What it means
Before 1940, anyone could call themselves an investment adviser and charge for recommendations with little oversight. The Act was passed to fix that, along with its sister law for investment funds, the Investment Company Act.
It gave the Securities and Exchange Commission (SEC) the power to register, inspect and discipline advisers. At the heart of the Act is the idea that an adviser owes clients a fiduciary duty, meaning a legal duty to put the client's interests ahead of its own.
Courts and the SEC have read this duty to include being honest about conflicts, giving advice that suits the client, and seeking good execution on trades. A firm cannot simply disclose its way out of every conflict, since some must be removed.
Registration depends mainly on the amount of client money managed. Larger advisers typically register with the SEC, while smaller ones register with state regulators, and the dividing lines are set by regulation and adjusted from time to time.
Registered advisers file a disclosure document called Form ADV, which describes their business, fees, conflicts and disciplinary history, and they must give clients a plain-English brochure. The Act matters to businesses in two ways.
A company that runs a fund, manages money for others or provides financial planning may itself fall under the Act. A company that hires an adviser, such as a pension committee choosing a manager, can rely on the Act's disclosure rules to compare candidates.
Other rules under the Act cover custody of client assets, advertising, record keeping and performance fees. Performance fees, which are fees based on gains, are generally limited to clients who meet wealth or experience tests because they can encourage excess risk-taking.
Enforcement is real. The regulator can examine an adviser's books, require changes, impose fines, bar individuals from the industry and, for fraud, refer cases for criminal prosecution.
For a finance reader the practical message is that an adviser's registration status is a quick and free first check before any money changes hands.
In practice
Real-world examples.
Example
A boutique firm with 15 employees manages money for wealthy families. It registers as an investment adviser, files Form ADV, appoints a chief compliance officer and keeps records of every recommendation. Clients can read the firm's fees and conflicts before signing, and the firm updates the document at least once a year.
Example
A pension committee at a mid-sized manufacturer is choosing between three external managers. It reads each firm's Form ADV and compares fees, disciplinary history and conflicts of interest, and it rejects one firm that had received a regulatory sanction.
Example
A financial planner who earns higher commissions on one insurance product recommends it to clients without saying so. An examiner finds the undisclosed conflict and the firm is required to disclose it, repay clients any harm and change its procedures. The planner also has to retrain staff and document how future recommendations are reviewed.
Case study
Seen in the real world.
Larkspur Wealth Advisers is an illustrative, fictional firm that grew from a one-person practice to a team of twelve managing a combined $300,000,000. As its assets grew, the founder realised the firm had passed the point where state registration was enough and that it needed to register with the federal regulator.
The firm hired a compliance consultant, wrote a code of ethics, set up procedures for personal trading by staff and prepared its Form ADV. During a later examination, the regulator found that the firm had not disclosed that it received payments from a fund provider it recommended.
The firm corrected its disclosures and refunded clients the extra fees of about $85,000. The illustrative lesson is that growth brings new obligations, and conflicts that seemed small must be written down and shown to clients before the regulator asks about them.
Watch out
Common mistakes.
- Assuming the Act applies only to large firms, when any person paid for advice about securities may fall within it unless an exemption applies.
- Believing disclosure alone cures every conflict, when some conflicts must be eliminated or managed.
- Confusing the Act with the Investment Company Act of 1940, which regulates funds rather than the advisers who serve them.
Questions
People also ask.
Who enforces the Act?
The Securities and Exchange Commission enforces it for federally registered advisers, and state securities regulators oversee smaller advisers registered at state level.
What is Form ADV?
It is the registration and disclosure document in which an adviser describes its business, fees, conflicts of interest and disciplinary record, and parts of it are given to clients.
Does the Act guarantee that advice will make money?
No, it governs honesty, disclosure and conduct, not investment results, so a fully compliant adviser can still give advice that loses money.
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