FINRA Series 65 Uniform Investment Adviser Law Exam Key Study Note

The Efficient Market Hypothesis (EMH) posits that asset prices fully reflect all available information. This has significant implications for investment advisers. If markets are efficient, it becomes exceedingly difficult to consistently achieve above-average returns through active management. The weak form of EMH suggests that current stock prices already reflect all past market data, implying that technical analysis is futile. The semi-strong form asserts that current prices reflect all publicly available information, rendering fundamental analysis ineffective in generating superior returns. The strong form claims that prices reflect all information, including private or insider information, making it impossible for anyone to gain an advantage. Investment advisers must understand these forms to manage client expectations and choose appropriate strategies. While some may still pursue active strategies, others may opt for passive strategies like indexing, which align with the EMH by accepting market returns. The choice depends on the adviser’s belief in market efficiency and the client’s risk tolerance and investment goals. It’s crucial to disclose the limitations of any strategy in light of the EMH, adhering to fiduciary obligations under the Investment Advisers Act of 1940.

Duration is a measure of a fixed-income security’s price sensitivity to changes in interest rates. It represents the approximate percentage change in a bond’s price for a 1% change in interest rates. A higher duration indicates greater sensitivity. Understanding duration is crucial for managing interest rate risk, a systematic risk affecting all fixed-income investments. For example, if a bond has a duration of 5, its price is expected to fall by approximately 5% if interest rates rise by 1%. An investment adviser can use duration to construct a bond portfolio that aligns with a client’s risk tolerance and investment objectives. If a client is risk-averse and concerned about rising interest rates, the adviser might shorten the portfolio’s overall duration by investing in shorter-term bonds or using strategies like interest rate swaps. Conversely, if a client anticipates falling rates, the adviser might lengthen the portfolio’s duration to capitalize on potential price appreciation. This management is part of the adviser’s fiduciary duty under the Investment Advisers Act of 1940, requiring them to act in the client’s best interest.

Strategic asset allocation involves setting target asset allocation percentages based on a client’s long-term investment objectives, risk tolerance, and time horizon. It’s a passive approach that assumes markets are relatively efficient over the long run. The portfolio is periodically rebalanced to maintain the target allocation. Tactical asset allocation, on the other hand, is an active management strategy that involves making short-term adjustments to asset allocation percentages based on market conditions and economic forecasts. The goal is to capitalize on perceived market inefficiencies and generate above-average returns. An investment adviser determines the most suitable approach by considering the client’s investment philosophy, risk tolerance, and investment knowledge. Clients with a long-term focus, low-risk tolerance, and limited investment knowledge may benefit from strategic asset allocation. Clients who are comfortable with higher risk, have a shorter time horizon, and believe in the potential for active management may prefer tactical asset allocation. The adviser must disclose the risks and costs associated with each approach, ensuring compliance with the Investment Advisers Act of 1940 and fulfilling their fiduciary duty.

Soft dollars refer to the practice where an investment adviser uses client brokerage commissions to pay for research and other services that benefit the adviser. This practice creates a conflict of interest, as the adviser may be incentivized to choose brokers based on the value of the research they provide rather than the best execution for the client’s trades. Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor for advisers who receive research services in exchange for client brokerage commissions, provided certain conditions are met. The research must provide lawful and appropriate assistance to the adviser in making investment decisions for its clients. This includes analysis, reports, and advice. The adviser must also determine that the commission paid is reasonable in relation to the value of the research services received. Advisers must disclose their soft dollar arrangements to clients, including the types of research and services received, the brokers used, and any potential conflicts of interest. This disclosure is required under the Investment Advisers Act of 1940 and helps clients understand how their brokerage commissions are being used. Failure to adequately disclose soft dollar arrangements can result in regulatory action.

The Uniform Prudent Investor Act (UPIA) provides a modern framework for trustees and investment advisers managing trust assets. It replaced the traditional “prudent man” rule with a more comprehensive and flexible standard of care. UPIA emphasizes diversification, risk management, and the suitability of investments for the specific trust beneficiaries. Under UPIA, an investment adviser must consider the overall investment strategy of the trust, taking into account the beneficiaries’ needs, risk tolerance, and other resources. The adviser has a duty to diversify investments to minimize risk, unless special circumstances warrant otherwise. UPIA also allows for the delegation of investment functions to qualified professionals, but the trustee (and by extension, the investment adviser) retains a duty to oversee the delegate’s performance. UPIA requires a focus on the total return of the portfolio, rather than just income generation, allowing for a more flexible investment approach. It also provides specific guidance on factors to consider when making investment decisions, such as tax implications and inflation. By adopting UPIA, states have modernized their trust laws to better reflect current investment practices and the needs of beneficiaries. Investment advisers managing trust assets must be familiar with UPIA to ensure they are meeting their fiduciary obligations.

“Selling away” refers to an Investment Adviser Representative (IAR) engaging in securities transactions outside the scope and supervision of their registered investment adviser (RIA) firm. This practice is a serious violation of securities regulations and ethical standards. It often involves the IAR recommending or selling investments that are not approved or offered by their firm, potentially without the firm’s knowledge or oversight. The legal ramifications of selling away can be severe. The IAR may face disciplinary action from regulatory bodies like the SEC or state securities administrators, including fines, suspensions, or revocation of their registration. The IAR may also be subject to civil lawsuits from clients who have suffered losses as a result of the unauthorized transactions. Ethically, selling away violates the IAR’s fiduciary duty to act in the best interests of their clients. By engaging in outside transactions, the IAR may be prioritizing their own financial gain over the clients’ needs. This practice also undermines the supervisory responsibilities of the RIA firm, which is responsible for ensuring that its representatives are complying with securities laws and regulations. Rule 203A-1(a) of the Investment Advisers Act of 1940 requires advisers to supervise their representatives.

A business continuity plan (BCP) is a comprehensive strategy that outlines how a registered investment adviser (RIA) will continue operating in the event of a significant disruption, such as a natural disaster, cyberattack, or pandemic. Key elements of a BCP include data backup and recovery, alternative communication methods, succession planning, and procedures for accessing client funds and securities. A BCP is essential for protecting clients’ interests because it ensures that the RIA can continue to provide investment advice and manage client assets even during a crisis. Without a BCP, clients could experience significant delays in accessing their funds or receiving important information, potentially leading to financial losses. While there isn’t one specific rule mandating a BCP, the SEC expects RIAs to have adequate plans in place as part of their overall compliance obligations under the Investment Advisers Act of 1940. Specifically, Rule 206(4)-7, the “Compliance Rule,” requires RIAs to adopt and implement written policies and procedures reasonably designed to prevent violations of the Act. A robust BCP is considered a critical component of these policies and procedures. Furthermore, some states may have specific requirements for BCPs. The SEC also provides guidance on cybersecurity and encourages firms to address these risks in their BCPs.

The Efficient Market Hypothesis (EMH) posits that market prices fully reflect all available information. There are three forms: weak (prices reflect past data), semi-strong (prices reflect all public information), and strong (prices reflect all information, public and private). If the market is efficient, active management strategies aimed at outperforming the market are futile. Investment advisers adhering to EMH typically favor passive strategies like indexing, minimizing transaction costs and focusing on asset allocation to match a client’s risk tolerance and investment goals. However, the EMH has limitations. Anomalies exist where certain strategies or securities persistently outperform the market, contradicting EMH. Behavioral finance demonstrates that investors are not always rational, leading to market inefficiencies. Furthermore, EMH doesn’t account for the impact of insider information, which can provide an unfair advantage. Investment advisers must balance EMH principles with real-world market dynamics and client-specific needs, as outlined in Investment Advisers Act of 1940, which emphasizes the fiduciary duty to act in the client’s best interest.

C corporations are subject to double taxation: the corporation pays taxes on its profits, and shareholders pay taxes on dividends received. S corporations, on the other hand, are pass-through entities, meaning profits and losses are passed directly to the shareholders’ individual income tax returns, avoiding corporate-level taxation. Partnerships also operate as pass-through entities, with partners reporting their share of income or losses on their individual returns. These differences significantly impact investment recommendations. For clients owning C corporations, strategies may focus on minimizing corporate tax liabilities and optimizing dividend distributions. For S corporations and partnerships, investment decisions must consider the individual tax situations of the owners, including their marginal tax brackets and the potential impact of pass-through income on their overall tax liability. Investment advisers must understand these nuances to provide suitable advice, adhering to the fiduciary duty outlined in the Investment Advisers Act of 1940, and considering relevant IRS regulations.

Custody, as defined under Rule 206(4)-2 of the Investment Advisers Act of 1940, involves holding, directly or indirectly, client funds or securities, or having the authority to obtain possession of them. This includes legal ownership, access to client funds, or the ability to withdraw funds. If an investment adviser has custody, they are subject to stringent requirements to protect client assets. These include: (1) qualified custodian: maintaining client assets with a qualified custodian (e.g., bank, broker-dealer); (2) notification: notifying clients of the custodian’s name, address, and account number; (3) account statements: ensuring clients receive quarterly account statements directly from the qualified custodian; and (4) surprise examination: undergoing an annual surprise examination by an independent public accountant to verify client assets. Failure to comply with these requirements can result in regulatory sanctions and potential legal liabilities. The SEC emphasizes these rules to prevent fraud and protect investors.

“Soft dollars” refer to arrangements where an investment adviser receives research or other services from a broker-dealer in exchange for directing client brokerage transactions to that broker. Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor, allowing advisers to pay more than the lowest available commission rate if they determine in good faith that the commission is reasonable in relation to the value of the brokerage and research services received. Permissible uses of soft dollars include research reports, analytical software, and attendance at research seminars. Impermissible uses include paying for travel, entertainment, or direct cash rebates. Investment advisers must disclose their soft dollar practices to clients, including the types of research and services received, and whether clients may pay more than the lowest available commission rate. Failure to adequately disclose soft dollar arrangements can constitute a breach of fiduciary duty under the Investment Advisers Act of 1940, potentially leading to regulatory action.

Performance-based fees, also known as incentive fees, are compensation arrangements where an investment adviser’s fee is based on a share of capital gains or appreciation in a client’s account. Rule 205-3 of the Investment Advisers Act of 1940 imposes strict limitations on charging such fees. Generally, performance-based fees are permitted only with “qualified clients,” defined as those having at least $1.1 million under management with the adviser or a net worth of more than $2.2 million. The rule also requires that the performance fee be based on a formula that includes a benchmark against which the adviser’s performance is measured. The contract must disclose the method of calculating the fee, the benchmark used, and any periods used for measuring performance. Furthermore, the adviser must reasonably believe that the client understands the risks associated with performance-based fees. These requirements aim to protect less sophisticated investors from potentially unfair or excessive fees.

“Selling away” refers to an Investment Advisor Representative (IAR) engaging in securities transactions outside the scope and supervision of their registered investment adviser (RIA) firm. This often involves recommending or selling investments that are not approved by the firm, potentially without proper due diligence or compliance oversight. “Market manipulation” involves actions taken to artificially inflate or deflate the price of a security for personal gain. Examples include spreading false information, creating artificial trading volume (wash sales), or engaging in matched orders. Both selling away and market manipulation are strictly prohibited under securities laws and regulations, including the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940. An IAR engaging in these activities faces severe consequences, including regulatory sanctions (e.g., fines, censures, suspensions, and revocation of registration), civil lawsuits from defrauded investors, and potential criminal prosecution. The RIA firm may also face liability for failure to supervise the IAR.

A business continuity plan (BCP) is a documented strategy that outlines how a registered investment adviser (RIA) will respond to and recover from disruptions to its business operations, including natural disasters, cyberattacks, and other emergencies. Key components of a BCP include: (1) data backup and recovery procedures; (2) alternative communication methods; (3) physical location contingencies; (4) financial and operational assessments; (5) regulatory reporting procedures; and (6) client communication protocols. The SEC’s guidance on cybersecurity emphasizes the importance of RIAs implementing robust cybersecurity measures to protect client data and prevent disruptions. This guidance directly impacts the BCP by requiring RIAs to incorporate cybersecurity incident response plans, including procedures for detecting, responding to, and recovering from cyberattacks. The BCP must address data breaches, system outages, and other cybersecurity-related disruptions, ensuring the RIA can continue to provide services to clients while protecting their sensitive information. Failure to adequately address cybersecurity risks in the BCP can result in regulatory scrutiny and potential enforcement actions.