Chapter 21 of 22 · Unit 8 · Rules and practice · 15 min read
Beginner path: read to Level 2 · Series 65 path: read to Level 3 · CFA path: read to Level 4
After this chapter you can
Every earlier chapter asked what an investment is worth. This one asks who may tell you what to buy, what that person owes you, and who checks. The rules differ for an adviser paid a fee to give advice and for a broker paid to carry out trades, and the difference shows up in your statement every year. We write this as general education on US rules. It covers the ground of the Series 65 exam at an introductory level, but it is no study course, and it gives no legal advice.
We quote dates and dollar lines only where the rule itself states them, and the Gaps section lists each one so a reader can check it against the regulator's own text before relying on it.
For every reader: the idea in plain words, no formulas.
Two kinds of professional help people invest. An investment adviser gives advice for pay, usually a yearly fee on the money looked after or a flat or hourly charge. Brokers, or more formally a broker-dealer, buy and sell securities for customers and have traditionally earned a commission on each trade or a share of the fund fees. Many people work for firms that do both, and one person may hold both licences.
Each one owes you a duty. Advisers are fiduciaries: the law expects advice that serves your interest first, with every conflict told to you plainly. Brokers owe a duty too. Since June 2020 any broker who recommends something to a retail customer must act in that customer's best interest at the time of the recommendation, under a rule called Regulation Best Interest. The two duties have grown closer, yet they still differ in one practical way: an adviser's duty runs for the whole relationship, while a broker's attaches to each recommendation.
Pay matters as much as titles. You pay a fee on assets every year whether you trade or not, and a commission only when you trade. Neither one is free of conflict. Fees on assets reward gathering assets and keeping them; commissions reward trading.
Several bodies share the job. The Securities and Exchange Commission (SEC) writes and enforces the federal rules and registers the larger advisers. Each state has its own securities regulator, which registers smaller advisers and licenses the people who work for advisers and brokers in that state. The states coordinate through the North American Securities Administrators Association, NASAA. Brokers answer to the SEC and to FINRA, an industry body that writes rules for brokers, examines them and runs most licensing exams.
You can look up any adviser or broker at no cost on the SEC's adviser search site and on FINRA's BrokerCheck. Both show registrations, past jobs and any disciplinary history.
Two safety nets get mixed up. The Federal Deposit Insurance Corporation (FDIC) insures bank deposits if the bank fails. The Securities Investor Protection Corporation (SIPC) steps in when a brokerage firm fails and customer assets are missing, by restoring the securities and cash that should have been there, up to a limit. Neither one covers a fall in the market. If your fund drops 30 % because stocks fell, no insurer pays you back. Fraud by an adviser who never held your assets at a failed broker falls outside SIPC too; your recourse then runs through regulators, arbitration and the courts. The protection most investors rely on in practice is simpler: assets held at a large, independent custodian, whose own statements show what is really there.
For readers who want the mechanism, with the diagrams.
Beginner path stops here
Congress passed the Investment Advisers Act of 1940 to cover people paid to give advice about securities. It requires registration for the larger advisers, sets record-keeping and disclosure rules, and holds an anti-fraud provision, Section 206, that applies to every adviser whether registered or not. Brokers come under a different statute, the Securities Exchange Act of 1934.
Each state acts under its own securities law, most of them modelled on the Uniform Securities Act. Drafters at the Uniform Law Commission wrote the original act in 1956 and a revision in 2002, and states have adopted parts of each. Under these laws a state registers advisers, broker-dealers, their agents and the investment adviser representatives who give advice for an adviser. A state can also refuse, suspend or revoke a registration, bring civil cases and refer criminal ones.
Federal law decides which level does what. The National Securities Markets Improvement Act of 1996 split the job: the SEC took the larger advisers and the states the smaller ones, while each state kept its anti-fraud power over everyone and its power to license the individual representatives who work there.
The Act defines an adviser by three tests, all of which must hold. The person gives advice or analysis about securities, does so as a business, and receives pay for it. A financial planner who recommends a mix of funds for a fee meets all three. So does a newsletter that tailors picks to each subscriber.
Some people meet the tests and still fall outside the definition. Banks have their own regulators. Lawyers, accountants, engineers and teachers whose advice is incidental to their profession stay outside. A broker-dealer whose advice is incidental to its brokerage and who receives no special pay for it stays outside too. In 1985 the Supreme Court held in Lowe v. SEC that a publisher of a general newsletter, sent on a regular schedule and not tailored to each reader, falls outside as well.
Which regulator an adviser registers with depends mostly on its assets under management, the money it manages on a continuous basis. Since the Dodd–Frank Act of 2010 the line has been $100 million. An adviser below $25 million registers with its home state. One between $25 million and $100 million, a mid-sized adviser, also registers with its state as a rule, with exceptions for a home state that does not examine its advisers or an adviser that would otherwise have to register in fifteen or more states. Above $100 million an adviser may register with the SEC, and above $110 million it must; once SEC-registered, it need not switch back to the state until its assets fall below $90 million at its yearly update. That band from $90 million to $110 million keeps an adviser from flipping between regulators each year as markets move.
An SEC-registered adviser still files notice in the states where it has clients, and the states still license its representatives. A state cannot make an adviser register there when it has no place of business in the state and fewer than six clients resident there during the preceding twelve months, a rule called the national de minimis standard.
Every registered adviser files Form ADV through an online system the SEC and the states share. Part 1 answers questions for the regulators: ownership, assets, types of clients, disciplinary events, and whether the adviser has custody of client money. Part 2A, the brochure, is a plain-English document for clients covering services, fees, conflicts, disciplinary history and how the adviser picks investments. Part 2B, the brochure supplement, describes each person who gives advice to a client.
An adviser hands the brochure to a client before or when they sign the advisory contract, files an updating amendment each year within 90 days of its fiscal year end, and updates it sooner when something material changes. Since June 2020 SEC-registered advisers and brokers that serve retail investors also hand out Form CRS, a short relationship summary of services, fees and conflicts. Reading a brochure before hiring anyone is the cheapest piece of research an investor can do.
Nowhere does the Act's text use the word fiduciary. Supreme Court justices read the duty into Section 206 in 1963, and in June 2019 the SEC set out in one interpretation what it means. It has two parts.
First comes the duty of care. It asks for advice in the client's best interest, based on a reasonable understanding of the client's goals, finances and tolerance for risk. It covers seeking best execution on trades and monitoring the account as often as the relationship calls for. Second, the duty of loyalty asks the adviser to put the client's interest ahead of its own. In practice that means full and fair disclosure of every material fact and conflict, so the client can give informed consent, and eliminating a conflict when disclosure alone cannot make it fair. A client can agree to the scope of the relationship. A client cannot waive the duty itself.
For decades a broker's standard was suitability: a recommendation had to fit the customer's profile, and FINRA's rule set out what the broker had to learn about the customer first. Suitability allowed a broker to recommend the higher-paying of two suitable funds.
In June 2019 the SEC adopted Regulation Best Interest, with compliance from 30 June 2020. A broker recommending a security or an account type to a retail customer must act in that customer's best interest and may not put its own interest ahead. The rule has four obligations: disclose the relationship, fees and conflicts; exercise reasonable care in each recommendation; identify and address conflicts, removing sales contests tied to particular products within a limited time; and keep written policies to comply. Reg BI still attaches to each recommendation. It sets no duty to monitor an account afterwards unless the broker agrees to.
How an adviser may promote itself changed in December 2020, when the SEC adopted a single Marketing Rule in place of its old advertising and cash-solicitation rules, with compliance from 4 November 2022. The old rules banned testimonials outright. Under the new rule an adviser may use testimonials, endorsements and third-party ratings with disclosures about who gave them and whether they were paid. Any performance shown must include net-of-fee results next to gross ones, and results for one, five and ten years when the adviser has that history. Hypothetical performance needs policies that fit it to the audience. Seven general bans apply to every advertisement, among them untrue statements, unsubstantiated claims and cherry-picked results.
An adviser has custody when it holds client money or securities, or has the authority to get hold of them. Deducting its fee straight from a client's account counts. The SEC's custody rule then asks for three protections. A qualified custodian, usually a bank or broker-dealer, holds the assets. The custodian sends account statements straight to the client at least every quarter. An independent accountant examines the assets by surprise once a year, unless the only form of custody is the fee deduction. A client who compares the custodian's statement with the adviser's own report has the best single check against theft.
FINRA began in July 2007 when the NASD merged with the member regulation arm of the New York Stock Exchange. It writes conduct rules for brokers, examines them, runs arbitration between customers and brokers, and administers the qualification exams, including the ones NASAA writes.
SIPC dates from the Securities Investor Protection Act of 1970. When a member broker fails and customer property is missing, it protects each customer up to $500,000, of which no more than $250,000 may be cash. The FDIC insures deposits at a member bank up to $250,000 per depositor, per bank, per ownership category, a level Congress made permanent in 2010. A money market fund is a security, so the FDIC does not insure it, though SIPC covers it at a failed broker the same way as other securities.
NASAA writes the Series 65, the Uniform Investment Adviser Law Examination, and FINRA delivers it. Most states require it, or a recognised designation in its place, before a person may act as an investment adviser representative. It needs no sponsoring firm. Questions fall into economics and business information, investment vehicles, client recommendations and strategies, and laws, regulations and ethics, with the law and ethics part carrying a large share of the questions. People who want both a broker's and an adviser's licence can sit the Series 7 with the Series 66, which combines the state law of the Series 63 with the adviser law of the Series 65. We leave the number of questions, the time allowed and the passing score to NASAA's own exam page, listed in the Gaps section, since those can change. Passing it does not by itself let anyone give advice: a person also needs an adviser to work for, or a registration of their own, in each state where the law asks for one. Several professional designations can stand in for the exam in many states. Readers on the Series 65 path will find the Level 3 fee math useful for the exam's questions on costs.
For Series 65 and CFA readers: formulas and worked examples.
Series 65 path stops here
A fee charged on assets comes off the return every year, so its cost compounds like the return does. We model a portfolio that earns a gross return a year and pays a fee on assets each year.
In words, the value after years equals the starting value grown at the gross return less the fee, once for each year.
Worked example A 1 % fee against a 0.25 % fee on $500,000
We assume a 6 % gross return a year, before any fee, held for twenty years; the 6 % is an assumption for the example, not a forecast. With no fee the account would reach $1,603,568. At a 0.25 % fee it reaches $1,529,599. At a 1 % fee it reaches $1,326,649. The gap between the two fees comes to $202,950 by year twenty.
The yearly difference of 0.75 percentage points looks small. Over twenty years the 1 % fee takes 25.1 % of the growth the account would have earned with no fee at all. A fee of this size can be worth paying for planning, tax work or behaviour coaching that adds more than it costs; the math tells you how much the service has to add to break even.
A clearer way to judge a fee is to set it against the return it comes out of. A 1 % fee on a 6 % gross return takes 16.7 % of the year's return. If inflation runs 2.5 %, the real return before the fee is 3.5 %, and the same fee takes 28.6 % of it.
In words, the share of the real return a fee takes equals the fee divided by the gross return less inflation.
Low expected returns make fixed fees heavier. When bond yields were near zero in 2020 and 2021, a 1 % fee on a bond fund would have taken most or all of the expected income.
Brokers often sell mutual fund shares with a front-end load, a sales charge taken once at purchase. An adviser charges a yearly fee instead. Which costs less depends on how long the investor holds. With a load the investor starts with of the money invested at the gross return; with a yearly fee the investor starts with all of it at the lower return.
In words, the break-even holding period is the log of what the load leaves you divided by the log of the yearly fee's growth penalty.
Worked example A 5.75 % load against a 1 % yearly fee
At a 6 % gross return, a 5.75 % load (a common top load on equity funds, used here as an illustration) and a 1 % yearly fee cost the same after 6.2 years. A buy-and-hold investor who keeps the fund longer pays less with the load. Moving a long-term holder with few trades from commissions into a 1 % fee account can raise the total cost, which regulators call reverse churning and treat as a conflict to examine under both the fiduciary duty and Reg BI.
Real portfolios have losing months. If monthly returns follow a normal curve with mean and standard deviation , the chance of a losing month is , and the chance of months in a row without one follows.
In words, the chance of a long run with no loss is the chance of one good month multiplied by itself once for every month.
Worked example One percent a month with a 3 % swing
We take illustrative inputs: a mean of 1 % a month and a standard deviation of 3 % a month, a stock-like strategy with a high return. The chance of a losing month is 37 %. Twelve months in a row without a loss has odds of about 1 in 253. Sixty months in a row has odds of about 1 in 1 trillion. A record of five years without a down month from a strategy that claims stock-like risk calls for an explanation before any money goes in.
The normal curve understates real tails, as Chapter 3 shows, which makes a long losing-free run even less likely for a risky strategy. A strategy with a very low standard deviation could show smooth returns honestly, so the test asks two questions together: does the claimed risk fit the smoothness, and does the claimed strategy fit the risk?
For readers who want past episodes run through the Level 3 math.
1963 Capital Gains Research Bureau and the adviser's duty
On 9 December 1963 the Supreme Court decided SEC v. Capital Gains Research Bureau. A newsletter publisher had bought shares, recommended them to subscribers, and sold into the rise its own advice caused, a practice called scalping. Writing for the Court, Justice Arthur Goldberg held that the Advisers Act's anti-fraud section made an adviser a fiduciary who must disclose such conflicts, even with no proof that any client lost money.
Scalping's arithmetic shows why disclosure became the remedy. Suppose an adviser buys at $10 and a recommendation lifts the price 5 %. Selling at the new price, the adviser keeps the rise per share; subscribers buy at the higher price and bear the fall if it fades. Each subscriber may never see a loss on a statement, which is why the Court did not require one. What harms them is advice given for a reason they cannot see.
2008 Madoff's fraud and the custody rule
The FBI arrested Bernard Madoff on 11 December 2008, a day after he told his sons his investment business was a Ponzi scheme. Final client statements showed about $65 billion in fictitious balances. He pleaded guilty in March 2009 and a federal judge sentenced him to 150 years in June 2009.
Madoff's business let him play two roles. His broker-dealer held the assets and produced the statements, so no outside custodian ever checked what the adviser reported. Harry Markopolos, an options analyst, had sent the SEC a detailed complaint in November 2005, arguing that the claimed split-strike strategy could not produce the reported returns and that the options volume it needed did not exist. SEC staff examined the business and missed the fraud. Its inspector general's 2009 report found that staff had received credible complaints from 1992 onward.
Level 3's probability test fits the case. Feeder funds reported gains near 1 % a month with very few down months over many years, from a strategy built on stocks and index options. For a strategy with stock-like risk, the odds we computed for sixty straight positive months, about 1 in 1 trillion, are the kind of number that should have stopped an investor. Nobody traded, which is why the returns looked so smooth.
In December 2009 the SEC answered with amendments to the custody rule. Advisers with custody, other than through fee deduction alone, now face a yearly surprise examination by an independent accountant. When the adviser or a related firm also acts as the qualified custodian, the adviser must get an internal control report from an independent accountant on how the custodian safeguards assets. Its aim was to stop the same people from holding the money and reporting on it with no outside check.
Dodd–Frank in 2010 asked the SEC to study whether brokers and advisers should owe the same duty, and the staff study of January 2011 recommended a uniform fiduciary standard. Rulemaking stalled. The Department of Labor moved first for retirement accounts. In February 2015 the White House Council of Economic Advisers estimated that conflicted advice cost retirement savers about $17 billion a year, roughly one percentage point of return on the affected assets. In April 2016 the Department finalised a broad fiduciary rule for retirement advice.
A one-point gap compounds the same way a fee does. On $100,000 held for thirty years at 6 % against 5 %, the Level 3 formula gives a shortfall of $142,155. Numbers of that size drove the political fight.
2018 The Fifth Circuit vacates the Labor Department's fiduciary rule
In March 2018 the Fifth Circuit Court of Appeals vacated the Department of Labor's 2016 fiduciary rule in a case brought by business groups, holding that the Department had gone beyond its authority. The SEC then finished its own package in June 2019: Regulation Best Interest, Form CRS, and the interpretation of an adviser's duty.
Reg BI was the result of that sequence. It raised the broker standard above suitability and wrote the conflict rules into regulation, while leaving the two business models in place. Investors still need to ask which hat a professional wears for each piece of advice, and Form CRS exists so they can.
Educational only. Not investment, tax, or legal advice, and not an offer of advisory services. InnovationStrat Wealth, LLC is not yet registered as an investment adviser.