The Washington Division of Securities recently amended its investment adviser rules effective July 13, 2014. Advisers doing business in that state should familiarize themselves with the changes and determine if they need to update their business practices to comply with the new requirements. These changes update various provisions of the rules, including the rules regarding custody, financial reporting, books and records, and unethical practices. The amendments also create new rules addressing proxy voting, advisory contracts, compliance policies and procedures, and provide new exemptions from registration for 3(c)(7) private fund advisers and venture capital fund advisers. The complete text of the rule changes is available at: http://www.dfi.wa.gov/sd/rulemaking/pdf/investment-adviser/investment-adviser-2014-adopted-rules.pdf.
The following is an overview of the changes to the rules that impact registered investment adviser (RIA) firms located in or conducting business in the state of Washington. The Division of Securities has also issued FAQs concerning some of the rule amendments which may provide additional guidance: http://www.dfi.wa.gov/sd/rulemaking/pdf/investment-adviser/investment-adviser-rules-faqs.pdf.
1) Custody
The amendments revise the definition of “custody” to allow advisers three business days (rather than one) to return client funds inadvertently received. WAC 460-24A-005(1)(b).
2) Financial Reporting
RIA firms that have custody or that require payment of advisory fees six months or more in advance and in excess of five hundred dollars per client, must now file an audited financial statement with the Division. WAC 460-24A-060(1).
The amendments provide a waiver from the audited balance sheet requirement for advisers who have custody solely because they deduct fees directly, if these advisers comply with the three safekeeping requirements (written authorization from client to deduct fees, notice to custodian of fee, invoice to client). WAC 460-24A-106(3).
3) Registration requirements for advisers to pooled investment vehicles
As part of their registration application, advisers to pooled investment vehicles must now file with the Division copies of the account agreement with each qualified custodian, engagement letter with an independent certified public accountant or agreement with an independent party, private placement memorandum or other offering circular used to solicit investors to purchase interests, and operating agreement for each pooled investment vehicle. WAC 460-24A-050(5)(c).
4) Definition of “client” of investment adviser
A new rule clarifies who is deemed to be a single client and specifies how to count clients for the purposes of determining who needs to register as an investment adviser. WAC 460-24A-035.
5) Registration exemption for investment advisers to private funds
A new rule adds an exemption from investment adviser registration for advisers to qualified private funds. This exemption does not, however, apply to advisers of funds exempt from the definition of “investment company” under Section 3(c)(1) of the Investment Company Act of 1940. WAC 460-24A-071
6) Registration exemption for investment advisers to venture capital funds
A new rule adds an exemption from investment adviser registration for venture capital fund advisers. WAC 460-24A-072
7) Pending application—Notice of termination—Application for continuation
A new rule provides for the termination of pending applications where an applicant has taken no action for 9 months. WAC 460-24A-059
8) Compliance procedures and practices
A new rule requires investment advisers with more than one employee to adopt compliance policies and procedures reasonably designed to prevent violations of the Securities Act by the adviser and its supervised persons. WAC 460-24A-120. This new rule is modeled after federal Rule 206(4)-7 and requires the adviser to adopt and implement written policies and procedures to prevent violations of the Securities Act, to annually review the adequacy of the policies and procedures, and to designate a chief compliance officer to administer the policies and procedures.
9) Proxy voting
A new rule requires investment advisers who vote client securities to adopt policies and procedures reasonably designed to ensure that the adviser votes proxies in the best interest of the clients. WAC 460-24A-125
10) Contents of investment advisory contract.
A new rule specifies the requirements for the contents of advisory contracts. WAC 460-24A-130. The Division’s FAQs note that many of these requirements were previously located in WAC 460-24A-200, the books and records rule, but have now been moved to a separate rule. However, the new rule contains a couple of new requirements for advisory contracts. The adviser now must indicate in the contract the nature and extent to which the adviser is granted proxy voting authority with respect to client securities. In addition, the adviser must now disclose in the contract the nature and extent to which the adviser will deliver documents (such as account statements) to the client electronically.
The rule also changes the governing law required for advisory contracts from Washington law to the “law of the state in which the client resides.” The Division’s FAQs note that these changes will only apply to new contracts or contracts that are revised after the effective date of the rule.
11) Performance compensation arrangements
The performance compensation rule is amended to be consistent with the NASAA Model Rule and the SEC’s rule. WAC 460-24A-150(6). These amendments provide that an investment adviser or its investment adviser representative must reasonably believe that a client entering into an advisory contract that provides for performance fee compensation understands the method of compensation and its risks. According to the Division’s FAQs, an adviser can demonstrate compliance with this requirement by clearly disclosing the risks associated with a performance compensation arrangement in plain language in the advisory contract. An adviser may choose to structure his or her contract in such a manner to require a client to initial or otherwise acknowledge specific disclosures. This type of acknowledgment would tend to demonstrate that a client is aware of the method of compensation and the risks associated with it.
The FAQs further indicate that an adviser can document the information he or she evaluated in determining that a client is a sophisticated investor for whom a performance compensation arrangement is suitable. An adviser might also document any discussions with the client regarding how the fee is calculated and why the adviser is being compensated by a performance fee. The FAQs note that the fact that a client meets the definition of a “qualified client” does not in itself indicate that a performance compensation arrangement is suitable for the client.
12) Books and records to be maintained by investment advisers
The books and records rule is amended to require that advisers retain written information concerning the basis for any investment advice or recommendation an adviser makes to a client to buy or sell a security. WAC 460-24A-200(1)(s). The Division’s FAQs indicate that this retained information may include research services, industry publications, offering documents, financial statements, or an adviser’s personal investigation of a company. The adviser should retain notes regarding the materials reviewed in evaluating the suitability of a security or an investment product for his or her clients.
The books and records rule also contains a new provision to require that investment advisers retain a current written business continuity plan which is reasonably designed to enable the adviser to meet his or her fiduciary obligations in the event of emergency or significant business disruption. According to the Division’s FAQs, the plan should designate a contact person who has agreed to assist the adviser’s clients in accessing their funds or records in the event of the death or disability of the adviser. The plan should describe what will happen to client funds over which the investment adviser has custody or exercises discretion, and should discuss the procedures for refunding any prepaid advisory fees.
13) Unethical business practices—Investment advisers and federal covered advisers
The unethical business practices rule is amended to specify that making, in the solicitation of clients, any untrue statement of fact, or omitting to state a material fact necessary in order to make the statement made, in light of the circumstances under which they are made, not misleading. WAC 460-24A-220(23).
As RIA compliance consultants, we strongly recommend that the Chief Compliance Officer (CCO) all RIA firms located in or conducting business in the state of Washington review these recent regulatory changes to ensure proper compliance.