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Investment Adviser Compliance: Should I be an Exempt Reporting Adviser? //

Investment fund organizers, whether managers or syndicate leads should ensure that they are properly registered or exempt from investment adviser registration before they put together an investment fund. Registration is a primary concern due to the penalties for failure to comply.

Under the Investment Advisers Act of 1940 (“Advisers Act”) it is unlawful for a fund organizer to transact business as an investment adviser unless it is properly registered. Failure to register may lead to the institution of Securities and Exchange Commission (“SEC”) cease and desist proceedings, administrative sanctions, and/or substantial monetary penalties. Likewise, under most state law it is unlawful to transact business as an investment adviser without being properly registered. For example, In the State of Utah, failure to register as an investment adviser is a third-degree felony, punishable by up to five years in prison and a fine of up to $5,000. U.C.A. Section 61-1-21(1)(a) & Section76-3-203(3).

The question for fund organizers then is not whether they should be an Exempt Reporting Adviser (“ERA”), rather the question is if they can qualify for the less onerous registration and disclosure requirements available to ERA’s?

Question 1: What is an ERA?

An ERA is an investment adviser that is not required to comply with the full Registered Investment Advisor (“RIA”) rules and application process. RIAs are required to register with the SEC or an applicable state regulatory authority by submitting the full version of Form ADV (Parts 1A, 1B, 2A Brochure, 2B Supplement) electronically using the Investment Adviser Registration Depository (“IARD”), an e-filing system administered by the Financial Industry Regulatory Authority (“FINRA”). RIAs must comply with fiduciary duties, anti-fraud provisions (Custody Rule, Solicitor’s Rule, Pay-to-Play Rule), adopt compliance and ethics manuals, abide by recordkeeping rules, and appoint a compliance officer.

If the investment adviser meets certain statutory qualifications, pays applicable fees, files and updates at least annually a truncated Form ADV (Part 1A and corresponding schedules) with the SEC (and notice file state where advisory business is located), or state regulator(s) then the adviser is exempt from full RIA registration. Additionally, ERAs are subject only to the Pay-to-Play Rule, anti-fraud provisions, recordkeeping rules, and periodic examinations. To qualify as an ERA, fund organizers should first address whether they are acting as investment advisers under applicable federal or state law.

Question 2: Am I an Investment Adviser?

Fund organizers that meet the definition of an “investment adviser” under applicable federal or state law are required to register or qualify for an exemption from registration. Under Section 202(a) (11) of the Advisers Act an “investment adviser” is any person or firm who:

(1)    for compensation;

(2)    is engaged in the business of;

(3)    providing advice to others on buying or selling securities, making recommendations, issuing reports, or furnishing analyses on securities, including in publications or writings.

If the person or firm does not satisfy all three elements, then it is not an “investment adviser” and is not required to register as an RIA or qualify as an ERA. To determine whether a fund organizer is an investment adviser, it should assess its advisory functions under these elements:

Element 1: Compensation

The compensation element is fulfilled if the fund organizer receives an economic benefit from a client (or any other person on behalf of the client) in return for investment advice. Common sources of advisory compensation include:

(1)    an advisory fee;

(2)    a fee for total services rendered;

(3)    a commission;

(4)    combination of sources.

To be considered compensation, the economic benefit received does not have to be characterized as an “advisory fee,” charged separately, nor does it need to be paid directly by the client. Fund organizers typically receive carried interest or advisory fees in return for provision of investment adviser services.

Element 2: Engaged in the Business Of

The business element is fulfilled by looking at the frequency and regularity of the fund organizer’s advisory activities including whether the person or firm:

(1)    holds itself out as providing investment advice, or advertising as an investment adviser, financial planner, investment manager; or any other title with advisory connotations;

(2)    receives a definable charge for providing investment advice;

(3)    gives investment advice on a regular basis.

To be considered as engaged in the business of providing investment advice the advisory actions do not have to be the primary or sole business activity of the person or firm. Fund organizer’s often sign advisory agreements, are listed as advisers in fund operating agreements, or provide investment advice to an investment fund by voting the fund’s interest in relation to various corporate actions as part of their general organizer responsibilities.

Element 3: Providing Investment Advice

The investment advice element is met if the advice is given in connection with investment in securities. Common security types include stocks, bonds, mutual fund shares, limited partnership interests, and LLC membership interests (see here for discussion regarding investment contracts as securities). Additionally, investment advice may include:

(1)    financial planning

(2)    advice on selecting investment advisers or managers;

(3)    advice on market trends;

(4)    allocation of assets;

(5)    advice on the value of investing in securities instead of other asset classes;

(6)    market valuations;

(7)    providing a selected list of securities even if no specific security is recommended;

(8)    advice in the form of statistical or historical data (unless the data is no more than an objective report of facts on a non-selective basis).

Fund organizer activity typically meets the definition providing investment advice on the basis that organizers source and direct a fund’s investment in a security, make on-going and regular decisions with respect to maintenance and disposition of the fund’s assets, and delegate adviser and management duties.

If the fund organizer determines that it does not meet the definition of an investment adviser then there is generally no requirement to register. However, if the fund organizer determines that it does meet the definition then it must determine its registration requirements. The registration analysis consists of two further determinations: (1) the fund organizer’s assets under management; (2) availability of the venture capital exemption or private fund adviser exemption at the federal or state level.

 Why Should I Engage Assure for ERA Compliance Services?

Assure provides expert assistance related to the set-up, management, and reporting associated with SEC and state ERA registration. Assure consults with client’s and provides services related to ERA registration, including IARD account set-up and maintenance, the filing of annual and other-than-annual amendments to a client’s Form ADV, and provides on-going advisory firm training and consulting. Assure’s ERA compliance service complements and supplements fund organizer’s special purpose vehicle administration and ensures compliance with related investment adviser rules and regulations.