IA Compliance:
Investment Advisers Offering Private Placements May Need to Register as Broker-Dealers
The following information reflects the views of NASAA’s Investment Adviser Section Resources and Publications Project Group. It does not necessarily represent the views of NASAA, and it is not intended as legal advice. Any questions should be directed to the appropriate state regulators.
Investment advisers must understand the potential need for a broker-dealer registration if they engage in securities activities beyond the scope of their investment advisory services, such as the sale of certain private placement securities to clients.
This article outlines the circumstances under which an investment adviser may need to register as a broker-dealer, and the implications of failing to do so.
Understanding the Roles: Investment Adviser vs. Broker-Dealer
Many investment advisers place orders for trades on behalf of their clients by establishing a partnership with a broker-dealer, who typically is also the custodian for that client’s account(s). The recommendation from the investment adviser is handled and executed by the registered broker-dealer, per an agreement between the adviser, broker-dealer, and client. In this case, the investment adviser may rely on the registration of the broker-dealer to effect the purchase or sale of the recommended security.
When investment advisers help effect transactions in securities without their partner broker-dealer, such as with an issuer of private placements, the investment adviser or its’ representatives may be acting as an unregistered broker-dealer. In addition, if an investment adviser recommends or suggests a security and then proceeds to facilitate the actual buying or selling of that security —such as executing the trade or working with the issuer to execute the trade on behalf of the client—this may also require registration as a broker-dealer. If an investment adviser receives compensation that is based on a securities transaction, such as commissions or fees tied directly to the purchase of the security, it may require broker-dealer registration.
Implications of Failing to Register as a Broker-Dealer
Failing to obtain the necessary broker-dealer registration when required can lead to significant legal and regulatory consequences, including:
- Enforcement Actions: The Securities and Exchange Commission (SEC), Financial Industry Regulatory Authority (FINRA), and state regulators may take enforcement actions against an adviser who fails to register as a broker-dealer when required. This can include penalties, fines, and registration sanctions.
- Legal Liability: If an investment adviser’s unregistered broker-dealer activities lead to client losses or disputes, the adviser may face legal action, including claims for negligence, breach of fiduciary duty, or violations of securities laws. Additionally, clients may have the right to rescind (cancel) their investments if they were acquired through an unregistered broker-dealer, possibly resulting in a refund of the entire purchase price.
- Loss of Client Trust: Engaging in activities that blur the lines between investment advisory services and broker-dealer transactions can erode trust with clients. Clients may view such activities as conflicts of interest, which could damage the adviser-client relationship and tarnish the investment adviser’s reputation.
Best Practices for Investment Advisers
To avoid potential regulatory pitfalls, investment advisers should consider these best practices:
- Understand the Scope of Activities: Clearly delineate when activities involve only providing investment advice versus facilitating transactions. If an investment adviser provides transaction execution services, it may need to seek broker-dealer registration.
- Do Not Rely on Issuer Characterizations: Issuers may not be aware of all regulatory requirements and their subscription materials may make references to “Referral Contractor”, “Consultant”, or “Finder” instead of referencing broker-dealer or investment adviser. In addition, the compensation paid may be referred to as a “Contractor Fee”, “Referral Fee”, “Consulting Fee”, “Finder Fee”, or “Marketer Fee” in lieu of a commission. Using different terms in the subscription materials does not relieve the investment adviser of their legal and regulatory obligations.
- Consult Legal Experts: When in doubt, investment advisers should consult with legal professionals to navigate the regulatory requirements and avoid unnecessary violations.
- Consider Partnering with a Broker-Dealer: Investment advisers seeking to execute trades in alternative investments, such as private placements for clients, should consider partnering with a registered broker-dealer.
- Review Compensation Structures: Ensure that the compensation structure is compliant with SEC and state regulations. If investment advisers receive compensation on a transaction-based model, this could trigger broker-dealer requirements.
Conclusion
Investment advisers must be vigilant in understanding their role and the specific activities they engage in to avoid inadvertently violating broker-dealer registration requirements. While providing advice on securities alone may not require a broker-dealer registration, executing transactions or receiving transaction-based compensation does. Ensuring compliance with the relevant securities laws and regulatory bodies is not only a legal obligation but also a key component of maintaining client trust and fostering a successful advisory practice.
By understanding the differences between advisory and broker-dealer activities and seeking guidance when needed, investment advisers can avoid regulatory violations and continue to offer valuable, compliant services to their clients.
