Steps for Implementing the RIA Business Model

A good number of CFA® charterholders consider adopting the RIA (registered investment adviser) business model. There are several reasons to do so. Some institutions and individuals only hire RIAs. Even clients who do not require that an adviser be registered may find registered advisers more appealing. (It should be noted, however, that a federally registered adviser may not make any inference that government registration equals government approval of the adviser; most if not all states are likely to have the same restriction.) In addition, a charterholder might be attracted to the structured disclosure form (Form ADV), which allows the adviser to provide clients with detailed information about his or her business, including advisory personnel, fees, and any conflicts of interest.

To be fair, there are some downsides to being an RIA that should be pointed out: there are specific rules and requirements to which you must adhere; there are annual renewals to update and file; and there is the possibility of a regulatory examination. But, all in all, most charterholders will find the benefits of the RIA business model outweigh the negatives. Whether you already have a practice or are considering starting an advisory business, the following steps will help guide you through the RIA process.

ARTICULATE YOUR BUSINESS

As obvious as this may sound, articulating the purpose of your business is the most important step in meeting the requirements to become an RIA. So, take the time to write a detailed description of your business. Use the answers to the following questions as a starting point:

1. What services are you providing or might you realistically provide in the near future? For example, are you offering investment advice on all types of securities or just mutual funds? Are you making the trades for clients or are you simply making recommendations for the clients to act on? Are you managing a mutual fund or a private fund? Are you offering any ancillary services?
2. Who are your target clients? Are they high-net-worth individuals, nonprofit institutions, corporations, and/or mutual fund shareholders? Are they pension funds that have ERISA (Employee Retirement Income Security Act) considerations?
3. What types of fees are you charging (e.g., fixed fees, fees based on assets under management, or performance fees) and in what amounts? Are you charging different types of fees for different types of clients?
4. What third parties—such as a broker, a prime broker, and/or custodian—are you using and what are their functions? Are any of them affiliated with your advisory business? Do you have any arrangements with other businesses to refer you business? Are there other businesses with which you partner?
5. Are there any conflicts of interest involved in your operations, either actual or potential? For example, are you charging some clients a performance fee that provides an inherent incentive for the adviser to favor a particular investment vehicle? Do you manage both a fund and separate accounts? Are employees allowed to personally trade in the same securities that the adviser recommends to clients? Do you plan on having soft-dollar arrangements?

REGISTER WITH THE SEC OR STATE

If you have a going concern with at least $25 million in assets under management—or if you have a new advisory business that you expect to reach that level of assets within 120 days—and/or you will be the manager of a mutual fund, you must register with the SEC (Securities and Exchange Commission). You will also need to register as an RIA with the state in which you have your principal executive office, as well as possibly other states in which you do business, depending on the requirements of that state. You will need to consult the securities law and accompanying rules that govern investment advisers in those states to determine whether you need to register.

Please remember that if you are an adviser registered with the SEC, you will also need to submit what are known as notice filings in the state in which you have your principal office and certain other states in which you do business. In most states, the test is whether you have six or more clients residing in that state, but each state has its own requirements for notice filers.

You can register as an investment adviser, whether with a state or with the SEC, by completing and filing Form ADV, Parts 1 and II. Filing is accomplished through a combination of the IARD (Investment Adviser Registration Depository) system and paper submissions. The SEC requires that a balance sheet accompany the Part II section if you ask for prepayment of fees of more than $500 per client and six or more months in advance. States often require additional forms, which may include financial statements, proof that adviser representatives have the appropriate qualifications, and proof of adequate insurance coverage.

Although much of Form ADV is “check the box,” it is critical to carefully consider the answer to each question. If you think an answer requires more than a simple yes or no to be complete—and quite a number, especially in Part II, will—provide additional explanation in the space provided. When completing the form, remember that it will be clients (some of whom may be disgruntled, despite your best efforts) and regulators who will read this document; full disclosure of each aspect of your business will benefit you in the long run.

ESTABLISH YOUR INVESTMENT ADVISORY AGREEMENT AND COMPLIANCE POLICIES

Together with the many documents you need to set up a business and register as an investment adviser, there are a number of other documents that you will need before you can operate as an RIA.

One of these is an investment advisory agreement between you and your client. This document must be tailored to the specifics of your business, but make sure it discloses: (a) the services you will or may likely provide, (b) the type of fee you will charge and the amount of the fee, (c) the basis on which the fee will be charged (prospectively or retroactively, quarterly or at other intervals), (d) whether you have discretion over the client’s assets, (e) whether it is you or the client who has the duty to vote proxies, and (f) whether there are any actual or potential conflicts of interest of which you want the client to be made aware. If you are becoming the adviser to a mutual fund, there are additional requirements contained in the applicable federal law, the Investment Company Act of 1940.

Some institutions and individuals only hire RIAs. Even clients who do not require that an adviser be registered may find registered advisers more appealing. In addition, a charterholder might be attracted to the structured disclosure form, which allows the adviser to provide clients with detailed information about his or her business, including advisory personnel, fees, and any conflicts of interest.

In addition, there are a number of compliance policies and procedures that you must (if you are federally registered) or should put in place. For SEC-registered investment advisers, the Investment Advisers Act and SEC rules require that you have a privacy policy (which must be provided to a potential client no later than at the time the client signs the advisory agreement), a code of ethics regulating employees’ personal securities transactions, an insider trading policy, a proxy-voting policy (unless your advisory agreement explicitly states that the client is responsible for voting proxies), and a compliance program with a designated chief compliance officer. There are also detailed record retention requirements.

State regulations vary but may include many of these requirements. For example, New York State regulations require registered advisers to have a code of ethics, to maintain specific records, and to have an income statement and balance sheet either audited or certified by management; CFA charterholders will generally be granted a waiver from the state qualification requirement.

PRODUCE YOUR MARKETING MATERIAL

Your marketing material, which includes your website, is an important part of your business’s success. In writing the copy, keep in mind that the very nature of this material invites a positive “spin” on you and your business. Even some of the most cautious advisers are apt to paint a totally rosy picture, make promises, or fail to point out risks (in addition to rewards).

While the SEC does not require you to file your marketing material, many states do. And if you are advising a mutual fund, FINRA® (Financial Industry Regulatory Authority) will review and make changes to your marketing material. In any case, if there is an examination of your advisory business or a regulatory inquiry, the marketing material is likely to be a focus. A balanced presentation of your advisory business is the safest bet.

While these steps will help you transition to the RIA format, it is wise to bring in a professional—in this case a lawyer or compliance expert experienced in the investment-adviser field—to assist you.

–Susan I. Grant is a lawyer with an independent practice who, following graduation from Columbia Law School, has spent her career providing counsel to members of the financial services industry, both as in-house counsel and as part of a major NYC law firm.

Comments

[I Braunstein]

This is a well written article and one which would have helped me 18 months ago when I set up an advisory firm.
Two questions- 1) what are the specific requirements if one wishes to manage a client account for a % of profits instead of the more typical % of AUM? 2) Does a % of profits approach increase an advisors liability/exposure in any fashion?

[Susan Grant]

Thank you for your kind review of my article.

Below is a general answer to your question:
Although the Investment Advisers Act contains a prohibition against RIAs charging a client a performance fee, based upon the belief that such a fee could encourage the RIA to make riskier investments, there are a number of exceptions, which are set forth in Rule 205-3 under that law. The exceptions are generally applicable for sophisticated clients, because the SEC believes that they could adequately protect themselves from that risk. One of those exceptions is a performance fee based upon a stated percentage of appreciation in the account’s assets, which is what you seem to be asking about.

First, clear, prominent disclosure of all of the relevant aspects of the performance fee is a must.

In terms of what type of client could be charged a performance fee, Rule 205-3 requires the client to be a “qualified client.” Thus the client, which could be a natural person or a company (but not a private fund relying on the registration exemption contained in Section 3(c)(1) of the Investment Company Act, a registered investment company [mutual fund] or a business development company), would have to meet one of the following three criteria: (1) the client has to have a minimum of $750,000 under management with the RIA right after signing the advisory contract with the RIA; (2) the RIA must reasonably believe that the client either has a net worth of over $1.5 million at the time the contract is executed or is a “qualified purchaser” under Section 2(a)(51)(A) of the Investment Company Act; or (3) the client is a natural person who, immediately before signing the advisory contract, is a senior person of the RIA or is involved with the investment activities of the RIA or another company.

If the client is a company, there may be a need to look to the owner, if that, too is a company, to determine if it also meets one of these criteria. In addition, there may be state laws or rules, ERISA requirements and FINRA requirements, depending on the RIA and client involved.

As to whether charging a performance fee increases an adviser’s liability/exposure in any fashion, there is no definitive answer to that, but my opinion is that, with all other things being equal in the business of two RIAs, a regulator would likely opt to examine the one that charges a performance fee over the one that charges a more standard fee based upon AUM.

[Richard Emmons]

I'll definitely forward your article to advisors considering a switch to the RIA business model from the broker-dealer structure.

One advisor told me this week his BD compliance department was taking a second look at a seminar system he has used for 11 years!

Another advisor's BD wants to charge him $100 per page to review a book he wrote for clients and prospects...on top of the $100 per page that FINRA wants to charge him!

Compliance departments can take months to approve a seminar system...while an RIA can do a seminar in a couple of weeks.

Thank you Susan for writing this article. Consider a follow-up article on the broker-dealer model and its legal advantages and disadvantages with the RIA model.

[Santos L. Halper]

This is an excellent article -- helpful and accurate. Your response to the 205-3 inquiry was also very good (and worth quite a lot as far as legal advice goes!)

[RIA Compliance]

Compliance is getting more and more for RIA's. More then likely it will be picking up for 2011.

[Ramanand singh]

It seems that the Rule 205-3 unfairly discriminates between common investors and well to-do investors. For example, I have devised a trading strategy which I have back tested using historical data available. The back test of my trading plan shows an average annual return of 245% - based on six and half years of trading data. So if I want to manage somebody's account, I would certainly would like to be compensated accordingly - rather than getting just small % of AUM.

Is there any alternative available through which high returning strategy can help smaller investors?