Last month I penned an article that described how the SEC expects advisors to calculate their Regulatory Assets Under Management (“RAUM”) with respect to investment management and financial planning clients. Only securities portfolios for which the advisor provides “continuous and regular supervisory or management services” count toward RAUM, but advisors that do so on a discretionary basis have a lower burden to overcome than non-discretionary advisors.
This month’s article attempts to answer the next logical question: how do I know if my firm has investment discretion?
The simplest definition can be found in the Form ADV Glossary, which states that an advisor has investment discretion if it has the authority to:
- Decide which securities to purchase and sell for the client, or
- Decide which investment advisors to retain on behalf of the client
Implicit in the definition of investment discretion is that such transaction decisions and third-party advisor selection decisions are made without the consent of the client. If the advisor simply has the authority to recommend various transactions or third-party advisors, and the client is required to consent to such recommendations before they are acted upon, the advisor does not have investment discretion.
Also notice that an advisor does not actually have to exercise its discretionary authority in order for it to be considered a discretionary advisor, it simply must have the authority to act with investment discretion. This authority is typically granted in the investment advisory agreement signed by the client, or perhaps a separate power of attorney.
It is also possible that the Investment Policy Statement (IPS) contains language pertinent to discretionary versis non-discretionary authority. However the advisor is granted discretionary authority, it should be in writing and signed by the client before such discretion is exercised. If the advisor does not want to have discretionary authority over a client’s account, that intention should also be clearly stated in writing.
Lastly, it’s important to understand the implications for advisors that outsource money management to a third party: if an advisor has the authority to hire or fire discretionary third-party money management firms without client consent, that outsourcing advisor is considered to have discretionary authority over such client assets even if the outsourcing advisor makes no other decisions with respect to the purchase and sale decisions in the client’s account.
Section 3(a)(35) of the Securities Exchange Act of 1934 also contains a definition of investment discretion, but the only meaningful difference between it and the Form ADV Glossary definition for purposes of this discussion is that the Exchange Act definition extends purchase/sale decisions to include “other property” in addition to just “securities”.
As described at the outset, whether an advisor is considered to be discretionary or non-discretionary may affects how it calculates its RAUM.
In addition, it also directly affects the advisor’s Form ADV Part 1 and Part 2. Form ADV Part 1, Item 5(f)(2), requires a breakdown of RAUM by discretionary and non-discretionary assets and accounts.
Form ADV Part 2, Item 16 is solely dedicated to an advisor’s investment discretion, and requires a discussion of any limitations a client may place over an advisor’s discretionary authority as well as the procedures the advisor follows before assuming such authority.
For certain large advisors, exercising investment discretion over $100 million or more in Section 13(f) securities triggers a quarterly holdings report that must be filed with the SEC. Section 13(f) securities “generally include equity securities that trade on an exchange (including the Nasdaq National Market System), certain equity options and warrants, shares of closed-end investment companies, and certain convertible debt securities. The shares of open-end investment companies (i.e., mutual funds) are not Section 13(f) securities.” For the avoidance of doubt, the SEC publishes an official list of Section 13(f) securities here.
I would be remiss if I did not underscore perhaps the most significant new implication for discretionary advisors: the Department of Labor’s Best Interest Contract Exemption (BICE) is not available as a prohibited transaction exemption. To quote Section I(c)(4) of BICE itself, “the exemption is not available if the Advisor has or exercises any discretionary authority or discretionary control with respect to the recommended transaction.”
Rather than butcher an explanation, I’ll let Footnote 17 of BICE do the talking: “The [DOL] notes that the exemption’s relief applies to investment advice, but not to discretionary asset management. Accordingly, the exemption would provide relief for a recommendation on how plan or IRA assets should be managed, but would not extend relief to an investment manager’s exercise of investment discretion over the assets. This is particularly relevant to ‘Level Fee Fiduciaries’…”
If nothing else I hope I’ve conveyed that investment discretion is not to be taken lightly, as it is inexorably intertwined with a host of other regulatory concepts, reporting obligations, and even ERISA.
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This article originally appeared on September 1, 2016 in ThinkAdvisor.