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What Regulatory Risks Do Unregistered Investment Advisers Hold?

May 23, 2016

The title of this article is an interesting question, one that we often hear advisers discussing amongst colleagues. Responses to this vexing question we have been privy to vary, depending on whether the entity is registered with the SEC. Generally, responses range from ‘no risk unless the adviser is fully registered with the SEC,’ to ‘low when filing as an exempt reporting adviser (“ERA”), and back to ‘no risk at all for firms not registered in either one of the two above categories because the SEC would be overreaching.’

Recent SEC actions demonstrate that these responses significantly understate the risk.

The Investment Advisers Act of 1940 (the “Advisers Act”) provides certain exemptions from SEC registration and excludes certain firms from the definition of an investment adviser. Unless these criteria are met, however, any person or firm who provides advice to others on securities and receives compensation must register with the SEC. Unregistered entities may avoid many requirements of the Advisers Act, but regulatory risk remains. Even unregistered advisers can be subject to SEC action through rulemaking and enforcement.

A Regulatory Perspective

To understand the regulatory risks, one must consider the SEC’s core mission: protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC advances its mission by identifying areas that present material risks to investors and securities markets, and mitigates these risks through regulation and enforcement actions. For example, the SEC adopted Rule 206(4)-8 in 2007, which explicitly prohibits fraud by private fund advisers. Consistent with the SEC’s mission, the rule’s main purpose was to protect investors in private funds. The rule applied to registered and unregistered advisers of private funds, although many such advisers later registered after the Dodd-Frank Act was enacted in 2010.

Recent enforcement cases also demonstrate how the SEC will take direct action against unregistered advisers.

Recent SEC Regulatory Action

A Canadian resident and general partner to a private fund marketed a fund based on a scientific stock selection strategy. However, in practice, the adviser, who was not registered with the SEC, deviated from its stated strategy, and the fund suffered heavy losses. The manager then decided to market the fund based on a combination of actual and hypothetical performance returns. However, the manager failed to notify fund investors that most of the assets were invested in a single penny stock and, among other things, misrepresented the value of the penny stock and did not maintain proper documentation to support the price.

The SEC charged the adviser with violating the anti-fraud rule by knowingly providing false and misleading material to investors. The manager was ordered to pay approximately $3 million to reimburse investors and in fines. In addition to the monetary penalty, the SEC barred the adviser from the securities industry. The adviser’s unregistered status did not shield him from SEC sanctions.

In another administrative proceeding, an individual owner of a state-registered investment adviser was barred from the securities industry by the SEC for actions taken against the adviser by a state regulatory body. The state-registered adviser, operated by its owner, caused its client to invest in unsuitable investments in the form of leveraged and inverse ETFs.


The key takeaway: regardless of registration status, the SEC maintains the regulatory reach to take action against advisers.The aforementioned cases demonstrate that attempting to fly under the SEC’s radar is an ineffective strategy. Whether or not registered with the SEC, advisers should adopt a compliance program that incorporates the same principles of the Advisers Act under Rule 206(4)-7, even when relying on an exemption from registering with the SEC (either as an ERA or state registered investment adviser). While this can be a costly undertaking, especially for new or emerging managers, failure to implement such a program significant increases an adviser’s regulatory risk.

Asset Management Intelligence - Q1 2016

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