RIA Business Practices & Disclosure 1 — Questions and Answers

Question 1: Fee-only investment advisers are compensated:

Solely through product commissions
Only by clients through advisory fees, with no third-party compensation (Correct answer)
Through a combination of fees and commissions
By the investment companies whose products they recommend

Correct answer: Only by clients through advisory fees, with no third-party compensation

Fee-only advisers receive compensation exclusively from clients (flat fees, hourly fees, or AUM percentages) with no commissions or third-party payments.

Fee-only advisers are widely considered to have fewer conflicts of interest because their compensation comes solely from clients. They do not receive commissions, trails, or referral fees from product companies. This structure eliminates the incentive to recommend expensive products to earn higher compensation. Fee-only is a designation used by organizations like NAPFA. In contrast, fee-based advisers may charge fees AND earn commissions, creating potential conflicts.

Question 2: An investment adviser's Form ADV Part 2A must be delivered to clients:

Only upon request
Annually and to prospective clients before or at contract signing (Correct answer)
Only when the client opens an account
Every five years or when regulations change

Correct answer: Annually and to prospective clients before or at contract signing

Advisers must deliver an updated Form ADV Part 2A annually and to new clients before or when entering the advisory agreement.

Rule 204-3 (the brochure rule) requires: (1) initial delivery to prospective clients before or at the time of signing the advisory contract; (2) annual delivery to all clients (or offer to deliver if no material changes); (3) prompt delivery if material changes occur that would require updating the brochure. The brochure must be written in plain English and include all required information about services, fees, conflicts, disciplinary history, and business practices.

Question 3: The term 'wrap fee program' refers to:

A fee for gift-wrapping financial documents
A bundled fee covering advisory, brokerage, and administrative services for a single periodic charge (Correct answer)
Fees that are gradually reduced over time
Performance-based fee arrangements

Correct answer: A bundled fee covering advisory, brokerage, and administrative services for a single periodic charge

Wrap fee programs bundle advisory, brokerage execution, and custodial services into a single comprehensive fee, typically charged as a percentage of AUM.

Wrap fee programs charge a single 'all-in' fee (typically 1-3% of AUM annually) covering investment advice, portfolio management, trade execution, and sometimes custodial services. They simplify billing and align adviser incentives (charging less per trade discourages excessive trading). Advisers sponsoring or participating in wrap programs must disclose the program in Form ADV and consider whether the wrap fee is cost-effective for individual clients.

Question 4: When advertising investment performance, advisers must:

Show only their best-performing accounts
Comply with SEC rules prohibiting misleading advertising, including cherry-picking results (Correct answer)
Use only gross (pre-fee) performance numbers
Avoid showing any historical performance

Correct answer: Comply with SEC rules prohibiting misleading advertising, including cherry-picking results

SEC advertising rules prohibit misleading performance presentations and require fair, complete, and not misleading performance advertising.

The SEC's marketing rule (Rule 206(4)-1) prohibits materially misleading advertising including cherry-picking (showing only best-performing accounts), using hypothetical performance without proper disclosure, presenting gross-only performance without net-of-fee figures for certain contexts, and making misleading references to past specific recommendations. Net performance must be shown for any advertisement showing gross performance. Advisers must retain records substantiating performance claims.

Question 5: An investment adviser using a solicitor to refer clients must ensure the solicitor:

Is a licensed securities broker
Delivers a written disclosure of the solicitation arrangement to referred clients (Correct answer)
Has at least 5 years of experience
Has no prior regulatory violations

Correct answer: Delivers a written disclosure of the solicitation arrangement to referred clients

Cash solicitation arrangements require the solicitor to deliver a written disclosure describing the arrangement and compensation to referred clients.

Rule 206(4)-3 allows advisers to pay solicitors for client referrals if: (1) there is a written solicitation agreement; (2) the solicitor is not subject to certain disqualifications; (3) the solicitor delivers a written disclosure to prospects describing the solicitation arrangement, compensation, and any affiliation with the adviser; (4) the adviser obtains a signed acknowledgment that the client received the disclosure. This transparency allows clients to evaluate potential bias in the referral.

Question 6: The primary purpose of the Form CRS (Client Relationship Summary) is to:

Replace Form ADV entirely
Provide retail investors a brief, plain-language summary of the adviser's services, fees, and conflicts (Correct answer)
Register new investment advisers
Disclose only broker-dealer information

Correct answer: Provide retail investors a brief, plain-language summary of the adviser's services, fees, and conflicts

Form CRS provides retail investors a standardized, concise summary of services, fees, conflicts, disciplinary history, and conversation starters in plain language.

Form CRS (Client Relationship Summary) was introduced by the SEC under Regulation Best Interest. Both broker-dealers and investment advisers serving retail investors must file and deliver Form CRS—a maximum 2-page (4 for dual registrants) standardized document covering: services offered, fee structures, conflicts of interest, disciplinary history, and 'conversation starters' (suggested questions for clients). It helps retail investors compare different types of financial professionals.

RIA Business Practices & Disclosure 1

Fee-only investment advisers are compensated: