RIA Business Practices & Disclosure 2 — Questions and Answers

Question 1: An investment adviser has discretionary authority over client accounts when:

The adviser can invest only in bonds
The adviser can buy and sell securities without obtaining client consent for each transaction (Correct answer)
The client approves each trade in advance
The SEC grants special permission

Correct answer: The adviser can buy and sell securities without obtaining client consent for each transaction

Discretionary authority allows the adviser to make investment decisions and execute trades without prior client approval for each transaction.

Investment advisers may manage accounts on a discretionary basis (trading without prior client approval) or non-discretionary basis (requiring client approval for each transaction). Discretionary authority is typically granted in writing in the advisory agreement. With discretionary authority comes greater fiduciary responsibility to act in the client's best interest. Advisers must have a reasonable basis for each trade and maintain documentation of their investment rationale.

Question 2: Trade aggregation (bunching orders) allows investment advisers to:

Skip required regulatory filings
Combine multiple client orders to obtain better execution and reduced costs (Correct answer)
Prioritize proprietary accounts over client accounts
Trade ahead of client orders

Correct answer: Combine multiple client orders to obtain better execution and reduced costs

Order aggregation combines multiple client orders into a single larger trade to achieve better execution prices and lower per-share transaction costs.

Advisers managing multiple client accounts may aggregate (bunch) orders for the same security, which can result in better execution prices (lower market impact) and reduced transaction costs. Policies must ensure fair and equitable allocation of aggregated trades among participating accounts—typically on a pro-rata basis. Advisers cannot use aggregation to favor certain clients (like proprietary accounts) or use allocation as a method of distributing good versus bad executions unfairly.

Question 3: 'Pay-to-play' rules for investment advisers primarily restrict:

Advisers from charging excessive fees to government clients
Advisers from receiving advisory fees from government entities after making political contributions to certain government officials (Correct answer)
All political activity by investment advisers
Investment advisers from managing public pension funds

Correct answer: Advisers from receiving advisory fees from government entities after making political contributions to certain government officials

SEC Rule 206(4)-5 prohibits advisers from receiving compensation for advisory services to government entities if they or their employees made political contributions to certain officials.

Rule 206(4)-5 (pay-to-play rules) prohibits investment advisers from providing advisory services for compensation to government entities for two years after the adviser or its 'covered associates' make political contributions to officials who can influence investment decisions. These rules address the practice of making political contributions to win government pension fund contracts. The rules also prohibit soliciting third parties to make contributions on the adviser's behalf.

Question 4: When an investment adviser charges performance-based fees, the client must be:

Any U.S. citizen over 18
A 'qualified client' as defined by SEC rules (typically $1.1M under management or $2.2M net worth) (Correct answer)
A corporate entity only
An accredited investor only

Correct answer: A 'qualified client' as defined by SEC rules (typically $1.1M under management or $2.2M net worth)

Performance-based fee arrangements with investment advisers are only permitted with 'qualified clients'—those meeting minimum AUM or net worth thresholds.

Rule 205-3 prohibits performance-based fee arrangements except with 'qualified clients': (1) at least $1.1 million under management with the adviser, or (2) a net worth of $2.2 million or more (thresholds are inflation-adjusted periodically). Performance fees create an incentive for advisers to take excessive risk to earn higher fees. Limiting such arrangements to sophisticated clients with significant wealth is intended to protect less sophisticated investors.

Question 5: The Investment Advisers Act prohibits assignment of advisory contracts without client consent. 'Assignment' includes:

Moving client accounts to a different custodian
Change of control of the advisory firm when a majority of ownership transfers (Correct answer)
Adding new investment products to the client portfolio
Hiring additional portfolio managers

Correct answer: Change of control of the advisory firm when a majority of ownership transfers

Under the Advisers Act, a change in control of the advisory firm constitutes an 'assignment,' requiring client consent to continue the advisory relationship.

Section 205(a)(2) of the Investment Advisers Act prohibits assignment of advisory contracts without client consent. Assignment includes: (1) actual transfer of the contract to another firm; (2) a transaction that results in a change of a majority of the voting securities of the adviser (change of control). When an advisory firm is acquired, clients must be notified and given the opportunity to consent or terminate. This protects clients' relationship-based choice of adviser.

Question 6: An investment adviser's books and records must be maintained for a minimum of:

1 year
3 years
5 years (with 2 years in accessible location) (Correct answer)
10 years

Correct answer: 5 years (with 2 years in accessible location)

SEC-registered investment advisers must maintain most records for 5 years, with records easily accessible for the first 2 years.

Rule 204-2 requires SEC-registered investment advisers to maintain books and records for at least 5 years, with records from the first 2 years maintained in an 'easily accessible place' (at the principal office). Records include: financial statements, trade records, client communications, supervisory procedures, performance records, and advisory agreements. Some records (like partnership agreements and corporate charters) must be maintained for the life of the adviser plus 5 years.

RIA Business Practices & Disclosure 2

An investment adviser has discretionary authority over client accounts when: