Series 66 Exam Questions & Answers (SIA Instructor Verified)

Investment advisers managing portfolios typically receive a flat fee. Maybe they charge 1% of the assets, which provides incentive for the adviser. One percent of $150,000 is nice, but one percent of $200,000 is even nicer. So, the percentage stays flat, and the adviser’s compensation only grows if the customer’s assets grow.

Some advisers would prefer to take a share of the paper gains or the profits made from trading the account. Every time the adviser buys at $10 and sells at $18, the adviser gets a piece of that capital gain. What about the rest of the stocks?

That is the problem. If a client were to pay an adviser with a share of capital gains, the adviser could make a profit on one lucky stock pick even if the rest of the account goes down to zero. Say a client invested $100,000 with an investment adviser who said they were not going to charge any ongoing fees. Rather, they would just take half of any “trading profits.”

Let’s say the investment adviser puts the client into 10 stocks with $10,000 invested in each. One stock goes up from $10,000 to $18,000, and the adviser sells it for an 80% profit. The client makes a short-term capital gain of $8,000, and the adviser takes $4,000.

Now, the adviser tells the client to be patient, just wait until those 9 other stocks go up. Only, they never do. The account drops from $90,000 to $60,000 in a hurry, then slowly drifts down to $36,000, at which point the client tells the adviser to sell everything and send a check for what’s left.

So, how did the client do in this case? After putting down $100,000 the client is left with $36,000 plus a pre-tax profit of just $8,000. How did the adviser do? They made a fast profit of $4,000 with no risk to the firm.

Ouch. Or, maybe dependable, blue-chip stocks are suitable for a client’s portfolio. Unfortunately, if the investment adviser is paid on a share of capital gains/appreciation, why bother with the slow-and-steady stocks that might not go anywhere for a while? Regardless of the client’s risk tolerance, why not pick 20 of the most speculative stocks trading through the non-NASDA OTC?

Offering to share the gains or capital appreciation with an investment adviser entices the adviser to take on bigger risks and often puts the adviser’s interests in conflict with those of the client.

That is why advisers cannot be compensated as a share of capital gains or “paper gains” as a general rule. Advisers managing a portfolio, typically, are compensated as a percentage of assets over a specified period.

The Uniform Securities Act then clarifies that this rule, “does not prohibit an investment advisory contract which provides for compensation based upon the total value of a fund averaged over a definite period, or as of definite dates or taken as of a definite date.” That means that while an adviser cannot share the gains on individual stocks or take a percentage of the amount that the account “went up,” the firm can bill the client based on the average account balance over a certain period or bill a percentage of assets as of, say, the end of each financial quarter, or on the last day the market is open for the calendar year.

As we said, this is the general rule for compensation. However, if the adviser has a contract with a qualified client, performance-based compensation is allowed. A qualified client includes certain institutional clients and individuals with either $2 million of net worth (excluding the value/equity of the primary residence) or—more typically—at least $1 million of assets under the adviser’s management. Advisers to mutual and pension fund portfolios typically earn performance bonuses based on matching or beating an index that represents the portfolio’s makeup.

So, although performance-based compensation, or compensation based on the capital gains/appreciation of the account, are generally not allowed, the Uniform Securities Act includes the caveat, “Except as may be permitted by rule or order of the Administrator.”

The U.S. Supreme Court’s Howey Decision says that an “investment contract” is an:

• investment of money due to
• an expectation of profits arising from
• a common enterprise
• which depends solely on the efforts of a promoter or third party

The SEC and state securities regulators use the Supreme Court’s four-pronged approach under the Howey case to determine if an investment is an investment contract and, therefore, a security. The, “depends solely on the efforts of a promoter or third party” above means this person is providing money, not labor or management, to the enterprise. The fact that the seller had no pre-existing relationship with the buyer would factor in, as well. For example, if you have been a trusted ranch hand for many years and the owners then sell you a part-ownership of the cattle ranch, you could just be a managing member of the LLC.

But, if a farmer is offering investors the chance to provide money in exchange for a share of the farm’s profits, that is an offer of a security. It is an investment of money in a common enterprise in which the investors expect to profit through the efforts of others.

Since the investment being offered is a “security,” the farmer could end up committing securities fraud if important facts were omitted or misstated. Since this investment fits the definition of a security, the offer must be registered. A registration statement allows the state securities Administrator to perform a background check on the issuer and requires the issuer to provide full disclosure of all risks and other material information to investors.

Sometimes the owners of an LLC forget that when the business offers shares of the LLC to non-managing members, this typically meets the definition of an offer of securities, subject to, at least, antifraud regulations and, maybe, registration requirements. Full disclosure must be provided, even if this disclosure is only for a few potential investors.

Since it is not always clear if a professional meets the definition of “investment adviser,” the SEC issued a release in 1987 that attempts to explain their thought process when determining if someone is or is not an investment adviser. This release made clear that the “three-pronged” test to determine if someone is an investment adviser involves the following:

• Does the professional provide investment advice?
• Is he/she in the business of providing advice?
• Do they receive compensation for this advice?

If the answer to all three questions is “yes,” the person is an investment adviser and must register unless they can claim an exemption.

So, first, does the professional provide investment advice? This is the most difficult of the three prongs to determine. Generally, if someone helps someone decide whether to invest in securities based on the client’s needs, that person is providing investment advice. The specificity of the advice is not a determining factor. For example, if a sports agent helps clients pick investments in securities in general as an alternative to an investment in real estate or insurance-based products, then that professional is acting as an investment adviser.

In fact, if they tell clients to avoid investing in securities/to invest elsewhere, they are acting as investment advisers.

Pension consultants who help pension plans decide either which securities to invest in or whether to invest in securities over some other asset are investment advisers. The consultants who help the funds determine which investment advisers to hire or retain are as well.

What does it mean to “be in the business of providing advice”? The SEC and NASAA determined that a person is in the business of providing advice if he or she gives advice on a regular basis and that advice, “constitutes a business activity conducted with some regularity.” The frequency is a factor, but not the only factor in determining if the person is “in the business” or not.

In other words, the regulators take it case-by-case.

Providing advice does not have to be the main activity of the person, either. The person could be a CPA doing tax planning work and only providing investment advice if a client asks for it. That is close enough. If the person “holds himself out to the public” as one who provides investment advice—via business cards, billboards, letterhead, office signage, etc.—then he is in the business and is considered to be an investment adviser.

What about the compensation question, the third prong? Some would like to think they are not advisers because they do not receive money for their advice. But regulators use the broader term “compensation” to determine who is and is not an investment adviser. Compensation is any economic benefit, not necessarily money.

Even if someone other than the client pays the compensation, the person is an investment adviser. For example, if a firm advises Coca-Cola’s employees on how to allocate their 401(k) investment dollars, and bills the company, they meet the definition of an investment adviser.

Some securities agents with a Series 6 or 7 function as financial planners, even if they do not call themselves that. Many of these planners assume they can put together a financial plan for free and only get paid off any resulting commissions to avoid being defined as investment advisers.

Unfortunately, Release IA-1092 says they would likely be considered investment advisers because they receive an economic benefit because of their advice. The compensation might come directly or indirectly as the result of providing investment advice to clients. However it comes, the regulators will probably require such people to get registered.

It does not matter whether the compensation is called a “commission” or a “fee.” The compensation does not have to be listed as a separate item. The regulators, as always, look at how things function. If it were based on terminology, those who wanted to escape registration could just use different terms and function in a way that threatens investors.

Let’s distinguish an “exclusion” from an “exemption.” Some institutions and individuals are excluded from the definition of “investment adviser.” This includes banks and savings institutions. They are simply not investment advisers. A broker-dealer or securities agent who provides some investment advice but is compensated only as a broker-dealer or agent also escape the definition of “investment adviser.” That is also true of certain professionals—lawyer, accountant, teacher, or engineer—whose advice is incidental to their profession. For example, if a CPA tells a tax planning client that opening a SIMPLE IRA would provide tax advantages, the CPA is not acting as an investment adviser. However, if the CPA goes too far and tells the business owner that mutual funds are “better” than other investment vehicles, now the CPA is acting as an investment adviser—probably an unregistered one, at that.

So, if these professionals refrain from offering investment advice, they are excluded from the definition of “investment adviser.” An exemption implies an investment adviser or IAR are not subject to registration in a particular jurisdiction—but, they are, still investment advisers or IARs.

Offers of exempt securities are not required to be registered with the Administrator. Also, securities offered through exempt transactions are either not required to be registered with the Administrator or are subject to scaled-down requirements. If a company in the state offers 40% of its stock to a venture capital firm, this is an exempt transaction. The company files a notice with the Administrator after the fact. Very little disclosure of the transaction or the parties involved is provided/required.

Exempt securities, such as Treasury and municipal securities, are not subject to any registration requirement by the Administrator.

So, an offer of municipal securities is an offer of exempt securities rather than an offer of non-exempt securities being done through an exempt transaction. Exempt securities offerings are “good to go” by their nature. Only securities without exemptions require transactional exemptions, including private placements and offerings to institutional investors, if the issuer wants to avoid the typical registration process with the Administrator.

Under the Uniform Securities Act, a party who is harmed through, say, a fraudulent offer of securities, may file a civil action if it is filed within 2 years of discovery or 3 years from the event, whichever comes first. Therefore, if the party has known about the illegal nature of the sale for more than 2 years, it is too late to sue. Or, if the sale took place more than 3 years ago, it is also too late to take civil action.

Not many criminal cases arise out of state securities law, but those that do must be filed by the State within 5 years of occurrence, which is how it works for most crimes other than homicide/manslaughter and a few others.

It is not that the investment advice must be specific or highly detailed for it to be deemed “investment advice.” If the advice involves investing—or not investing—in securities, the key is whether the person providing such advice knows the investment situation of the person receiving the advice. A sports agent who knows his client’s financial situation is providing investment advice even if he says something vague, such as, “If I were you, I would put that signing bonus into real estate. Stay away from stocks and bonds.”

The sports agent receives compensation from the client. He knows his financial situation. And he just provided investment advice. If he is registered as an investment adviser, no problem. If not, he probably should be registered. Or he should stick to his area of expertise and refer his client to an investment adviser or broker-dealer who can help him.

 When an agent terminates employment with the current broker-dealer, the firm completes and files Form U5. When that is finished, the agent and the new broker-dealer complete and file Form U4. Therefore, the answer to an exam question is that the agent and both broker-dealers must/will notify the Administrator of the change of association.

Some individuals and small firms solicit new business on behalf of an investment adviser. The regulators call such persons solicitors. To use a solicitor, the adviser must be registered; there can be no outstanding order suspending, limiting, or barring the solicitor’s activities; and there must be a written agreement between the solicitor and the adviser. Also, the following conditions must be met:

• The agreement between the adviser and the solicitor must describe the solicitation activities and the compensation arrangement.
• The solicitor must provide the client with the adviser’s disclosure brochure and a separate solicitor disclosure document.
• The adviser must receive a signed acknowledgment from the client that he/she received both the
• RIA’s and the solicitor’s disclosure documents

The adviser must obtain a signed acknowledgment from the client that both disclosure brochures were received. Also, if the solicitor were some shady character, the adviser would not be able to stand back shrugging off responsibility to the regulators. The adviser is expected to do due diligence on the solicitors they use, and if an adviser knew the individual was a convicted felon and hired the solicitor anyway, the adviser would face regulatory action.

Is the solicitor required to be registered? Not by the SEC and not by all the state securities Administrators. The important point is that the adviser must be registered, must oversee the solicitor, and the solicitor cannot be someone ineligible for registration because of criminal or regulatory events.

Most states call a “solicitor” an “investment adviser representative” and make him—or them—register as such. But not all states feel that way.

Before issuing a punitive order to deny, suspend, or revoke an application or registration, the Administrator must provide prior notice, written findings of fact/conclusions of law, and an opportunity for a hearing. The Administrator can take two specific actions without first giving notice and an opportunity for a hearing. The cease & desist order can be issued without prior notice, because sometimes the thing that someone is doing or is planning to do is so outrageous the State needs to stop it immediately. Also, the Administrator can, “summarily suspend a registration pending final determination” of the matter. That means until the hearing has been held and the decision has been reached, the license is “summarily suspended.” Some states refer to a summary suspension as a “show-cause order.”