Series 65 Laws and Regulations Core: The Investment Advisers Act
Definition of an Investment Adviser
The Investment Advisers Act of 1940 establishes a three-prong test to determine if an individual or firm must register as an investment adviser (IA). To meet the definition, an entity must provide advice about securities, as a regular part of their business, for compensation. On the Series 65, examiners often use the acronym "ABC" (Advice, Business, Compensation) to test this concept. It is vital to note that compensation includes any economic benefit, not just hourly fees or assets under management (AUM) charges. The exam frequently tests exclusions from this definition, such as the L.A.T.E. exclusion, which applies to lawyers, accountants, teachers, and engineers whose investment advice is solely incidental to their professional practice. If an accountant charges a separate fee for a financial plan, they lose this exclusion and must register, as the advice is no longer incidental.
Registration Requirements and Exemptions
Registration is required at either the federal or state level, but never both. Under the National Securities Markets Improvement Act (NSMIA) of 1996, the division of labor is based primarily on AUM. Federal Covered Advisers (FCAs) generally include those with $110 million or more in AUM, those advising registered investment companies, or those operating in 15 or more states. The exam focuses on the buffer zone between $100 million and $110 million, where an adviser may choose to register with the SEC. Conversely, those with less than $100 million usually fall under state investment adviser registration mandates. Notable exemptions include the "Foreign Private Adviser" exemption and the "Private Fund Adviser" exemption for those advising solely outstanding private funds with less than $150 million in AUM. Understanding these thresholds is critical for answering questions regarding which regulatory body has primary jurisdiction over a firm's operations.
The Antifraud Provisions of Section 206
Section 206 of the 1940 Act serves as the broad statutory basis for prohibiting fraudulent, deceptive, or manipulative acts by any investment adviser, regardless of whether they are registered or exempt. This section is unique because it applies to the conduct of the adviser toward both clients and prospective clients. The Series 65 tests the concept of "scienter"—the intent to deceive—but emphasizes that under Section 206, an adviser can be held liable for a breach of fiduciary duty even if the intent to defraud is not explicitly proven. This is often referred to as constructive fraud. Key applications include the prohibition of principal trades without prior written disclosure and client consent on a transaction-by-transaction basis. This rule ensures that advisers do not use their own inventory to fill client orders at unfavorable prices, thereby maintaining the integrity of the advisory relationship.
State vs. Federal Jurisdiction
The Uniform Securities Act acts as a model law that states use to draft their own legislation, and it governs the registration of state-level advisers. A critical distinction tested on the exam is the de minimis exemption. Under state law, an investment adviser with no place of business in a state is exempt from registration if they have five or fewer retail clients in that state during the preceding 12 months. This differs from the federal standard, which does not recognize a numerical de minimis for retail clients in the same manner. Furthermore, even if an adviser is a Federal Covered Adviser, they may still be required to complete a notice filing in states where they have a place of business or a certain number of clients. This involves paying a fee and filing a copy of the documents submitted to the SEC (Form ADV) with the State Administrator.
Agent and Security Registration
The Series 65 requires knowledge of how individuals, known as Investment Adviser Representatives (IARs), register. Unlike the firm (the IA), the IAR almost always registers at the state level. If an IAR works for a state-registered adviser, they must register in any state where they have a place of business or more than five retail clients. However, for IARs of Federal Covered Advisers, the rule is narrower: they only register in states where they have a physical place of business. Additionally, the exam covers security registration, distinguishing between notice filing, coordination, and qualification. Registration by coordination is used for securities also being registered under the Securities Act of 1933, while registration by qualification is typically used for intra-state offerings that require a rigorous review by the State Administrator before the registration becomes effective.
State Antifraud Provisions
State-level antifraud rules under the USA are remarkably broad and apply to any person involved in the offer, sale, or purchase of a security. This includes the prohibition of misleading statements or the omission of material facts—information that a reasonable investor would consider important when making an investment decision. In the context of the exam, candidates must realize that these provisions apply to everyone, including those selling exempt securities like U.S. Treasuries or municipal bonds. The Administrator has the power to issue cease and desist orders without a prior hearing if they believe a violation is occurring, though the respondent has the right to request a hearing within 15 days. Understanding the Administrator’s jurisdiction over activities originating in their state or directed into their state is essential for solving complex scenario-based questions.
The Investment Adviser's Fiduciary Duty
Duty of Loyalty and Duty of Care
A central theme of the exam is the Series 65 fiduciary duty, which elevates the adviser's obligations above the "suitability" standard used by broker-dealers. The fiduciary duty is comprised of the Duty of Loyalty and the Duty of Care. The Duty of Loyalty requires the adviser to put the client's interests ahead of their own at all times. This means the adviser must not only avoid conflicts of interest but also proactively seek the best execution for client trades. The Duty of Care requires the adviser to act with the competence and diligence that a prudent professional would exercise. This involves conducting thorough due diligence on investments before recommending them. On the exam, a violation of the Duty of Care might involve failing to investigate the underlying assets of a complex derivative before placing it in a conservative client's portfolio.
Identifying and Disclosing Conflicts
Since it is often impossible to avoid every conflict of interest, the regulatory focus shifts to full and fair disclosure. An adviser must disclose any compensation received from third parties that might influence their recommendations, such as 12b-1 fees or soft dollar arrangements. Soft dollars are a specific exam topic; they refer to the practice of receiving research or brokerage services from a broker-dealer in exchange for directing client trades to that firm. Under Section 28(e) of the Securities Exchange Act of 1934, this is permitted only if the services provide lawful and appropriate assistance to the adviser in the investment decision-making process. Items like office furniture, rent, or travel expenses do not qualify for the soft dollar safe harbor and must be disclosed as a conflict of interest that could lead to "churning" or excessive trading.
Suitability Obligations
Suitability is a subset of the fiduciary duty that focuses on the alignment between a client's profile and the recommended investment strategy. To fulfill this obligation, an adviser must perform a Know Your Customer (KYC) analysis, gathering data on the client’s financial goals, risk tolerance, time horizon, and tax status. On the Series 65, suitability questions often present a hypothetical client (e.g., a 70-year-old retiree) and ask which investment is most appropriate. Recommending an aggressive growth fund to a retiree with a need for immediate income is a classic suitability violation. Candidates should also be aware of "pattern" suitability, where an adviser must ensure that the overall portfolio remains balanced and consistent with the client's Investment Policy Statement (IPS) over time, rather than just evaluating each trade in isolation.
Prohibited Practices and Ethical Violations
Fraud, Deception, and Manipulation
Series 65 prohibited practices extend beyond simple theft to include any activity that creates a false impression of market activity. One such practice is painting the tape, where market participants buy and sell securities among themselves to create the illusion of high volume or price movement. Another is "wash sales," where an investor buys and sells the same security to generate a tax loss without changing their economic position. In the advisory context, fraud includes making guarantees of performance. An adviser may never tell a client that a specific return is "guaranteed" or that the adviser will "make up for any losses." Such statements are inherently deceptive because all securities investments carry some level of risk, and promising otherwise is a violation of the antifraud provisions of the USA.
Insider Trading and Front-Running
Insider trading involves trading on the basis of material, non-public information (MNPI). The exam tests the Insider Trading and Securities Fraud Enforcement Act of 1988, which established significant penalties for both the person who trades (the tippee) and the person who provides the information (the tipper). Firms are required to establish written policies to prevent the misuse of MNPI, often including the use of "Chinese Walls" to separate departments. Front-running is a related unethical practice where an adviser or trader places a personal order ahead of a large client order they know is coming. For example, if an adviser knows a mutual fund client is about to buy 100,000 shares of a stock, and the adviser buys 1,000 shares for their personal account first to benefit from the price increase, they have committed front-running. This is a direct breach of the fiduciary duty of loyalty.
Unauthorized Trading and Churning
Unauthorized trading occurs when an adviser executes a trade for a client without having the proper authority. To trade on a client's behalf, the adviser must have discretionary authority, which must be granted in writing. A unique rule for investment advisers is that they can exercise oral discretionary authority for up to 10 business days after the first trade, provided they obtain written authorization thereafter. This is a common exam trick, as it differs from the broker-dealer rule which requires written consent prior to any trade. Churning refers to excessive trading in a client's account for the primary purpose of generating commissions. While most advisers charge a flat fee (reducing the incentive to churn), those who receive transaction-based compensation must ensure the volume and frequency of trades are consistent with the client's investment objectives and financial situation.
Compliance and Operational Requirements
Form ADV is the primary document used for adviser registration and is a frequent subject of exam questions. Part 1 is primarily for regulatory use and contains information about the adviser’s ownership, business practices, and any disciplinary history (the "Disclosures Reporting Pages"). Part 2, often called the Brochure, is a narrative document written in plain English that must be provided to clients. It details the adviser's fee schedule, investment strategies, and conflicts of interest. Under the Brochure Rule, advisers must deliver the brochure to a client at or before the time of entering into a contract. If there are material changes, the adviser must provide a summary of these changes to existing clients annually within 120 days of the end of the adviser’s fiscal year. Failure to deliver this document is a significant compliance failure.
Recordkeeping and Books & Records Rules
Advisers are subject to strict adviser compliance requirements regarding the maintenance of records. Under the 1940 Act and the USA, advisers must generally maintain most records for a period of five years, with the first two years' records kept in the principal office of the adviser. These records include checkbooks, bank statements, ledgers, and copies of all advertisements sent to 10 or more people. A specific requirement often tested is the Articles of Incorporation or partnership agreements, which must be kept for the life of the firm and for three years after the firm is dissolved. All records must be kept in an easily accessible place and are subject to periodic, unannounced examinations by the SEC or State Administrator to ensure the firm is operating within the bounds of the law.
Custody of Client Assets
An adviser has custody if they hold, directly or indirectly, client funds or securities, or if they have the authority to obtain possession of them. This includes having the ability to withdraw funds from a client’s account to pay advisory fees. If an adviser has custody, they must follow the Custody Rule: assets must be held by a "qualified custodian" (like a bank or broker-dealer), clients must be notified in writing of the custodian's location, and account statements must be sent at least quarterly. Furthermore, the adviser must undergo an unannounced surprise audit by an independent public accountant once a year. If an adviser inadvertently receives client securities (e.g., a client mails them a stock certificate), they are generally not deemed to have custody if they return the securities to the sender within three business days.
NASAA Model Rules on Unethical Conduct
Specific Prohibitions for Investment Advisers
The NASAA model rules provide a detailed list of activities that constitute unethical business practices. One major prohibition is the borrowing of money or securities from a client unless the client is a broker-dealer, an affiliate of the adviser, or a financial institution in the business of lending. Note that unlike some other registrations, an IAR cannot borrow from a client simply because the client is a family member. Similarly, lending money to a client is prohibited unless the adviser is a financial institution or the client is an affiliate. Another prohibited practice is the sharing in the profits or losses of a client's account. While broker-dealer agents can sometimes do this with written permission, investment advisers are strictly prohibited from such arrangements because they compromise the objective nature of the fiduciary advice.
Advertising by investment advisers is highly regulated to prevent misleading the public. An advertisement is defined as any communication directed to more than one person. The Series 65 tests the prohibition on the use of testimonials; advisers may not use statements from clients that attest to the adviser's services or success (though recent SEC rule changes have modified this slightly, the exam often sticks to the traditional NASAA prohibition). Furthermore, any mention of past successful recommendations must include all recommendations made during the period (usually the last 12 months) to prevent "cherry-picking." Performance reporting must be shown net of fees, meaning the returns must reflect the deduction of advisory fees, ensuring the client sees a realistic representation of what they would have actually earned.
Client Solicitor and Cash Referral Fees
Advisers often pay third parties, known as solicitors, to find new clients. Under the Cash Solicitation Rule, an adviser can pay a referral fee only if several conditions are met. There must be a written agreement between the adviser and the solicitor. The solicitor must provide the client with both the adviser’s brochure and a separate Solicitor’s Disclosure Document that explains the relationship and the compensation structure. The client must sign an acknowledgment that they received these documents. The exam focuses on the fact that the solicitor’s fee cannot result in the client being charged a higher advisory fee than other clients with similar profiles. This ensures that the cost of the referral is transparent and does not unfairly penalize the referred client through hidden expenses.