for purposes of the client relationship. For example, if a CPA in the business of providing investment advice performed several services for a client, including providing investment advice, and earned a commission from selling the client an insurance product or other investment, that commission would be compensation.

SAFE HARBOR

Any CPA who meets this three-part investment adviser definition is, unless excepted, subject either to state or SEC registration and the act’s anti-fraud provisions (see “The Reach of the Anti-Fraud Provisions,” below). Nonetheless, CPAs have a safe harbor available to them. The act explicitly excludes from its definition of an investment adviser any “lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession” [Section 202(a)(11)(B)].

The Reach of the Anti-Fraud Provisions

Any CPA who meets the definition of an investment adviser and is not excepted is subject to the anti-fraud provisions of the Investment Advisers Act of 1940. Section 206(1)-(4) makes it unlawful for any investment adviser to, among other things, defraud any client or prospective client or engage in a practice that defrauds or deceives any client or prospective client. In addition, the SEC developed rules under section 206(4) addressing advertising, custody of assets, payments for client referrals and disclosure of disciplinary information. The SEC division of enforcement is authorized to investigate and prosecute violations of these provisions and works closely with the Department of Justice in referring violations that warrant criminal prosecution.

Eligibility hinges on whether the CPA’s investment advisory service is “solely incidental” to the practice of accounting. The exception, however, is not available to an accountant who acts as a financial planner. The division of investment management staff weighs three factors in determining who meets the solely incidental test: 1) whether the accountant (or firm) holds him- or herself (or itself) out to the public as an investment adviser; 2) whether the advisory services rendered are connected with and reasonably related to accounting services; and 3) whether the fee charged for advisory services is based on the same factors as those used to determine the accounting fee.

With one exception these factors are relatively straightforward. The holding out test is the same one used to determine whether a CPA is in the business under the investment adviser definition. In essence, holding out to the public as an investment adviser defines you as being in the business and simultaneously eliminates any possibility of falling under the “solely incidental” safe harbor.

Although fee structure is considered in determining whether a CPA is in the business, the approach for the solely incidental test is not the same. To qualify for eligibility, the CPA must use the same factors to determine both the accounting and investment advisory fees. For example, a CPA’s investment advice to a client would not qualify as solely incidental if the CPA charged the client an hourly fee for accounting services but a percentage-of-assets fee for investment advisory services.

Finally, the definition of “in connection with and reasonably related” is less clear cut. It raises the question: “What kind of ‘accounting services’ qualify?” Today, accountants provide many business services other than traditional accounting. Although scant guidance is available, it is doubtful that investment advice solely incidental to one of these nontraditional services would qualify. Notwithstanding this issue, the SEC division of investment management staff said that if a partner of an accounting firm acted as an offeree representative for a limited partnership by discussing with prospective investors the risks of investing and past performance of the general partners of similar partnerships, and generally assisted investors, this conduct was not solely incidental to the practice of accounting.

PROCEED WITH CAUTION

As the issues discussed here clearly demonstrate, investment advisory services are a complex area with far-reaching consequences. A CPA contemplating providing investment advice to his or her clients should exercise caution. Without expertise in this area, the CPA’s best approach is to consult with legal counsel to ensure he or she is not unintentionally providing investment advice without registering. Because of the far reaching consequences, competent legal advice offers CPAs the best protection.

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