CHAPTER 23 DELIVERY MODELS AND REGULATORY ISSUES

LEARNING OBJECTIVES

After finishing this chapter, you should be able to do the following:

  Identify when registration, licensing, reporting, and adherence to compliance regulations are required by an individual or firm offering personal financial planning services.

  Apply securities and insurance regulations to the personal financial planning process.

  Distinguish between the different delivery platforms available to a CPA firm for purposes of providing personal financial planning services.

Introduction

By now you have learned all the essential information that a personal financial planner should know, from insurance to investing, estate planning to financial independence. But what is being a personal financial planner really like? How does the overall industry work?

The discipline of personal financial planning is not yet a recognized profession. In point of fact, anyone may say they provide personal financial planning services and refer to themselves as a financial planner. Personal financial planning services may be offered by broker-dealers and their registered representatives, registered investment advisers, insurance agents or brokers, and even individuals who have no credentials related to financial services. Therefore, there is no consistency of services afforded to the public. A personal financial plan may be a detailed financial assessment of a client’s complete financial picture that addresses and integrates every aspect of the client’s financial picture, including college funding, risk management, investments, retirement, and tax and estate planning. Conversely, a planner may provide only a limited assessment, and offer one or several planning recommendations based on the products and services they sell and for which they are compensated. For example, an insurance broker may focus on personal financial planning solutions based solely on life insurance or annuities.

Because personal financial planning is not yet a recognized profession, there is not one overriding regulatory body for the profession, such as the state bars or the state boards of accountancy for the professions of law and accountancy. Instead, individuals who call themselves personal financial planners are regulated based on the products they sell or the services they offer. For example, a CPA who prepares personal financial plans is regulated by the CPA’s state board of accountancy and is subject to the Statement on Standards in Personal Financial Planning No. 1 (AICPA, Professional Standards). If that same CPA is also a registered investment adviser (RIA), then he or she has an additional layer of regulation under the SEC, as well as the state where he or she practices. And if that CPA also sells insurance products, then there is one more layer of regulation through the department of insurance in the state in which the CPA practices. Of course, not one of these regulatory bodies is integrated with the other. As a result, the CPA could inadvertently come into conflict with one body by following the rules of another.

It is the hope of the authors that personal financial planning becomes a recognized profession like accountancy, engineering, law, and medicine, and that it gains its own regulatory body. Until that time, personal financial planners will simply have to navigate a complex landscape of regulations and requirements. This chapter will help you do so by explaining current regulations.

Regulatory Landscape

The full regulatory landscape for personal financial planners is far too complex to cover exhaustively here. Instead, we will note the primary regulatory bodies involved, as well as some notable legislation at the federal and state level.

REGULATORY BODIES

There are four regulatory bodies that have the potential to affect all personal financial planners: the SEC, the Financial Industry Regulatory Authority (FINRA), the state department of insurance, and the state securities division. A personal financial planner may come under the authority of one, two, three, or all four of these regulatory agencies, contingent on the services offered or products sold.

Securities and Exchange Commission (SEC)

The SEC is an agency of the federal government. The SEC regulates the securities industry, as well as the activities of RIAs who manage assets in excess of $100 million. It also oversees the nation’s stock and options exchanges and proposes new securities regulations. Additionally, the SEC enforces securities laws such as the Securities Act of 1933, the Investment Company Act of 1940, the Investment Advisers Act of 1940, and the Sarbanes-Oxley Act of 2002.

SECURITIES NOT REGISTERED WITH THE SEC

Financial Industry Regulatory Authority

The Financial Industry Regulatory Authority (FINRA) is a not-for-profit nongovernmental organization and is a self-regulatory organization (SRO) that regulates member brokerage firms. SROs were created by the Securities Exchange Act of 1934 in order to enforce securities industry standards and the requirements related to securities trading and brokerage. FINRA is subject to regulatory oversight by the SEC and provides oversight and enforcement to the New York Stock Exchange, NASDAQ, and other over-the-counter stock exchanges.

State Departments of Insurance and State Departments of Securities

The individual states regulate the business of insurance within their individual borders. As a result, it is the state legislatures that establish laws and provide for the regulation of the business of insurance. In addition to a department of insurance, the individual states also have departments of securities that oversee the activities of RIAs who do not come under the supervision of the SEC (assets under management of less than $100 million, for example). These departments also regulate the sales of securities within, and from, the state.

SIGNIFICANT FEDERAL LEGISLATION

As we have seen, personal financial planning is not a profession per se, and as a result, there are no “laws” which govern its practice. The only federal legislation that covers personal financial planning issues—other than tax law, of course—concerns securities. There are many other products and issues related to personal financial planning, but only securities are regulated at the federal level.

Four acts form the foundation of securities law in the U.S.: the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Advisers Act of 1940, and the Investment Company Act of 1940. These laws were drafted in response to the stock market crash of 1929 and were enacted to stabilize financial markets through the regulation of the securities industry.

Securities Act of 1933

The Securities Act of 1933 (aka “truth in securities” law) requires that purchasers of new securities be provided with a detailed prospectus, or registration statement, before the purchase of the security. Full and fair disclosure of financial and other significant information concerning securities being offered for sale must be made to the potential purchaser. The act also prohibits deceit, misrepresentations, and other fraud in the sale of securities. It is important to note that although all information provided is required to be accurate, there is no regulatory body that actually guarantees the validity of the information.

Securities Exchange Act of 1934

The Securities Exchange Act of 1934 was passed to regulate the trading of securities in the secondary market on the exchanges. This act also created the SEC and gave the agency broad powers over all aspects of the securities industry. These powers include the power to register, regulate, and oversee brokerage firms and transfer agents as well as the nation’s securities SROs. The act identifies and prohibits certain types of behavior in the markets, and provides the SEC with disciplinary powers over regulated entities and persons associated with them.

Investment Advisers Act of 1940

The Investment Advisers Act of 1940 was created to monitor and regulate the activities of investment advisers and, as a result, the act defines the role and responsibilities of an investment adviser. Under the act, an investment adviser is an individual who provides advice on the management of investments, makes investments on behalf of a client, or both. Additionally, the act contains antifraud provisions protecting investors from predatory advisers, even advisers who are not registered with the SEC. Like the previous acts, the Investment Advisers Act of 1940 is enforced by the SEC.

Investment Company Act of 1940

The Investment Company Act of 1940 is the primary source of regulation for open-end mutual funds, unit investment trusts, and closed-end funds. Additionally, the act also affects the operations of hedge funds, private equity funds, and holding companies. It establishes procedures regarding filings, service charges, financial disclosure, and the fiduciary duties of investment companies. The SEC is tasked with the enforcement of the act.

SIGNIFICANT STATE LEGISLATION

Unlike securities, insurance is regulated at the state level. As a result, the regulatory landscape for insurance is very broad, as it varies from state to state. Generally, though, each state has the four goals noted in exhibit 23-1 regarding the regulation of insurance.

EXHIBIT 23-1	STATE GOALS IN REGULATING INSURANCE

There are two main acts to note regarding state legislation of insurance: the McCarran-Ferguson Act of 1945 and the Financial Services Modernization Act of 1999.

McCarran-Ferguson Act of 1945

Unless specifically prohibited by federal law, the McCarran-Ferguson Act of 1945 provides the states the authority to regulate the “business of insurance” without interference from federal regulation. The act states that the “business of insurance, and every person engaged therein, shall be subject to the laws of the several states which relate to the regulation or taxation of such business.” It should be noted that the act grants the states broad authority to regulate the insurance industry within their borders, but leaves the door open for federal legislation by not specifically preventing the federal government from regulating the insurance industry.

Financial Services Modernization Act of 1999

The Financial Services Modernization Act of 1999, also known as the Gramm-Leach-Bliley Financial Services Reform Act, allows insurance companies and banks to provide a wide variety of financial services, and reaffirmed that insurance activities, regardless of entity (bank, broker-dealer, or insurer), are regulated by the states.

Financial Services Industry Regulations and Requirements

Not all of the regulatory environment surrounding personal financial planning is dictated by federal and state laws. Rather, many of the regulations come from SROs and state licensing bodies. In this section, we discuss the main regulatory issues surrounding licensing and investment reporting.

SECURITIES LICENSING

As mentioned in the preceding section, FINRA is an SRO that regulates brokerage firms. FINRA licenses individuals and admits firms to the securities industry, writes rules to govern their behavior, examines them for regulatory compliance, and disciplines registered representatives and member firms that fail to comply with federal securities laws and FINRA’s rules and regulations. FINRA maintains the Central Registration Depository, a database of all registered individuals and firms. In addition, FINRA provides education and qualification examinations for securities industry professionals.

If an individual chooses to sell or manage securities, whether as a registered representative or an investment adviser representative, he or she must attain one of more securities licenses regulated by FINRA or the North American Securities Administrators Association (NASAA). Note that FINRA administers the licensing examinations for NASAA. The license required depends on the type of investment to be sold and how the adviser will be compensated. Table 23-1 shows the most common licenses to sell securities.

TABLE 23-1	MOST COMMON LICENSES TO SELL SECURITIES

FINRA LICENSES	NASAA LICENSES
Series 6—The Series 6 license is a limited license and permits holders to sell investment products such as mutual funds, variable annuities, and unit investment trusts. The Series 6 exam is 135 minutes long.	Series 63—The uniform securities agent license is required by each state and authorizes holders to transact business within the state. All Series 6 and Series 7 licensees must hold a Series 63, as well. The examination is 75 minutes and addresses principles of state securities regulation reflected in the Uniform Securities Act.
Series 7—The Series 7 License is a general securities representative license and permits holders to sell virtually any type of individual security. The Series 7 exam assesses the candidate’s knowledge in the areas of: sales of corporate securities, municipal securities, investment company securities, variable annuities, direct participation programs, options, and government securities. The exam is 6 hours long and quite extensive.	Series 65—The uniform investment adviser license is required for financial planners and advisers who provide investment advice on an hourly or fee basis instead of commission basis. This examination qualifies candidates to be investment adviser representatives. The exam is 180 minutes and covers rules and regulations for registered investment advisers, as well as various investments, economics, ethics, and analysis. The majority of states waive this requirement for the CPA/PFS.
	Series 66—The Uniform Combined State Law Examination combines the Series 63 and Series 65 examinations into one 150-minute exam. This exam is only available to candidates who are already Series 7 licensed.

INSURANCE LICENSING

The sale of insurance products is state-specific and, as a result, each state determines what licenses are necessary in order for an agent or broker to sell an insurance product within that jurisdiction. There is a good deal of state-by-state variation but, generally, there are three broadly defined types of insurance licenses:

•Life, Accident and Health. This license allows an agent or broker to sell life, disability, long-term care, health insurance and fixed annuities.

•Variable Contracts. Variable insurance products are a hybrid financial product. In fact, they are contracts of insurance; however, a prospectus is required when they are sold because of the variable sub-accounts they contain. These sub-accounts (Investment Company Act of 1940) are securities and are not an asset of the insurance company and are considered a separate account. In order to sell a variable product, an insurance agent must possess both an insurance license and have, as a minimum, a Series 6 and 63 registration with FINRA.

•Property and Casualty Insurance. This license allows an agent or broker to sell insurance products to businesses and individuals to insure against a variety of economic risks: liability, property damage, theft, and workers’ compensation.

In order to sell variable insurance contracts, the investment adviser must hold two licenses: either a Series 6 or 7 license and a variable contracts license from the applicable state insurance department.

REGULATORY INVESTMENT REPORTING

FINRA must be notified in writing promptly if a broker-dealer, its registered representatives, a registered investment adviser, or its investment adviser representatives are involved in any of the following circumstances:

•Violates any provision of securities law

•Subject to a written customer complaint alleging theft, misappropriation of funds, or forgery

•Named as a defendant or respondent in any legal proceeding alleging violations of the securities acts brought by a regulatory authority

•Indicted, convicted, or pleading guilty to any criminal offense

These circumstances represent some, but not all, of the events that mandate a reporting obligation to FINRA. Additionally, the information must be maintained on an annual basis. The registered representative and the investment adviser representative report to their firm any changes on Form U-4 (examples include addresses, telephone numbers, and outside business activities). The firm then notifies FINRA of these changes. Any disciplinary action taken against an adviser is also reported on Form U-4.

Delivery Platforms (Business Models)

In the current regulatory environment, personal financial planning encompasses many types of services and skills. Individuals who hold themselves out as personal financial planners come from a variety of different backgrounds and areas of specialization. In addition, there are several delivery platforms, also referred to as business models, for providing personal financial planning services. Each delivery platform has its own bias and often follows its own set of regulations. The authors hope the inherent bias of the delivery platforms can be eliminated from personal financial planning services and that the provision of these services can be standardized. For now, though, we present an overview of the various delivery platforms available to personal financial planners.

In chapter 10, our focus was primarily on regulatory models and the various ways an individual may be compensated for providing investment planning services: a registered investment adviser; a registered representative through a broker-dealer; an insurance agent, or an insurance broker. We revisit those platforms here, as well as those of insurance and trust companies as models for the delivery of personal financial planning services.

INVESTMENT ADVISERS

An investment adviser (IA) must register and be licensed with either the SEC or a state regulatory agency. Larger investment advisers, those with over $100 million of assets under management (AUM), are required to register with the SEC. Investment advisers with assets under $100 million are subject to state investment adviser laws. There are several nuances to the law, and many are jurisdictionally dependent (for example, New York and Wyoming) and are not covered in this material.

Definition of an Investment Adviser

Many times, there is a question as to whether an individual needs to be registered as an investment adviser. The Investment Advisers Act of 1940 applies a three-pronged definition for the purposes of identifying who needs to be registered as an investment adviser. Under the act, an investment adviser is any person or firm that fulfills the following:

•Provides advice to others or issues reports or analysis regarding securities

•Is in the business of providing such advice and services

•Provides those services for compensation

As shown in exhibit 23-2, these are best remembered as the ABCs of being an investment adviser. All three elements must be met in order for the definition to apply. Through extensive interpretive releases, the SEC has applied the act to personal financial planners, regardless of whether they manage assets or not, as well as other individuals who, as a part of some other financially related service, provide investment advice for compensation.

EXHIBIT 23-2	ABCS OF AN INVESTMENT ADVISER

Registration as an Investment Adviser

In order to register as an investment adviser, whether with the SEC or a state securities agency, Form ADV Parts I and II must be completed. Part I requires information about the investment adviser’s business, ownership, clients, employees, business practices, affiliations, and any disciplinary events of the adviser or its employees. Part I investment adviser forms are available to the public on the SEC’s Investment Adviser Public Disclosure (IAPD) website.

Form ADV Part II requires investment advisers to prepare a narrative brochure written in plain English that contains information such as fee structure, other business activities, educational background, security industry affiliations, and disciplinary information. This is called the Brochure Rule. The brochure is the primary disclosure document investment advisers provide to their clients. The brochure, like Form ADV Part I, is available to the public on the IAPD website.

In order to comply with the Brochure Rule, the investment adviser must provide each client with a written disclosure (normally ADV Part II) not less than 48 hours prior to entering into an investment advising contract. The Form ADV is required to be updated annually.

An investment advisory contract may not be assigned unless the client expressly consents to the transfer. Investment advisory operations are terminated by filing Form ADV-W (withdrawal). Also, the RIA’s client records must be maintained for a period of not less than five years from the end of the fiscal year of the last recorded entry.

EXCLUSIONS FROM REGISTRATION

REGISTERED INVESTMENT ADVISER

An investment adviser is an individual or a firm in the business of providing advice about securities for compensation (Advice, Business, Compensation). Typically, but not exclusively, an investment adviser will manage a portfolio of securities for clients. A registered investment adviser (RIA) is simply an IA who is “registered” with the SEC or a state securities agency. An RIA is generally paid in any one or combination of the following ways: a percentage of the value of the assets they manage (assets under management, or AUM); an hourly fee; or a fixed fee.

An RIA may be a hybrid firm and be licensed as a registered representative, as an insurance agent or broker, or both. If so, the RIA may also receive a commission on the securities or insurance products sold.

INVESTMENT ADVISERS AND FIDUCIARY DUTY

BROKER-DEALER

Because most brokerage firms operate as both brokers and dealers, they are known as broker-dealers. As you will recall, a dealer is an individual or firm acting as a principal in a securities transaction. Dealers will trade from their own securities account. The dealer purchases a security from a seller and sells the security to a buyer. The buyer receives the security from the firm’s (broker’s) inventory rather than going out into the marketplace and purchasing the security at the lowest cost.

An individual who works for a broker-dealer is referred to as a registered representative (RR) (as opposed to investment adviser representative or an insurance agent). An RR is compensated with commissions from the sale of securities products such as open-end mutual funds. Unlike an investment adviser, who is subject to a fiduciary standard, an RR is subject only to a suitability standard, which states a product or service only needs to be appropriate to a broad class of individuals as opposed to being specific to the individual client. Oftentimes, an RR will provide personal financial planning as a solely incidental benefit to a purchaser of a security.

INSURANCE COMPANY

An insurance company helps clients meet their financial goals by providing insurance products to protect their financial assets and income from a variety of risks. Insurance products can be accumulation vehicles (annuities or cash value life insurance) or a contract to purely address risk (disability insurance, term life insurance). An insurance agent or broker may provide personal financial planning as a solely incidental benefit to a purchaser of an insurance product.

TRUST COMPANY

A trust company is an organization, regulated by state law and usually associated with a commercial or private bank, that is engaged as a trustee, fiduciary, or agent for an individual. The business of a trust company is the administration of trust funds, estates, and custodial arrangements; stock transfer and registration; and other related services. A trust company may also engage in personal financial planning, fiduciary investment management, and estate planning.

Chapter Review

The concept of personal financial planning has been around for over four decades, and yet the discipline of personal financial planning has yet to become a recognized profession. The current regulatory environment allows anyone to hold themselves out as a personal financial planner. As a result, personal financial planning services are regulated by the delivery model selected by the practitioner. The result of this regulatory void is a lack of consistent services offered to the consumer. It is the continued hope of the authors that personal financial planning becomes a recognized profession.

CASE STUDY REVISITED

Recall that Pat and Robert have come to you for advice on the possibility of expanding the services offered by their CPA firm into the realm of personal financial planning.

Pat and Robert have the option of referring their clients to the various firms approaching them about providing personal financial planning services in exchange for a referral fee; however, they should be aware that in order to receive a referral fee, they have to be licensed for the product or service. They also have the option of providing personal financial planning services through these firms and their various delivery platforms. In this case, interviewing the providers of these platforms will be time well spent. They should ask each company what assistance it will provide with the regulatory structures, what training programs it provides, how the company is compensated, and whether these firms focus on personal financial planning or merely treat this service as an incidental benefit. These are all critical components of the decision-making process.

If Pat and Robert want to provide personal financial planning services in their own firm, they should consider establishing their own registered investment adviser (RIA), with themselves as investment adviser representatives or employing individuals to fulfill those roles. If they do establish their own RIA, they must decide whether they will offer personal financial planning and manage assets, or offer personal financial planning only. However, they should be aware that a new operation is very difficult to establish due to numerous regulatory requirements. If they establish their own RIA, they will need to interview several compliance firms and select one to take them through the registration process.

ASSIGNMENT MATERIAL

REVIEW QUESTIONS

1. Rendering a legal decision on the meaning of policy terms in an insurance contract is a function of which of the following?

A. National Association of Insurance Commissioners.

B. SEC

C. State insurance commissioner.

D. State court system.

2. Chocolate Cake, Inc. is going to have its initial public offering. Which of the following securities acts applies?

A. Securities Act of 1933.

B. Securities Exchange Act of 1934.

C. Insider Trading Act of 1988.

D. Investment Company Act of 1940.

3. The provisions of the Securities Act of 1933 applies to which of the following?

A. Issuance of initial public offerings.

B. Regulation of securities on the secondary market.

C. Trading of securities on exchanges.

D. Trading of Treasury bonds.

4. Kimberly is a personal financial planner who provides integrated financial planning with an emphasis on income tax planning. She is registered with the SEC as an investment adviser. Kimberly wants to sell open-end mutual funds to her clients. Does she have to register with FINRA?

A. No, because of the income tax planning she is exempt under the Investment Advisers Act of 1940.

B. No, because she is already registered as an investment adviser.

C. Yes, she is providing investment advice.

D. Yes, she will be selling open-end mutual funds.

5. Which of the following is correct under the Investment Advisers Act of 1940?

A. Allows for assignment of advisory contracts with a client’s consent.

B. Applies only to advisers registered with the SEC.

C. Does not contain antifraud provisions.

D. It regulates open-end investment companies.

6. Thomas Wade, CPA/PFS provides Form ADV Part II (Brochure Rule) to all potential clients. Which of the following items of information does not have to appear in the brochure?

A. Educational background.

B. Fee structure.

C. Other business activities.

D. Name and address of bank for the investment advisory firm.

7. Which of the following must be accomplished in order to register as an investment adviser with the SEC?

I. File with FINRA.

II. File with the state department of insurance.

III. File Form ADV Part I.

IV. File Form ADV Part II.

A. I, II.

B. II, III.

C. III, IV.

D. I, III.

8. The Investment Advisers Act of 1940 exempts certain entities and individuals from registration as an investment adviser. Which of the following is not excluded?

A. Bank.

B. Bank holding company.

C. Bank holding company investment adviser.

D. A broker or dealer whose performance of advisory services is solely incidental.

9. The SEC enforces all of the following except

A. Investment Advisers Act of 1940.

B. McCarran-Ferguson Act of 1945.

C. Sarbanes-Oxley Act of 2002.

D. Securities Act of 1933.

10. FINRA is a

I. Governmental agency.

II. Not-for-profit organization.

III. Nongovernmental organization.

IV. Self-regulatory organization.

A. I, II, IV.

B. I, III, IV.

C. II, III, IV.

D. IV.

INTERNET RESEARCH ASSIGNMENTS

1. What personal financial planning resources does FINRA make available to investors?

2. Download the SEC report Regulation of Investment Advisers by the U.S. Securities and Exchange Commission (March 2013). Other than typical accounting records, what additional records does the SEC require an RIA to maintain?

3. What are your state’s registration requirements to become an investment adviser firm or an investment adviser representative? What examinations or credentials are required to register?

4. Download the GAO report Regulatory Coverage Generally Exists for Financial Planners, but Consumer Protection Issues Remain (January 2011). What are the key findings?

5. What information is available from the Insurance Information Institute on insurance company distribution channels?

6. Visit your state’s department of insurance, often referred to as the Office of Insurance and Safety Fire Commissioner, and look up your insurance agent. What insurance licenses does your agent have?