RIA Ethics & Regulatory Guidelines 2 — Questions and Answers

Question 1: Under the Investment Advisers Act of 1940, an adviser must disclose material conflicts of interest:

Only when requested by the client
Only to regulators, not clients
To clients, as part of the fiduciary duty (Correct answer)
Only in annual reports

Correct answer: To clients, as part of the fiduciary duty

Fiduciary duty requires advisers to disclose all material conflicts of interest to clients so they can make informed decisions.

The SEC's interpretation of the Investment Advisers Act requires advisers to disclose material conflicts of interest that could affect their advice. This includes compensation arrangements, proprietary products, affiliated broker-dealers, and other relationships that might compromise objectivity. Disclosure must be made in writing (typically Form ADV Part 2) and in a way clients can reasonably understand.

Question 2: Churning refers to:

Excessive trading to generate commissions at client's expense (Correct answer)
Switching clients between advisers
Changing investment strategies quarterly
Investing in high-turnover mutual funds

Correct answer: Excessive trading to generate commissions at client's expense

Churning is excessive trading in a client account primarily to generate commissions, violating fiduciary duty and suitability requirements.

Churning is a fraudulent practice where an adviser excessively trades a client's account to earn commissions, without regard to the client's investment objectives. It violates both fiduciary duty (for RIAs) and suitability standards. Courts evaluate churning based on turnover rate, cost-to-equity ratio, and whether trading was in the client's best interest. It is prohibited under securities laws and FINRA rules.

Question 3: The 'brochure rule' under the Investment Advisers Act requires advisers to:

Provide clients with marketing materials only
Deliver Form ADV Part 2 to clients and prospects (Correct answer)
Register all brochures with FINRA
Update marketing materials quarterly

Correct answer: Deliver Form ADV Part 2 to clients and prospects

The brochure rule requires investment advisers to deliver Form ADV Part 2 (their disclosure document) to clients and prospects.

Rule 204-3 (the brochure rule) requires SEC-registered investment advisers to deliver their written disclosure document (Form ADV Part 2) to clients and prospective clients. Part 2A is the firm brochure; Part 2B is the brochure supplement for supervised persons. Delivery must occur before or at the time of entering the advisory contract, and updated annually if material changes occur.

Question 4: Which action would violate the prohibition on fraudulent conduct under the Investment Advisers Act?

Charging fees above competitors
Recommending conservative investments to elderly clients
Making material misrepresentations about investment strategy (Correct answer)
Declining to manage certain investment types

Correct answer: Making material misrepresentations about investment strategy

Making material misrepresentations about investment strategies, performance, or qualifications is fraud under Section 206 of the Investment Advisers Act.

Section 206 of the Investment Advisers Act prohibits advisers from engaging in fraud, deception, or manipulation. This includes false statements about qualifications, performance, strategies, or conflicts of interest. It also covers misleading performance presentations, cherry-picked results, or omitting material information. Violations can result in disgorgement, civil penalties, and criminal prosecution.

Question 5: Under ERISA, a fiduciary of a pension plan is required to:

Maximize short-term returns regardless of risk
Act solely in the interest of plan participants and beneficiaries (Correct answer)
Follow only state investment laws
Invest primarily in employer securities

Correct answer: Act solely in the interest of plan participants and beneficiaries

ERISA fiduciaries must act solely in the interest of plan participants and beneficiaries and for the exclusive purpose of providing benefits.

ERISA's fiduciary rules require that plan fiduciaries act solely in the interest of participants and beneficiaries, for the exclusive purpose of providing benefits, following the prudent man standard, diversifying investments, and complying with plan documents. ERISA fiduciaries face personal liability for breaches. The DOL has enforcement authority and can bring civil actions against fiduciaries.

Question 6: The Investment Advisers Act defines 'investment adviser' to include persons who:

Only provide tax advice
Provide advice about securities for compensation (Correct answer)
Give financial planning advice exclusively for free
Only advise on real estate

Correct answer: Provide advice about securities for compensation

An investment adviser is any person who provides advice about securities, is in the business of doing so, and receives compensation.

The three-part test for investment adviser status: (1) provides advice or analysis about securities, (2) is in the business of providing such advice, and (3) receives compensation (direct or indirect). Certain professionals (lawyers, accountants, brokers, publishers) may qualify for exclusions if advisory services are incidental to their primary business. Understanding this definition is crucial for determining registration requirements.

RIA Ethics & Regulatory Guidelines 2

Under the Investment Advisers Act of 1940, an adviser must disclose material conflicts of interest: