Tag Archives: series 65

Series 65 Exam Opinions Requested

Seeking Opinions on How to Pass to the Series 65 Exam

I am hoping readers of this blog would be able to provide some feedback on their experiences with the Series 65 exam. As a

little background, many of our firm's clients are managers who will be state registered investment advisers and therefor these groups will need to make sure certain individuals take the Series 65 exam in order to become registered in the state of principal residence.

The North American Securities Administrators Association (NASAA) is the group in charge of creating the Series 65 and the exam is administered by FINRA at any number of locations across the U.S. and in different countries. At the beginning of 2010 NASAA changed the grading of the Series 65 exam so that it was more difficult to pass. From that time forward we have anecdotally noticed that there were in fact less people who were passing the exam on the first try.  Accordingly, we are trying to gather information on the exam to help out those people who will be taking it in the future.

If you have taken the e

xam over the last year we are asking if you can provide us with a little information on your experiences and some thoughts on how you would prepare for the exam, given what you know now. For example, we think the following information would be helpful:

  • Date you took the exam (month, year)
  • Final score
  • Series 65 Exam prep / study guide(s) you used
  • Amount of time spent studying (approximate number of hours)
  • Number of practice exams you took? Scores on those exams?
  • Areas you did well on/ could have done better on
  • Overall impressions – was it similar to the practice exams?
  • How would you study for the exam differently?

If you have other comments or information that might be helpful, please feel free to post that as well.  Responses can be posted in the comment section below or you can contact us directly.


Cole-Frieman & Mallon LLP is a boutique law firm focused on the hedge fund industry.  We help fund managers with investment adviser registration and hedge fund formation matters.  Bart Mallon can be reached directly at 415-868-5345.


Securities Exam Changes in 2010

Series 63, Series 65 and Series 66 Changed as of January 1, 2010

In an earlier post, we discussed that the passing grades for the Series 65 and 66 have increased.  Below is further information from the Securities Training Corporation on the changes to the securities exams in 2010.


The Series 63, 65, and 66 Examinations Are Changing

The North American Securities Administrators Association (NASAA), the organization responsible for designing the Series 63, 65, and 66 Examinations, has informed us that the composition of these examinations will change as of January 1, 2010. The most significant impact will be on the Series 66 Examination, in which the balance of the questions will change significantly. In comparison, the changes to Series 63 and Series 65 are relatively minor.

Series 66

The Series 66 Examination currently consists of 100 questions, 80 of which test the candidate’s knowledge of Legal and Regulatory Issues (including Unethical Business Practices). The remaining 20 questions cover Investment Analysis, Recommendations, and Strategies.

The revised Series 66 will still contain 100 questions. As of January 1, 2010, however, there will be 50 questions covering Legal and Regulatory Issues and 50 questions testing Investment Recommendations, Strategies, and Products.

NASAA is also adding new topics to the Series 66 outline concerning specific Investment Products and Strategies, such as Annuities, much of which we already cover in our materials. NASAA stated that these changes are “based on responses to the survey indicating that dually licensed individuals should have enhanced testing in the areas of Economic Factors and Business Information, Investment Vehicle Characteristics and Client Investment Recommendations and Strategies.”

Series 65

The Series 65 Examination currently has 130 questions.  Of these questions, 45 test Legal and Regulatory Issues, while 80 questions cover Economic Concepts, as well as Investment Products, Recommendations, and Strategies. The new examination will still have a total of 130 questions, but the number of questions devoted to Legal and Regulatory Issues will decrease from 45 to 40. In addition, there will be a few questions on Capital Markets Theory and specific types of accounts, such as College Savings Plans.

Series 63

NASAA has not added new topics to the Series 63 Examination, and the test will continue to contain 60 questions. The distribution of these questions, however, will change on January 1, 2010.  There will be 3 more questions covering business practices (now called Ethical Practices and Fiduciary Obligations). There will also be an additional 6 questions devoted to the Registration and Regulation of Broker-Dealers, Agents, Investment Advisers, and Investment Adviser Representatives. The number of questions covering the Registration and Issuance of Securities will be decreased correspondingly.

STC will have supplemental material available in late November for students who anticipate taking one of these examinations in January. Our online practice examinations will be updated by January 1.


Other related hedge fund law articles:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog.  He can be reached directly at 415-868-5345.

Series 65 and Series 66 Passing Grade Increased

IA Exams Pass Rates Expected to Plummet

The North American Securities Administrators Association (“NASAA”) recently announced that the two central investment advisor exams (the Series 65 and the Series 66) will become even more difficult.  Starting January 1, 2010 candidates will need to attain a score of 72% in order to pass the Series 65 exam and a 75% in order to pass the Series 66 exam.  NASAA did not make any statements on its website or at its Annual Conference earlier this year about the change or the reason for the change.

I had a chance to talk with Chuck Lowenstein of Kaplan Financial Education about the announcement.  “The exams have been oddities,” said Lowenstein, “everything else in the business requires a 70% to pass and the 65 had been kind of weird at 68.5% and the 66 as well at 71%. With these new numbers, NASAA has entered new territory. I suspect pass rates will plummet, unless they feel that the new exams will be so much easier (never happened in the past) that they need to bump up the minimum.”

Chuck went on to discuss the likely future performance for people taking the exams.  “Based on our students’ performance, this will have a devastating effect on the overall pass rate. A significant percentage of exam takers pass with little room to spare and bumping the requirements by 4 or 5 questions on these exams (the 68.5% on the 65 was 89 correct – 72% is 93.6 questions so they’ll either round up to 94 or down to 93, that has not yet been disclosed) is going to catch many exam takers.”

We do not recommend that exam takers study any differently for the exam, but we urge all potential exam takers make sure they are adequately prepared.  If an applicant does not pass the 65 or 66 on the first try, they will need to wait 30 days to take the exam again which will obviously have an effect on the timing of a hedge fund launch.

For more information please see NASAA’s post on the Series 65 and Series 66 exams.

Thank you to Chuck Lowenstein for bringing this issue to my attention.


Other related hedge fund law articles:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog.  He can be reached directly at 415-868-5345.

Hedge Fund Registration Quick Facts

Hedge Fund Transparency Act of 2009 Overview

This article provides an overview of the major provisions of the Hedge Fund Transparency Act of 2009.  There are two major things that the HFTA does: (1) increases regulation of hedge funds under the Investment Company Act and (2) requires hedge funds to adopt anti-money laundering programs.

Changes under the Investment Company Act

The HFTA replaces Section 3(c)(1) of the Investment Company Act  with a new Section 6(a)(6).  Section 3(c)(7) is replaced by new Section 6(a)(6).  These new sections, which are functionally equivalent to Section 3(c)(1) and Section 3(c)(7) respectively, will exempt hedge funds from the mutual fund regulations that are found in the Investment Company Act, provided that the hedge funds comply with the provisions of Section 6(g).

Section 6(g) applies to hedge funds with assets under management (AUM) of $50 million or more.  Those hedge funds which have less than $50 million of AUM will not be subject to Section 6(g).  Section 6(g) requires:

1.  The hedge fund manager to register with the SEC.  (HFLB note: I believe the statute is not clearly written.  It seems that the hedge fund itself would be required to register with the SEC which does not make sense.)

2.  Maintain certain books and records as required by the SEC.  This requirements is likely to look like the current books and records rule of the Investment Advisors Act (Rule 204-2), for more background please see article on Investment Advisor Compliance Information.

3.  Cooperate with the SEC with regard to any request for information or examination.

4.  File the following information with the SEC on a no less than annual basis:

a.  The name and current address of each investor in the fund.

b.  The name and current address of the primary accountant and broker of the fund.

c.  An overview of the fund’s ownership structure.

d.  An overview of the fund’s affiliations, if any, with financial institutions.

e.  A statement of the fund’s terms (i.e. minimum investment).

f.  Other information including the total number of investors and the current value of the fund’s assets.

The SEC is charged with issuing forms and guidance on the implementation of the above.  Such forms and guidance must be issued within 180 days from the enactment of the HFTA.

New AML Requirements

The HFTA requires the Secretary of the Treasury (in consultations with the Chairman of the SEC and the Chairman of the CFTC) to establish AML requirements for hedge funds.  The bill sets aggressive timelines for drafting and implementation of the rules.

Hedge Fund Transparency Act Analysis

In the current politically charged environment it is not surprising that a hedge fund regulation law is being contemplated.  What is interesting, however, is the way that Grassley and Levin have chosen to regulate hedge funds.  The prior hedge fund registration rule, promulgated by the SEC, was enacted under the Investment Advisors Act – in essence requiring hedge fund managers (and not the hedge fund itself) to register as Investment Advisors with the SEC.  The Hedge Fund Transparency Act does not follow this path – instead, it regulates hedge funds under the Investment Company Act by modifying the current exemptions which hedge funds enjoy under the act.  In essence the changes subject hedge funds to a kind of light version of the mutual fund regulations.  In this way Congress is going past previous registration by regulating the hedge fund vehicle, as well as the hedge fund management company through the registration requirement.

While it is no surprise that regulation and registration has reached the hedge fund industry, one aspect of the bill is surprising.  The act would require hedge funds to disclose the names and addresses of each investor in the fund.  These names and addresses would be made available to the general public through an electronic searchable format to be developed by the SEC.  Hedge fund investors are notoriously protective of their privacy and I cannot imagine that there will not be pushback by the hedge fund industry on this point.

Another consequence of investment advisor registration is that hedge fund managers (if not currently regulated by the state in which their business resides) may be subject to certain state investment advisory rules including a “notice” filing requirement.  Depending on the nature of the management company’s business, some employees may need to register as investment advisor representatives at the state level which generally requires an employee to have passed the Series 65 exam.  We will keep you updated on this possibility as we learn more about the HFTA over time.


Please contact us if you have any questions releted to this post or registering your management company as an investment advisor with the SEC.  Other related posts include:

Hedge Fund Comments/ Questions and Answers

Questions and discussions from Hedge Fund Law Blog readers

I get quite a few questions from readers and usually I am able to answer these questions via email within a couple of days.  If you have any questions, comments or simply want more information on starting a hedge fund, please feel free to contact us.  We also will take requests for blog posts on certain issues and we also will publish articles (with all appropriate recognition and links) by guest authors.  [Note: any grammatical errors in the original messages have not been corrected.] Continue reading

Comments on the Series 65 and Series 66 Exam

I received a couple of comments regarding my posts on the Series 65 exam and the Series 66 exam which I would like to share with the community.  Both comments were made by Chuck Lowenstein, a Senior Editor – Securities at Kaplan Financial Education.

Regarding the post Differences between the Series 65 and Series 66 Exam, I received the following comment:

I must take issue with the statement that the Series 66 exam is easier to pass than the Series 65 for those with a Series 7 registration. Our experience with many thousands of students who have taken these tests indicates differently. An applicant with a Series 7 license will almost always have an easier time passing the Series 65 than the 66 and there are several obvious reasons for this.

1) Passing score on the 65 is only 68.5% while it is an industrywide high requirement of 71% on the Series 66.

2) The “extra” material added to the Series 65 is on subjects very familiar to most Series 7’s. For example, there are questions on common and preferred stock, mutual funds, options and limited partnership programs; all topics thoroughly covered on an Series 7 training program. There is extensive coverage of economics and analysis, but very little that is not part of the Series 7 exam.

3) 80 of the 100 questions (80%) of the Series 66 are based upon state and federal laws, while only 45 questions (35%) of the Series 65 cover this topic. Because these questions deal with the intracies of the law, these are typically the most difficult questions for students to handle.

The real advantage in taking the Series 66 is that, for those who will be selling securities as well as giving advice, is that it “kills two birds with one stone”. That is, instead of being required to sit for both the Series 65 and the Series 63 (Uniform Securities Agent State Law Examination), taking the Series 66 covers one for both.

Regarding the post The Series 65 Exam, I received the following comment:


Thanks for the kind words about the Kaplan course. I have recently taken the responsibility for editing the Series 63, 65 and 66 exams and was amazed at the number of errors. Although most were typographical in nature, there were far too many where one would mark the correct answer to a question only to be told that it was wrong.

Our 4th Editions of the Series 65 and Series 66 are just released and I believe I have caught virtually all of these mistakes. In addition, our new platform allows us to post errata on our website on a daily basis so, just in case there is something that I overlooked, it will be posted for all to see.

Differences between the Series 65 and the Series 66

Hedge fund managers who must register as investment advisor representatives with the SEC (through notice filings) or the state securities commission will need to have the proper FINRA exam licenses. Generally this means that the hedge fund manager will need to have passed the Series 65 exam within two years of registration (or the license must not have been inactive for two years prior to the registration).

However, if a manager has a Series 7 exam license, he will only need to take the Series 66 exam instead of the Series 65. This would generally be a good idea because the Series 66 exam is easier than the Series 65 exam and managers should be able to pass the Series 66 with less effort than the Series 65. I have detailed below the different requirements for the Series 65 versus the Series 66

Series 65 Exam

  • 140 multiple choice questions
  • 10 pre-test; 130 count towards score
  • 180 minutes to take the exam
  • Must achieve a 72% to pass
  • Test covers: economics and analysis; investment vehicles; investment recommendations and strategies; and legal and regulatory guidelines, including prohibition on unethical business practices.
  • NASAA test outline link.

Series 66 Exam

  • 110 multiple choice questions
  • 10 pre-test; 100 count towards score
  • 150 minutes to pass the exam
  • Must achieve 72% to pass
  • Test covers: much of the material included on the Series 65, but it does not include the product, analysis and strategy questions that are a large part of the Series 65.
  • NASAA test outline link.

Other related articles include:

If you have any questions, please contact us.

How to Register as an Investment Advisor

Many hedge fund managers come from brokerage firms or other investment advisory firms and may, accordingly, have some of the FINRA licenses like a Series 7 or a Series 65.  However, most managers have not registered an as investment advisor and do not understand the process.  This guide is designed to familiarize managers with the  investment advisor registration process.

Investment Advisor Compliance Firm

First, you will want to find a firm that will help you through the process of registering as an investment advisor.  A hedge fund lawyer or a hedge fund compliance firm (usually consisting of former SEC or state securities commission examiners) will be able to help you with this process. Potential investment advisors should not try to go through the registration process by themselves – it will take too much time and subject the advisor to potential liability.


The manager can register as an investment advisor with the SEC or the state securities commission of the state in which the manager resides.  The manager should have a conversation with the lawyer or complaice firm regarding the pros and cons of the registration with the SEC or state.  Generally, however, a manager will only be able to register with the SEC if the manager has at least $25 million under management.


The costs should be the same for the advisor whether they go with a hedge fund lawyer or with a compliance firm.  Generally, for state-registered investment advisers, the professional fees run anywhere from $2,500-$3,500 for the registration.  For SEC-registered investment advisors, the professional fees will run anywhere from $4,000 to $8,000 depending on the complexity of the investment advisory firm.
The above costs are service provider fees and do not include the fees an investment advisor firm will pay to the state of residence of the investment advisor.  Such fees will generally include the following:

  • IA firm registration fee (State registered IAs only)
  • IA representative fee
  • Form U-4 fee
  • Notice filing fee (SEC registered IAs only)
  • Other miscellaneous fees


The manager who is registering to be an investment advisor will typically need to have taken and passed the Series 65 exam within the two years prior to registration.  Most all states will also allow managers to register if they have the Series 7 exam and the Series 66 exam.  Since most managers who have the Series 7 will not have the Series 66, the managers will need to take this exam.

Additionally, most states will not require a manager to have any of the above exams if they have one of the following designations

  • Chartered Financial Planner (CFP);
  • Chartered Financial Consultant (ChFC);
  • Personal Financial Specialist (PFS);
  • Chartered Financial Analyst (CFA); or
  • Chartered Investment Counselor (CIC).


The investment advisor will need to complete a wide variety of forms during the registration process.  These forms include:

IARD entitlement Forms – “IARD” stands for the Investment Adviser Registration Depository which is sponsored by the SEC and the NASAA (the association of state securities regulations, www.nasaa.org) but which is operated by FINRA.  As the IARD system is an online system, these forms need to be manually completed and processed by FINRA before you can begin the registration process.  The forms can be found here: IARD Entitlement Forms

Form ADV – this is the form which all investment advisors complete.  When a firm is registered with the SEC or the state, then the filings can be seen here by typing in the advisor’s name.  Please see Form ADV.  (HFLB note: we will have a detailed guide on Form ADV coming out soon.)

Form ADV Part II – this is the part of Form ADV which provides more information on the advisor’s activities.  It is sometimes refered to as the investment advisory “brochure.”  Please see Form ADV Part II.  (HFLB note: we will have a detailed guide on Form ADV Part II coming out soon.)

Form U4 – this form will need to be completed for all members of the firm which will be investment advisor representatives.  If such members have been in the securities industry for a while, they will likely already have a U4 on file with FINRA.  (HFLB note: we will have a detailed guide on Form ADV Part II coming out soon.)

Registration Timeline

Your compliance provider will be able to help you determine how long it will take to become registered as an investment advisor.  Generally SEC registration will be quicker than state registration and many times registration can be completed within 2 to 4 weeks.

State registration is more difficult to determine and will depend on the state of registration.  A state like California may take 6 to 8 weeks.  A state like South Carolina will take about 2 weeks, it just depends and you should discuss this issue with your compliance provider if the registration is time sensitive.

Other helpful articles include:

Please contact us if you would like to register your firm as an investment advisor or if you have any questions on the above.

Important compliance information for registered investment advisors

Many registered investment advisors are happy once a registration has gone through. The individual, or firm, has gone through all of the following:

  • Receiving entitlement to the IARD system
  • Passing the Series 65 exam (tips on the series 65 exam)
  • Completing both the investment advisory firm’s Form ADV and Form ADV Part II (the investment advisor brochure)
  • Filing Form ADV through the IARD system
  • Notice filing in the state of the firm’s principal place of business

Once a firm has become registered as an investment advisor with the SEC, however, the important work is not over. The firm and the principals of the firm must make sure that all of the investment advisor rules are followed. Below is an overview of the laws a SEC registered investment advisor must follow; it was prepared by the SEC and serves as a good guide for the newly registered investment advisor. In addition to the following guide for newly registered investment advisors, it is also recommended that you thoroughly review your investment advisor compliance manual with your lawyer or your compliance professional.
Full article can be found here.

For the presentation below, I have changed the SEC’s spelling of “investment adviser” to “investment advisor” as appropriate.  Which begs the question: What is the difference between an “investment adviser” and an “investment advisor”?

There is no difference between the term “investment adviser” and “investment advisor” despite the incongruent spellings. The term “investment advisor” is most commonly used within the securities industry, however the SEC uses spelling “investment adviser”. It is likely that the reason the SEC uses this spelling is because the laws passed by congress specifically use the term.

Please feel free to contact us if you have any questions regarding any of the items below.  We will try to answer all questions in another blog post.  Also, we can provide you with help if you need assistance with an SEC mock examination and help with your compliance manual or code of ethics.

Information for Newly-Registered Investment Advisors

Prepared by the Staff of the Securities and Exchange Commission’s Division of Investment Management and Office of Compliance Inspections and Examinations

This information sheet contains general information about certain provisions of the Investment Advisers Act of 1940 (also called the “Advisers Act”) and selected rules under the Advisers Act. It is intended to assist newly-registered investment advisors in understanding their compliance obligations with respect to these provisions. This information sheet also provides information about the resources available to investment advisors from the SEC to help advisers understand and comply with these laws and rules.

As an adviser registered with the SEC, you have an obligation to comply with all of the applicable provisions of the Advisers Act and the rules that have been adopted by the SEC. This information sheet does not provide a complete description of all of the obligations of SEC-registered advisers under the law. To access the Advisers Act and rules and other information, visit the SEC’s website at www.sec.gov (the Advisers Act and rules are available at http://www.sec.gov/divisions/investment.shtml).

Investment advisors Are Fiduciaries

As an investment advisor, you are a “fiduciary” to your advisory clients. This means that you have a fundamental obligation to act in the best interests of your clients and to provide investment advice in your clients’ best interests. You owe your clients a duty of undivided loyalty and utmost good faith. You should not engage in any activity in conflict with the interest of any client, and you should take steps reasonably necessary to fulfill your obligations. You must employ reasonable care to avoid misleading clients and you must provide full and fair disclosure of all material facts to your clients and prospective clients. Generally, facts are “material” if a reasonable investor would consider them to be important. You must eliminate, or at least disclose, all conflicts of interest that might incline you — consciously or unconsciously — to render advice that is not disinterested. If you do not avoid a conflict of interest that could impact the impartiality of your advice, you must make full and frank disclosure of the conflict. You cannot use your clients’ assets for your own benefit or the benefit of other clients, at least without client consent. Departure from this fiduciary standard may constitute “fraud” upon your clients (under Section 206 of the Advisers Act).

Investment Advisors Must Have Compliance Programs

As a registered investment advisor, you are required to adopt and implement written policies and procedures that are reasonably designed to prevent violations of the Advisers Act. The Commission has said that it expects that these policies and procedures would be designed to prevent, detect, and correct violations of the Advisers Act. You must review those policies and procedures at least annually for their adequacy and the effectiveness of their implementation, and designate a chief compliance officer (“CCO”) to be responsible for administering your policies and procedures (under the “Compliance Rule” — Rule 206(4)-7).

We note that your policies and procedures are not required to contain specific elements. Rather, you should analyze your individual operations and identify conflicts and other compliance factors that create risks for your firm and then design policies and procedures that address those risks. The Commission has stated that it expects your policies and procedures, at a minimum, to address the following issues to the extent that they are relevant to your business:

  • Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients’ investment objectives, your disclosures to clients, and applicable regulatory restrictions;
  • The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;
  • Proprietary trading by you and the personal trading activities of your supervised persons;
  • Safeguarding of client assets from conversion or inappropriate use by your personnel;
  • The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
  • Safeguards for the privacy protection of client records and information;
  • Trading practices, including procedures by which you satisfy your best execution obligation, use client brokerage to obtain research and other services (referred to as “soft dollar arrangements”), and allocate aggregated trades among clients;
  • Marketing advisory services, including the use of solicitors;
  • Processes to value client holdings and assess fees based on those valuations; and
  • Business continuity plans.

Investment Advisers Are Required to Prepare Certain Reports and to File Certain Reports with the SEC

As a registered investment advisor, you are required to file an annual update of Part 1A of your registration form (Form ADV) through the Investment Advisers Registration Depository (IARD). You must file an annual updating amendment to your Form ADV within 90 days after the end of your fiscal year. In addition to making annual filings, you must promptly file an amendment to your Form ADV whenever certain information contained in your Form ADV becomes inaccurate (the Form ADV filing requirements are contained in Rule 204-1 of the Advisers Act, and in the instructions to the Form).

  • Make sure your Form ADV is complete and current. Inaccurate, misleading, or omitted Form ADV disclosure is the most frequently cited finding from our examinations of investment advisors.
  • Please keep the e-mail address of your contact person current (Form ADV, Part 1A, Item 1J). We use this e-mail address to keep you apprised of important developments (including when it’s time to file an amendment to your Form ADV).
  • Accurately report the amount of assets that you have under management (Form ADV, Part 1A, Item 5F(2)). Advisers who have less than $25 million of assets under management, who are not otherwise eligible to maintain their registration with the SEC, or who stop doing business as an investment advisor, should file a Form ADV-W through IARD to withdraw their registration.

With respect to Part II of your Form ADV, you are not required to file it through IARD at this time. Rather, it is considered to be ‘filed’ with the SEC when you update the form and place a copy in your files. As with Part 1A, you must update Part II annually within 90 days of the end of your fiscal year and whenever it becomes materially inaccurate.

You may also be subject to other reporting obligations. For example, an adviser that exercises investment discretion (or that shares investment discretion with others) over certain equity securities (including convertible debt and options), which have a fair market value in the aggregate of $100 million or more, must file a Form 13F each quarter that discloses these holdings. “Discretionary authority” means that you have the authority to decide which securities to purchase, sell, and/or retain for your clients.

You should also be aware that it is unlawful to make any untrue statement or omit any material facts in an application or a report filed with the SEC (under Section 207 of the Advisers Act), including in Form ADV and Form ADV-W.

Investment Advisors Must Provide Clients and Prospective Clients with a Written Disclosure Statement

Registered investment advisors are required to provide their advisory clients and prospective clients with a written disclosure document (these requirements, and a few exceptions, are set forth in Rule 204-3 under the Advisers Act). As a registered adviser, you may comply with this requirement either by providing advisory clients and prospective clients with Part II of your Form ADV or with another document that contains, at a minimum, the information that is required to be disclosed in Form ADV, Part II. This written disclosure document should be delivered to your prospective clients at least 48 hours before entering into an advisory contract or, if it is delivered at the time the client enters into the contract, the client should be given five business days after entering into the advisory contract to terminate the contract without penalty (under certain conditions, you may comply with the delivery requirements through electronic media).

Each year, you must also deliver or offer (in writing) to deliver a disclosure document to each client, without charge. You are required to maintain a copy of each disclosure document and each amendment or revision to it that was given or sent to clients or prospective clients, along with a record reflecting the dates on which such disclosure was given or offered to be given to any client or prospective client who subsequently became a client (under Rule 204-2(a)(14)).

Investment Advisors Must Have a Code of Ethics Governing Their Employees and Enforce Certain Insider Trading Procedures

As a registered investment advisor, you are required to adopt a code of ethics (under the “Code of Ethics Rule” — Rule 204A-1 under the Advisers Act). Your code of ethics should set forth the standards of business conduct expected of your “supervised persons” (i.e., your employees, officers, directors and other people that you are required to supervise), and it must address personal securities trading by these people.
We note that you are not required to adopt a particular standard of business ethics. Rather, the standard that you choose should reflect your fiduciary obligations to your advisory clients and the fiduciary obligations of the people you supervise, and require compliance with the federal securities laws. In adopting a code of ethics, investment advisors may set higher ethical standards than the requirements under the law.
In order to prevent unlawful trading and promote ethical conduct by advisory employees, advisers’ codes of ethics should include certain provisions relating to personal securities trading by advisory personnel. Your code of ethics must include the following requirements:

  • Your “access persons” must report their personal securities transactions to your CCO or to another designated person each quarter. “Access persons” are any of your supervised persons who have access to non-public information regarding client transactions or holdings, make securities recommendations to clients or have access to such recommendations, and, for most advisers, all officers, directors and partners.
  • Your access persons must submit a complete report of the securities that they hold at the time they first become an access person, and then at least once each year after that.3 Your code of ethics must also require that your access persons obtain your approval prior to investing in initial public offerings or private placements or other limited offerings, including pooled investment vehicles (except if your firm has only one access person).
  • Your CCO or another person you designate in addition to your CCO must review these personal securities transaction reports.
  • Your supervised persons must promptly report violations of your code of ethics (i.e., including the federal securities laws) to the CCO or to another person you designate (provided your CCO also receives a report on such issues). You must also maintain a record of these breaches.

Also, as a registered investment advisor, you are required to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the misuse of material non-public information (under Section 204A of the Advisers Act). These policies and procedures must encompass your activities and those of your supervised persons. Advisers often include this prohibition on insider trading in their code of ethics.

Provide each of the people that you supervise with a copy of your code of ethics (and any amendments that you subsequently make to it), and also obtain a written acknowledgement from the supervised person that he/she has received it. In addition, you must describe your code of ethics in your Form ADV, Part II, Item 9 and provide a copy to your advisory clients, if they request it.

Investment Advisors are Required to Maintain Certain Books and Records

As a registered adviser, you must make and keep true, accurate and current certain books and records relating to your investment advisory business (under “the Books and Records Rule” — Rule 204-2). The books and records that you must make and keep are quite specific, and are described below in part:

  • Advisory business financial and accounting records, including: cash receipts and disbursements journals; income and expense account ledgers; checkbooks; bank account statements; advisory business bills; and financial statements.
  • Records that pertain to providing investment advice and transactions in client accounts with respect to such advice, including: orders to trade in client accounts (referred to as “order memoranda”); trade confirmation statements received from broker-dealers; documentation of proxy vote decisions; written requests for withdrawals or documentation of deposits received from clients; and written correspondence you sent to or received from clients or potential clients discussing your recommendations or suggestions.
  • Records that document your authority to conduct business in client accounts, including: a list of accounts in which you have discretionary authority; documentation granting you discretionary authority; and written agreements with clients, such as advisory contracts.
  • Advertising and performance records, including: newsletters; articles; and computational worksheets demonstrating performance returns.
  • Records related to the Code of Ethics Rule, including those addressing personal securities transaction reporting by access persons.
  • Records regarding the maintenance and delivery of your written disclosure document and disclosure documents provided by certain solicitors who seek clients on your behalf.
  • Policies and procedures adopted and implemented under the Compliance Rule, including any documentation prepared in the course of your annual review.

Some advisers are required to maintain additional records. For example, advisers that have custody and possession of clients’ funds and/or securities must make and keep additional records that are described in the Books and Records Rule (Rule 204-2, paragraph (b)), and advisers who provide investment supervisory or management services to any client must also make and keep specific additional records (which are described in Rule 204-2, paragraph (c)).

You must keep these records for specified periods of time. Generally, most books and records must be kept for five years from the last day of the fiscal year in which the last entry was made on the document or the document was disseminated. You may be required to keep certain records for longer periods, such as records that support performance calculations used in advertisements (as described in Rule 204-2, paragraph (e)).

You are required to keep your records in an easily accessible location. In addition, for the first two of these years, you must keep your records in your office(s). If you maintain some of your original books and records somewhere other than your principal office and place of business, you must note this practice and identify the alternative location on your Form ADV (in Section 1K of Schedule D). Many advisers store duplicate copies of their advisory records in a location separate from their principal office in order to ensure the continuity of their business in the case of a disaster.

You may store your original books and records by using either micrographic media or electronic media. These media generally include microfilm or digital formats (e.g., electronic text, digital images, proprietary and off-the-shelf software, and email). If you use email or instant messaging to make and keep the records that are required under the Advisers Act, you should keep the email, including all attachments that are required records, as examiners may request a copy of the complete record. In dealing with electronic records, you must also take precautions to ensure that they are secure from unauthorized access and theft or unintended destruction (similar safeguarding provisions regarding client information obtained by you is required by Regulation S-P under the Gramm-Leach-Bliley Act). In general, you should be able to promptly (generally within 24 hours) produce required electronic records that may be requested by the SEC staff, including email. In order to do so, the Advisers Act requires that you arrange and index required electronic records in a way that permits easy location, access, and retrieval of any particular electronic record.

Investment Advisors Must Seek to Obtain the Best Price and Execution for Their Clients’ Securities Transactions

As a fiduciary, you are required to act in the best interests of your advisory clients, and to seek to obtain the best price and execution for their securities transactions. The term “best execution” means seeking the best price for a security in the marketplace as well as ensuring that, in executing client transactions, clients do not incur unnecessary brokerage costs and charges. You are not obligated to get the lowest possible commission cost, but rather, you should determine whether the transaction represents the best qualitative execution for your clients. In addition, whenever trading may create a conflicting interest between you and your clients, you have an obligation, before engaging in the activity, to obtain the informed consent from your clients after providing full and fair disclosure of all material facts. The Commission has described the requirement for advisers to seek best execution in various situations.

In selecting a broker-dealer, you should consider the full range and quality of the services offered by the broker-dealer, including the value of the research provided, the execution capability, the commission rate charged, the broker-dealer’s financial responsibility, and its responsiveness to you. To seek to ensure that you are obtaining the best execution for your clients’ securities trades, you must periodically evaluate the execution performance of the broker-dealers you use to execute clients’ transactions.

You may determine that it is reasonable for your clients to pay commission rates that are higher than the lowest commission rate available in order to obtain certain products or services from a broker-dealer (i.e., soft dollar arrangement). To qualify for a “safe harbor” from possible charges that you have breached your fiduciary duty by causing your clients to pay more than the lowest commission rate, you must use clients’ brokerage commissions to pay for certain defined “brokerage or research” products and services, use such products and services in making investment decisions, make a good faith determination that the commissions that clients will pay are reasonable in relation to the value of the products and services received, and disclose these arrangements.

The SEC staff has stated that, in directing orders for the purchase or sale of securities, you may aggregate or “bunch” orders on behalf of two or more client accounts, so long as the bunching is done for the purpose of achieving best execution, and no client is systematically advantaged or disadvantaged by the bunching. The SEC staff has also said that, if you decide not to aggregate orders for client accounts, you should disclose to your clients that you will not aggregate and the potential consequences of not aggregating orders.

If your clients impose limitations on how you will execute securities transactions on their behalf, such as by directing you to exclusively use a specific broker-dealer to execute their securities transactions, you have an obligation to fully disclose the effects of these limitations to the client. For example, if you negotiate volume commission discounts on bunched orders, a client that has directed you to use a specific broker should be informed that he/she will forego any benefit from savings on execution costs that you might obtain for your other clients through this practice.

You should also seek to obtain the best price and execution when you enter into transactions for clients on a “principal” or “agency cross” basis. If you have acted as a principal for your own account by buying securities from, or selling securities to, a client, you must disclose the arrangement and the conflicts of interest in this practice (in writing) and also obtain the client’s consent for each transaction prior to the time that the trade settles. There are also explicit conditions under which you may cross your advisory clients’ transactions in securities with securities transactions of others on an agency basis (under Rule 206(3)-2). For example, you must obtain advance written authorization from the client to execute such transactions, and also provide clients with specific written disclosures. Compliance with Rule 206(3)-2 is generally not required for transactions internally crossed or effected between two or more clients you advise and for which you receive no additional compensation (i.e., commissions or transaction-based compensation); however, full disclosure regarding this practice should be made to your clients.

Requirements for Investment Advisors’ Contracts with Clients

As a registered investment advisor, your contracts with your advisory clients must include some specific provisions (which are set forth in Section 205 of the Advisers Act). Your advisory contracts (whether oral or written) must convey that the advisory services that you provide to the client may not be assigned by you to any other person without the prior consent of the client. With limited exceptions, contracts cannot include provisions providing for your compensation to be based on the performance of the client’s account. In addition, the SEC staff has stated that an adviser should not enter into contracts with clients, except with certain sophisticated clients, that contain terms or clauses commonly referred to as a “hedge clause” because such clauses or provisions are likely to lead other clients to believe that they have waived their rights of legal action, whether under the federal securities laws or common law.

Investment Advisors May be Examined by the SEC Staff

As a registered investment advisor, your books and records are subject to compliance examinations by the SEC staff (under Section 204 of the Advisers Act). The purpose of SEC examinations is to protect investors by determining whether registered firms are complying with the law, adhering to the disclosures that they have provided to their clients, and maintaining appropriate compliance programs to ensure compliance with the law. If you are examined, you are required to provide examiners with access to all requested advisory records that you maintain (under certain conditions, documents may remain private under the attorney-client privilege).

More information about examinations by the SEC and the examination process is provided in the brochure, “Examination Information for Broker-Dealers, Transfer Agents, Clearing Agencies, Investment Advisers and Investment Companies,” which is available on the SEC’s website at http://www.sec.gov/info/cco/ccons2006exambrochure.pdf.

Requirements for Investment Advisors that Vote Proxies of Clients’ Securities

As a registered investment advisor, if you have voting authority over proxies for clients’ securities, you must adopt policies and procedures reasonably designed to ensure that you: vote proxies in the best interests of clients; disclose information to clients about those policies and procedures; and describe to clients how they may obtain information about how you have voted their proxies (these requirements are in Rule 206(4)-6 under the Advisers Act).

If you vote proxies on behalf of your clients, you must also retain certain records. You must keep: your proxy voting policies and procedures; the proxy statements you received regarding your client’s securities (the Rule provides some alternative arrangements); records of the votes you cast on behalf of your clients; records of client requests for proxy voting information; and any documents that you prepared that were material to making a decision as to how to vote or that memorialized the basis for your decision (these requirements are described in Advisers Act Rule 204-2(c)(2)).

Requirements for Investment Advisors that Advertise their Services

To protect investors, the SEC prohibits certain types of advertising practices by advisers. An “advertisement” includes any communication addressed to more than one person that offers any investment advisory service with regard to securities (under “the Advertising Rule” — Rule 206(4)-1). An advertisement could include both a written publication (such as a website, newsletter or marketing brochure) as well as oral communications (such as an announcement made on radio or television).

Advertising must not be false or misleading and must not contain any untrue statement of a material fact. Advertising, like all statements made to advisory clients and prospective clients, is subject to the general prohibition on fraud (Section 206 as well as other anti-fraud provisions under the federal securities laws). Specifically prohibited are: testimonials; the use of past specific recommendations that were profitable, unless the adviser includes a list of all recommendations made during the past year; a representation that any graph, chart, or formula can in and of itself be used to determine which securities to buy or sell; and advertisements stating that any report, analysis, or service is free, unless it really is free.

The SEC staff has said that, if you advertise your past investment performance record, you should disclose all material facts necessary to avoid any unwarranted inference. For example, SEC staff has indicated that it may view performance data to be misleading if it:

  • does not disclose prominently that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material;
  • does not disclose the effect of material market or economic conditions on the results portrayed (e.g., an advertisement stating that the accounts of the adviser’s clients appreciated in value 25% without disclosing that the market generally appreciated 40% during the same period);
  • does not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that accounts would have or actually paid;
  • does not disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;
  • suggests or makes claims about the potential for profit without also disclosing the possibility of loss;
  • compares model or actual results to an index without disclosing all material facts relevant to the comparison (e.g., an advertisement that compares model results to an index without disclosing that the volatility of the index is materially different from that of the model portfolio); and
  • does not disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed (e.g., the model portfolio contains equity stocks that are managed with a view towards capital appreciation).

In addition, as a registered adviser, you may not imply that the SEC or another agency has sponsored, recommended or approved you, based upon your registration (under Section 208 of the Advisers Act). You should not use the term “registered investment advisor” unless you are registered, and you should not use this term to imply that as a registered adviser, you have a level of professional competence, education or special training. For example, the SEC staff has stated that advisers should not use the term “RIA” after a person’s name because using initials after a name usually indicates a degree or a licensed professional position for which there are certain qualifications; however, there are no federal qualifications for becoming an SEC-registered adviser.

Requirements for Investment Advisors that Pay Others to Solicit New Clients

Registered investment advisors may pay cash compensation to others to seek out new clients on their behalf, commonly called “solicitors” or “finders,” if they meet certain conditions (under Rule 206(4)-3 of the Advisers Act):

  • The solicitor is not subject to certain disciplinary actions.
  • The fee is paid pursuant to a written agreement to which you are a party and (with limited exceptions) the agreement must: describe the solicitor’s activities and compensation arrangement; require that the solicitor perform the duties you assign and in compliance with the Advisers Act; require the solicitor to provide clients with a current copy of your disclosure document; and, if seeking clients for personalized advisory services, require the solicitor to provide clients with a separate written disclosure document containing specific information.
  • You receive from the solicited client, prior to or at the time you enter into an agreement, a signed and dated notice confirming that he/she was provided with your disclosure document and, if required, the solicitor’s disclosure document.
  • You have a reasonable basis for believing that the solicitor has complied with the terms of your agreement.

Requirements for Investment Advisors that have Custody or Possession of Clients’ Funds or Securities

Registered investment advisors that have “custody” or “possession” of client assets must take specific measures to protect client assets from loss or theft (under “the Custody Rule” — Rule 206(4)-2(c)(1) under the Advisers Act).

The first step is to determine whether you have custody or possession of client assets. “Custody” is defined as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” This includes situations in which you:

  • have physical possession of client funds or securities, even temporarily;
  • enter into arrangements (including a general power of attorney) authorizing you to withdraw funds or securities from the client’s account (note that if you are authorized to deduct your advisory fees or other expenses directly from clients’ accounts, you have custody); and
  • serve in a capacity that gives you or a supervised person legal ownership or access to client funds or securities (note that if you are a general partner to a privately-offered pooled investment vehicle, you have custody).

If you have custody, with limited exceptions, you must maintain these client funds and securities at a “qualified custodian.” Generally, qualified custodians include most banks and insured savings associations, SEC-registered broker-dealers, Commodity Exchange Act-registered futures commission merchants, and certain foreign financial institutions. With a limited exception, for client accounts over which you have custody, you must have a reasonable basis for believing that the client (or a designated representative) receives periodic reports directly from the custodian that contain specific information with respect to the funds and securities in custody. With respect to pooled investment vehicles over which you have custody, the qualified custodian must send account statements for the pooled vehicle directly to each investor.
If you, rather than a qualified custodian, send account statements directly to your clients, you must have a “surprise verification” by an independent public accountant. The independent public accountant must verify the funds and securities in your custody or possession at least once each calendar year, and must then promptly file a “certificate of examination” with Form ADV-E with the SEC.4

Requirements for Investment Advisors to Disclose Certain Financial and Disciplinary Information

Registered investment advisors may be required to disclose certain financial and disciplinary information (under Rule 206(4)-4 under the Advisers Act). These requirements are described below.
Registered advisers that have custody or discretionary authority over client funds or securities, or that require prepayment six months or more in advance of more than $500 in advisory fees, must promptly disclose to clients and any prospective clients any financial conditions that are reasonably likely to impair their ability to meet their contractual commitments to their clients.

All registered advisers must also promptly disclose any legal or disciplinary events that would be material to a client’s or a prospective client’s evaluation of the adviser’s integrity or its ability to meet its commitments to clients (regardless of whether the adviser has custody or requires prepayment of fees). The types of legal and disciplinary events that may be material include:

  • Criminal or civil actions, where the adviser or a management person of the adviser was convicted, pleaded guilty or “no contest,” or was subject to certain disciplinary actions with respect to conduct involving investment-related businesses, statutes, regulations, or activities; fraud, false statements, or omissions; wrongful taking of property; or bribery, forgery, counterfeiting, or extortion.
  • Administrative proceedings before the SEC, other federal regulatory agencies, or any state agency where the adviser’s or a management person’s activities were found to have caused an investment-related business to lose its authorization to do business or where such person was involved in a violation of an investment-related statute or regulation and was the subject of specific disciplinary actions taken by the agency.
  • Self-regulatory organization (SRO) proceedings in which the adviser or a management person was found to have caused an investment-related business to lose its authorization to do business; or was found to have been involved in a violation of the SRO’s rules and was the subject of specific disciplinary actions taken by the organization.

Informational Resources Available From the SEC

The SEC provides a great deal of helpful information about the compliance obligations of investment advisors on the SEC’s website at http://www.sec.gov/divisions/investment.shtml. This information includes links to relevant laws and rules, staff guidance and studies, enforcement cases, and staff no-action and interpretive letters (generally from 2001 — present). In addition, the SEC’s website contains a list of the source materials that were used in preparing this information sheet.

To assist chief compliance officers of investment advisors and investment companies in meeting their compliance responsibilities and to help enhance compliance in the securities industry, the SEC has established the “CCOutreach Program.” This program includes regional and national seminars on compliance issues of concern to CCOs. Information about CCOutreach and any scheduled events is available at http://www.sec.gov/info/ccoutreach.htm.

Finally, the SEC staff regularly receive calls and correspondence concerning the application of the federal securities laws, and advisers and other registrants are encouraged to communicate any questions or issues to SEC staff. To ensure that you reach the right person at the SEC, the SEC’s website lists the names and contact information for SEC staff in the Division of Investment Management who are responsible for responding to communication from the public about specific topics (http://www.sec.gov/divisions/investment/imcontact.htm).

With respect to issues or questions that arise in the context of a compliance examination by the SEC, advisers are encouraged to raise any questions or issues directly with the SEC examination team, or with examination supervisors in their local SEC office (contact information for senior examination staff is available at http://www.sec.gov/about/offices/ocie/ocie_org.htm).

What licenses do you need to start or manage a hedge fund?

Question: What licenses do you need to start or manage a hedge fund?

Answer: This is a question that comes up quite often. Many people wonder whether they need a series 7 license or the series 65 license or the series 3 to manage a hedge fund. First, a potential hedge fund manager does not need to have a series 7 license in order to manager a hedge fund. The series 7 license is the general securities representative licese which allows an individual to be a representative (broker) of a FINRA registered member firm (brokerage firm or broker-dealer). The series 7 allows a representative to take and place trades for a customer. It is also a prerequisite for many of the other FINRA exams (such as the series 24). Because the hedge fund in not regulated as a broker, a hedge fund manager does not need to have a series 7 license (assuming that the manager is also concurrently acting as a broker-dealer representative).

Second, a start up hedge fund manager may need to have a series 65 license in order to become registered as an investment adviser. There are two potential ways a hedge fund manager would be required to register as an investment adviser – under the federal rules (the Investment Advisers Act of 1940) or under the various state rules (commonly referred to as the state blue sky laws). If a manager is required to register with the SEC under the Advisers Act* then, for federal purposes, the manager will not need to have taken the Series 65. However, the Advisers Act allows states to impose certain requirements on all federally registered investment advisers with a place of business in their state. Generally the states will require all federally registered investment advisers to “notice file” in their state which entails paying a fee to the state. The state can also require that all investment adviser representatives have the series 65 license. This means that anyone who talks to clients/investors or makes any trading decisions or analysis will need to have this license. The definition of investment adviser representative basically encompasses every employee or owner of the investment adviser other than secretary type employees. If you are a federally registered investment adviser you should discuss whether members of your team need to be licensed as representatives at the state level.

If you are not a federally registered investment adviser (generally all managers with less than 30 million of assets under management) then you will need to determine whether your management firm needs to be registered as an investment adviser at the state level. Many states require investment advisers with a place of business** in the state to register. Some popular states that require investment adviser registration are California, Texas, Washington and Colorado. However, there are many states which have exemptions from the registration requirements. Some popular states that have exemptions (through regulation or special order) from investment adviser registration for hedge fund managers are New York, Connecticut, Florida and Georgia. Again, you should speak with your legal counsel or compliance professional to determine whether your hedge fund management firm will need to be licensed as an investment adviser in the state.

Finally, if the hedge fund trades futures or commodities then the manager may need to be registered as a commodity pool operator with the National Futures Association. In order to register as a commodity pool operator at least one person at the management company will need to take the Series 3 exam. For more information on the Series 3 exam and this part of the registration process please read how to register as a CPO or CTA.

* Many potential hedge fund managers are confused with whether a management company will need to be registered as an investment adviser with the SEC. The answer is that in most cases a hedge fund manager will not have to be registered as an investment adviser with the SEC because of an exemption provision within the investment advisers act. Section 203(b)(3) of the Advisers Act specifically exempts from the registration provisions “any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser …” The term “client” in the hedge fund context means a “corporation, general partnership, limited partnership, limited liability company, trust …, or other legal organization … to which you provide investment advice based on its investment objectives rather than the individual investment objectives of its shareholders, partners, limited partners, members, or beneficiaries…”

This means that as long as a hedge fund manager will not need to count the investors in the hedge fund as his “client” and that the hedge fund itself is the only “client.” You will probably recall that a couple of years ago the SEC proposed a change to the rules under the Advisers Act that required a manager to count all of the investors in the hedge fund as clients. Under the proposed rule hedge fund managers would have been required register with the SEC (if they had at least $30 million under management), but Phillip Goldstein successfully challenged the SEC in court. His successful challenge to the rule change allows hedge fund managers to escape SEC regulation.

** “Place of business” of an investment adviser means: (1) An office at which the investment adviser regularly provides investment advisory services, solicits, meets with, or otherwise communicates with clients; and (2) Any other location that is held out to the general public as a location at which the investment adviser provides investment advisory services, solicits, meets with, or otherwise communicates with clients.