The Division’s State investment advisor Exam Function

• What to expect if you are examined
• Common compliance issues

Table of Contents

The Division’s Securities Examiners visit and review registered State Investment Advisors who reside in or maintain offices in Alaska. The Securities conducts routine exams, as resources are available, but may also initiate examinations for cause. A for cause examination is conducted where the division has reason to believe a firm may have violated securities laws. Most exams are conducted on a routine basis.

If you or your firm are to be examined, the Securities will generally schedule a date and time with you prior to the exam. The exam may last a day or longer and the examiner will review books and records to determine if the rules and regulations pertaining to State Investment Advisors are being followed.

These are some of the books and records we review:

• Journals, including cash/check receipts and disbursements, and any other records of original entry forming the basis of entries in any ledger
• General and auxiliary ledgers showing asset, liability, reserve, capital, income and expense accounts
• Check books, bank statements, canceled checks and reconciliations
• Bills and documents pertaining to the expenses of the firm
• Trial balances, financial statements and internal working papers
• Correspondence and complaints
• Account information including contracts, disclosures and transaction activities
• Documents pertaining to discretion and custody of customer securities and cash

Record keeping compliance issues may be uncovered during our exam. Potential compliance issues include incomplete record keeping, outdated disclosures on Form ADV, inadequate supervisory procedures, and outdated or incorrect account information. Another potential compliance issues may arise because investment advisor regulation is now divided between state and federal authorities. Our examiners will review the State investment advisor ’s operations to determine whether the investment advisor is properly registered at the state level or whether the Advisor should instead be registered with the Securities and Exchange Commission. Generally, this depends on the value of the assets the investment advisor has under management.

The exam may also uncover sales practice compliance issues such as misrepresentation to clients, inflated performance claims, lack of suitability of investments offered to clients, inadvertent custody of client funds and securities, and engaging in investment advisor related activities without being licensed.

Discovery of such problems might result in the State investment advisor receiving a warning letter, a follow-up exam, an administrative order, or monetary penalties.

The following information covers the most common compliance issues found in examinations of State Investment Advisors:

• Disclosure
• Conflicts of Interest
• Advertisement and Performance Claims
• Custody
• Suitability
• investment advisor Representative Registration

If you have further questions about these areas, you can reach the Securities at (907) 465-2521.

DISCLOSURE

Securities examiners review records for the purpose of determining whether there is adequate disclosure to investment advisory clients on the following topics:

• what investment advisory services are being provided,
• who is providing those services,
• what is the client being charged for the services, and
• what conflicts of interest, if any, might be involved for the State investment advisor .

What services are being provided and who is providing the advisory services are questions that may arise where the investment advisor only introduces the clients to one or more other Advisors. These questions also arise in connection with wrap fee programs, where a third party firm may provide advisory services. The investment advisory agreement should answer these questions, as should the State investment advisor ’s brochure and/or Part II of Form ADV. Securities examiners review the investment advisory contract and compares the contract with the activity conducted at the firm and with the contents of Form ADV. Beginning with renewals for 2001, there is a newly crafted Form ADV Part I which will become mandatory for use for the December 2001 renewals. It can be filled out on the investment advisor Registration Depository (IARD) over time and saved. The form can be submitted when one clicks on the "send" button, after being satisfied that everything on the form is complete and correct. A new Form ADV Part II will be ready for use by the December 2001 renewal date. To check on continuing information on the IARD and Form ADV, go to www.sec.gov/iard/

Securities examiners also check to see if investment advisory clients are being given adequate disclosure of any conflicts of interest the State investment advisor may have. The examiners also review investment advisory agreements to make sure they do not contain "hedge clauses" in which the State investment advisor disclaims liability for losses occasioned by any negligence of the investment advisor . The Securities and Exchange Commission has taken the position, to which the Division agrees, that "hedge" clauses are unenforceable and therefore their inclusion in an advisory agreement is misleading to clients.

CONFLICTS OF INTEREST

Securities examiners look for conflicts of interest when they exam State Investment Advisors. Different kinds of conflicts of interest arise depending on the number of roles the investment advisor and its affiliates play with regard to the customer. The investment advisor is a fiduciary who must put the customer’s interest before his own. These are some of the situations involving conflicts of interest an examiner looks for:

• Conflicts where the investment advisor is also the broker-dealer or the broker-dealer is an affiliate of the investment advisor
• Conflicts where the investment advisor or its representative has an ownership interest (or especially a controlling interest) in an issuer whose securities the Advisor or representative recommends to customers
• Conflicts relating to the payment of finder’s fees
• Conflicts between the investment advisor ’s interest in trading for the investment Advisors account and the interests of customers

In all conflicts situations the key issue is the effect of the conflict on the customer. Has the customer been told of the conflict? Has the customer consented to the transaction despite the disclosed conflict? If the customer consented, was the customer in a position to evaluate the effect of the conflict on the customer’s interest? The more vulnerable or unsophisticated the customer, the greater the burden is on the investment advisor to show that the customer has knowingly consented to the conflict. Disclosure and customer consent may not always be sufficient remedies for conflicts of interest.

An examiner will review any written policy of the investment advisor on conflicts of interest and will consider conflicts issues throughout the review of books and records. An examiner might spot a conflict through review of customer correspondence, complaints, and statement of accounts or by operational review of the investment advisor itself and interviews of its employees or customers. Once an examiner has spotted a conflict, the examiner will generally ask the principals of the investment advisor for an explanation and may seek further evidence to confirm the extent of the conflict of interest.

Conflicts of interest may involve serious securities law violations, such as sale of unregistered securities, fraud in connection with the purchase or sale of securities, and unlawful acts of a person advising another. Some of the most serious conflict problems arise when the investment advisor is also an issuer or is an affiliate of an issuer. If there is an apparent conflict of interest, the investment advisor has a greater burden of showing that the investment recommendation was suitable for the customer.

ADVERTISEMENT AND PERFORMANCE CLAIMS

The examiner will review the investment advisor ’s advertising files containing a copy of all advertisements (pamphlets, circulars, solicitation letters, etc.) the Advisor uses to solicit new business and maintain current clients. All advertisements should be dated and initialed by a principal (or designated supervisor) of the Advisor prior to or immediately after distribution to ensure that the advertisement falls within applicable guidelines.

There is a new regulation 03 AAS 08.045 which provides that all use of performance figures must comply with guidelines adopted by the Association for Investment Management and Research (AIMR). This regulation will become effective soon. It will be announced on this page when it is effective.

Common compliance issues include:

• The use of testimonials by clients or other individuals (which are not allowed)
• Using advertising of previous performance that does not comply with AIMR standards
• Use of inappropriate indices which make the Advisor appear superior to its competitors
• Money managers using simulated performance figures
• "Puffing" or exaggerating the services and qualifications of the Advisor

During the review of advertisement files, the examiner may examine software and other programming the Advisor uses to record and retain client data and the examiner may verify performance claims compliance with AIMR standards.

CUSTODY

Definition of custody

On October 1, 1999, Alaska adopted a definition of "custody of client funds or securities" at 3 AAC 08.950 (22) which states that custody, " means for a state investment advisor , the state investment advisor directly or indirectly holds client funds or securities, has authority to obtain possession of client funds or securities, or has the ability to appropriate the client funds or securities, except a state investment advisor is not considered as having constructive custody of a client’s funds or securities, if such possession is for the sole purpose of immediately forwarding those funds or securities to a third party at the request of the client;".

However, until the recent adoption of this definition, the term "custody" had not been defined under most State Securities laws or the investment advisor ’s Act of 1940. As a result, court cases involving custody, along with SEC interpretations and no-action letters, have established fairly broad parameters and deem an Advisor to have "custody" of client assets if it has any direct or indirect access to them. This body of interpretive information will still be applicable in the course of our SIA examinations. For instance, an investment advisor may be deemed to have custody of client funds if it sends the bills for its services directly to the custodian, who then automatically pays the Advisor. However, the SEC has established guidelines (‘no action’ positions) that establish strict procedures to follow so that this situation would not be considered constructive custody of client funds. The SEC have allowed automatic payment of advisory fees where:

• The client authorizes the arrangement in writing;
• The Advisor sends the bill to both the client and the custodian at the same time;
• The bill shows the amount of the fee, how it was calculated and the value of the assets on which the bill is based; and
• The custodian notifies the client at least quarterly of how much has been paid to the Advisor.

The Division also holds to this position regarding automatic payment of advisory fees and, in general, rules consistently with the established SEC "no action" positions on matters of custody.

SIA’s who are issuers of securities

An Advisor who is also an issuer of securities is deemed to have custody unless an independent custodian is utilized and the custodial agreement(s) include provisions that define the method by which the Advisor receives payment and withdraws funds (via an independent representative).

Requirements for SIA’s with "custody"

Additional financial and books and records requirements ( 3 AAC 08.025 and .040(b)) are imposed on Advisors that have custody or possession of client securities or funds, which include:

SIA’s who have custody of clients funds or securities must have a $35,000 surety bond and maintain a positive net worth at all times;

Securities of each client must be segregated, marked to identify the particular client having the beneficial interest in the security, and held in safekeeping in a place reasonably free from risk of destruction or other loss;

The SIA must deposit all client funds in one or more bank accounts that contain only client funds and the account or accounts are maintained in the name of the SIA as agent or trustee for the clients;

The SIA, immediately after accepting custody of funds or securities from any client, notifies the client in writing of the place and the manner in which the funds and securities will be maintained, and thereafter immediately notifies the client in writing of any changes in the place or the manner in which the funds or securities are maintained;

The SIA maintains a separate record for each client’s bank account that shows the name and address of the bank where the account is maintained, the dates and amounts of deposits to and withdrawals from the account, and the exact amount of each client’s beneficial interest in the account;

The SIA, at the end of every three months, sends each client an itemized statement showing the funds and securities in the state investment advisor ’s custody and all debits, credits, and transactions in the client’s account during the period; and

at least once every calendar year, an independent certified public accountant or public accountant verifies all client funds and securities by actual examination at a time chosen by the accountant without prior notice to the SIA, and the accountant issues a report stating that the accountant has made an examination of all client funds and securities and describing the nature and extent of the examination, and the report is filed with the administrator promptly after each examination.

The SIA shall maintain a journal or other record showing all purchases, sales, receipts and deliveries of securities for all accounts and all other debits and credits to the accounts;

The SIA shall maintain a separate ledger account for each client showing all purchases, sales, receipts and deliveries of securities, the date and price of each purchase and sale, and all debits and credits;

The SIA shall keep copies of confirmations of all transactions effected by or for the account of any client; and

The SIA shall maintain a record for each security in which a client has a position showing the name of each client having an interest in the security, the amount or interest of each client, and the location of the security.

Exam procedure for SIA’s with custody

In addition to an examination of all the books and records required of state investment Advisors (3 AAC 08.040) including those listed above, additional tasks of the exam staff may include:

Determining whether the Advisor has any affiliation with the custodian; and

Obtaining information regarding how instructions are conveyed to a custodian, who determines where the client funds or securities are maintained, and, if the custodian is a person other than a broker-dealer (such as a bank) how the transactions are settled.

SUITABILITY

Examiners review for suitability issues by comparing customer new account information with the services contracted for under investment advisory agreement and with the advice given to the customer. State investment Advisors need to maintain adequate information on their customers to document the suitability of the recommendations made. At a minimum, the investment advisor should maintain information on the customer’s annual income, net worth, and investment objectives. If the customer has specific objectives (for example, to retire in the year 2005 with a certain level of investment income, or to have funds available for their children’s future education), those objectives should be reflected in the customer’s file.

The examiner will pay special attention to the suitability of recommendations where the investment advisor has discretion over the customer’s account. However, the suitability of investment recommendations is an issue relating to all investment advisory customers, not only those who have given the investment advisor discretion over his or her account.

investment advisor Representative (IAR) Registration

During an exam, the issue of whether individual’s, working at or for the SIA, should be registered as investment advisor representatives may arise. SIA’s shall register individuals who meet the definition of an investment advisor representative under the Alaska Securities Act.

As a rule of thumb, the SIA should register individuals associated with the firm who:

Questions regarding registration can be directed to the Division’s Securities at (907) 465-2521.

TOP TEN COMPLIANCE ISSUES FOUND ON investment advisor EXAMS

To assist you in meeting your compliance responsibilities, we have compiled and identified the most common issues and problem areas found during state review of investment Advisors:

Lack of a written customer contract. You must have a written contract with each client (AS 45.55.023(a)(16)), even if you are a fee only financial planner. The contract must disclose: the services to be provided, the term of the contract, the advisory fee, the formula for computing the fee, whether the fee is negotiable, the amount of prepaid fee to be returned in the event of contract termination or nonperformance, whether the contract grants discretionary power to the Advisor, and that the contract will not be assigned by the investment advisor without the consent of the client. The contract may not include a so-called "hold harmless" or "hedge" clause, which purports to require clients to waive potential claims they may be entitled to bring under state or federal statutes, or which seeks to hold the investment advisor to a lesser standard of care than is required by statute. You are allowed to include an arbitration clause in the contract.

Outdated Form ADV or brochure. You are required to update Form ADV (and file the amendment with the Securities Division) whenever information disclosed in the form changes in any material respect. If brochures are used for providing required disclosures to clients, they should be updated as required (at the same time the Form ADV is updated) and filed with the division. Part II of Form ADV or the brochure must be furnished to prospective clients 48 hours before they sign a contract, or at the time of signing the contract if the client can cancel without penalty within five days after signing. In addition, every year you must deliver to each client, or offer to deliver, a copy of the updated ADV Part II or brochure. As always, a brochure must include at least all information required by Part II of Form ADV. You need to keep records of to whom the disclosure was offered or sent, and which clients requested the update.

Inadequate or outdated client information. Before recommending or executing an investment transaction on behalf of a client, you must have reasonable grounds for believing the investment transaction is suitable for the client. You are required to make reasonable efforts to obtain information concerning the client's financial status, tax status, investment objectives, and other information necessary to make a reasonable suitability determination. For an investment advisor , merely asking for estimated net worth and income, and checking a box for investment objective probably is not sufficient to establish suitability, particularly if you have to establish it in an arbitration or court action. A better practice is to obtain detailed information such as a client's: assets, liabilities, income and expenses; existing investments, financial goals and risk tolerance; marital status, dependents, family obligations, age, health, and mortality issues; and insurance coverage. You may need to obtain documents such as tax returns, company benefit (e.g., 401k) booklets, will and trust documents, and stock option agreements. Since suitability will change over time as a client's family and financial circumstances change, you need to update this information periodically. The best practice is to update this information annually, and the Division considers three year old information to be stale.

Misleading business cards, letterhead and advertising. There can be some confusion about who can use the term "Registered (State) investment advisor ." If on Form ADV Part I, No. 8, the box for "A. Corporation," "B. Partnership," or "D. Other" has been checked, then an entity is the registered investment advisor , and persons employed by the entity and providing investment advice must refer to themselves as "investment advisor representatives." Nor can anyone call themselves "registered principals" of an investment advisor . While the Division requires that each investment advisor have a principal, we do not technically "register" them.

Lack of documentation regarding discretionary authority over client accounts. As stated in No. 1 above, this information needs to be included in the client contract. In addition, you should have a copy of the client's agreement with any brokerage firm at which you are authorized to trade on the client's behalf.

Problems with invoices for fees. You need to keep a copy (electronic is ok) of each invoice sent to a client. The invoice should show how the fee was calculated. In addition, if fees are to be deducted directly from a client's brokerage account, in order to avoid "inadvertent custody" of client funds (1) the client must authorize the arrangement in writing; (2) the invoice must be sent to both the client and the custodian at the same time; (3) the invoice must show the amount of the fee, how it was calculated, and the value of the assets on which it is based; and (4) the custodian must notify the client at least quarterly how much it has paid you.

Misleading performance claims.

• Annualized rate of return. Rates of return should be shown only for the period being actually measured, i.e., rates should not be annualized. In other words, if the return being shown is for three months, then it should not be multiplied by four and an annual rate shown, since there is no assurance that the rate of return will be sustained for a 12-month period.
• Rate of return incorrectly calculated. Rates of return should be disclosed net of all fees. Also, various states have come across instances where Advisors did not have adequate knowledge of the software they were using to calculate rates of return and therefore made errors.
• Inconsistent methods of calculating performance. The method of calculating performance (e.g., AIMR time-weighted rate of return) should be consistent from period to period. Methods should not be switched to whatever method shows the largest gain for a particular time period.
• Inaccurate comparisons to indices. If comparisons are going to be made to indices, then (1) the securities making up the particular index should be of like kind to the Advisor’s portfolio, i.e., you do not compare an equity portfolio to a bond fund; (2) rates of return must be shown net of fees; and (3) comparisons to the S&P 500 and Dow Jones may be misleading because those indices do not factor in reinvested dividends.
• Failure to include disclaimer. A disclaimer to the effect that past performance is no guarantee of future performance needs to be included.

Other books and records issues.

• You need to set up a complaint file, even if you have never had any complaints.
• You need to keep all incoming correspondence from clients, either in a correspondence file or in each client's file. Similarly, you need to keep copies of all outgoing correspondence, and any documents sent to clients. This can be done by a central file or in each client's file. This can also be kept electronically, so long as an item can be easily retrieved for an examiner to review, and it can be determined to whom it was sent (and do not forget to back up your computer on a regular basis).
• Files should be maintained for paid bills and bills payable.
• Bank statements should be reconciled on a monthly basis.
• If you are managing money, you must maintain: (1) documentation on each investment in a client's portfolio and each purchase and sale (including date and price) on behalf of the client; and (2) for each security, a record of which clients hold it and the amount held, and purchases and sales.

Inadequate documentation of supervision. If more than one person is employed by the investment advisor , then the principal will have supervisory responsibilities. A compliance manual (which even a sole proprietor should have) should be established and maintained. There should be evidence that the principal is providing supervision, such as reviewing and initialing incoming and outgoing correspondence, order tickets, new client forms, and advertising.

Inadequate financial statements. You are required to maintain financial records for the business, such as journals for cash receipts and disbursements, and ledgers reflecting asset, liability, reserve, capital, income and expense accounts. These should be kept in such a manner that you can produce financial statements on a timely basis in accordance with generally accepted accounting principles (i.e., on an accrual basis). Some software programs, like "Quickbooks," are generally sufficient to generate these statements. The examiners will also want to review your check register, so sole proprietors may want to set up a separate business checking account so that business income and expenses are segregated from personal (the examiners may still request to see a sole proprietor's personal account, however).

If you have custody of, or discretion over, client funds or securities, then you will need to have a surety bond of $35,000 for custody and $10,000 for discretion. You have discretion even if all you can do is trade among a family of mutual funds. If needed, a surety bond form can be obtained from the Division (see forms page). A positive net worth must be maintained at all times, not just at quarter or year end.

If you need assistance regarding these compliance issues or other investment advisor matters, please contact Sharla Kasper at (907) 465-2521.