Financial Requirements for Registration as an Investment Adviser

Under the Investment Advisers Act of 1940, no specific financial requirements, such as a minimum net worth, are spelled out. However, there are financial disclosures that must be made to clients under certain conditions. Under the Uniform Securities Act, the Administrator may, by rule or order, establish minimum financial requirements for registration as an investment adviser in the state.

The Substantial Prepayment of Fees

Both state and federal law offer extra protection to those clients of investment advisers who have made substantial advance payment of fees for services to be rendered in the future. The term used is substantial prepayment of fees. In the case of a federal covered adviser, it is considered substantial if the investment adviser collects prepayments for more than $1,200 per client, six months or more in advance. Under the USA, it is more than $500, and again, six months or more in advance

Balance Sheet Requirements for Federal Covered Advisers

Any federal covered investment adviser who requires or solicits clients for a substantial prepayment of fees must include a balance sheet with the adviser’s Form ADV Part 2A for the adviser’s most recent fiscal year. The balance sheet must be prepared in accordance with generally accepted accounting principals (GAAP), audited by an independent public accountant, and accompanied by a note stating the principles used to prepare it, the basis of securities included, and any other explanations required for clarity.

Balance Sheet Requirements for State Registered Advisers

An audited balance sheet must be included in the brochure for any state registered investment adviser who requires or solicits clients for substantial prepayment of fees. In addition, those who maintain custody of client funds and/or securities must include an audited balance sheet with their Form ADV Part 2A for their most recent fiscal year with the same requirement. The audited balance sheet is also required when the custodian is a related (affiliated) broker-dealer. Furthermore, state registered advisers who exercise discretionary authority over client accounts but do not maintain custody must file with the administrator within 90 days of the end of the adviser’s fiscal year a balance sheet, but this one does not have to be audited. However, it must follow GAAP and be true and accurate.

Disclosure of Financial Impairment

Any investment adviser that has discretionary authority or custody of client funds or securities, or requires or solicits substantial prepayment of fees must disclose any financial condition that is reasonably likely to impair their ability to meet contractual commitments to their clients. As an example, the SEC has indicated that disclosures may be required of any arbitration award “sufficiently large that payment of it would create such a financial condition.”

Here is the way it is stated in the Form ADV Part 2:

“If you have discretionary authority or custody of client funds or securities, or if you require or solicit prepayment of more than $1,200 in fees per client, six months or more in advance, disclose any financial condition that is reasonably likely to impair your ability to meet contractual commitments to clients.”

Specific Financial Requirements for State Registered Financial Advisers

The Administrator may require an adviser who has custody of client funds or securities or has discretion over a client’s account to post a surety bond or maintain a minimum net worth. Usually, the requirement is higher for custody than for discretion. Typically, the net worth required of investment advisers with discretionary authority is $10,000 and that for those taking custody is $35,000. An adviser who does not exercise discretion and does not maintain custody, but does accept prepayment of fees of more than $500, six or more months in advance, must maintain a positive net worth at all times.

Failure to Maintain Minimum Net Worth

The USA specifies the action to be taken by a registered investment adviser whose net worth falls below the required minimum. By the close of business on the next business day, the adviser must notify the Administrator that the investment advisers net worth is less than the required minimum After sending that notice, the adviser must file a financial report with the Administrator by the close of business on the next business day. One more item that must be included in the report is the number of client accounts. When the adviser’s net worth is below the minimum requirement, the adviser must obtain a bond in an amount of the net worth deficiency rounded up to the nearest $5,000.

Computing Net Worth

For NASAA purposes, the term net worth means an excess of assets over liabilities, as determined by generally accepted accounting principles, but shall not include the following as assets:

Goodwill
Patents
Copyrights
All other assets of an intangible nature, home, home furnishing, automobile(s), and any other personal items not readily marketable in the case of an individual; advances or loans to stockholders and officers in the case of a corporation; and advances or loans to partners in the case of a partnership.

However, furniture used in the office, such as a sofa in the reception room, or bookcases in the company research library, are considered assets for the purpose of the computation.

For more information related to investment adviser registration check out our other blogs on the topic:

If you need assistance with understanding how the financial requirements for registration as an investment adviser apply to you, please contact us. MasterCompliance provides expert consulting, outsourcing, and implementation tools in planning and budgeting your firm’s compliance responsibilities.