Prohibited Transactions of Investment Advisers

A trading desk meets this provision from two directions. Its firm may act as an adviser in a given transaction, and its customers include advisers whose own conduct the provision governs. Whether it applies turns on capacity, not on a registration record.

Who Does the Investment Adviser Antifraud Provision Bind?

The provision makes it unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly, to do any of the things it lists.

Three parts of that opening do work in a fact pattern:

• Any investment adviser. The text names no registration test.
• The mails or any means or instrumentality of interstate commerce. This is the jurisdictional hook the conduct has to travel through.
• Directly or indirectly. Conduct routed through another person is inside the provision.

Exam Tip: Gotchas

• Registration is not the test for this provision. An unregistered adviser and an exempt adviser are both inside a provision whose own text says "any investment adviser."
• The jurisdictional element is easy to satisfy and easy to forget. The conduct must use the mails or a means or instrumentality of interstate commerce, and the statute names that element expressly.

Who Counts as an Investment Adviser?

The Investment Advisers Act definitions give the term two limbs, joined by "or." The first covers any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.

The second covers any person who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.

The definition then excludes eight categories. The one a broker-dealer relies on covers any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.

Exam Tip: Gotchas

• The broker-dealer exclusion has two limbs and both have to hold. The advisory services must be solely incidental to the brokerage business, and the firm must receive no special compensation for them.
• Special compensation defeats the exclusion even where the advice is incidental. A separate advisory fee is the usual way a firm falls out of the carve-out and into the definition.
• Compensation is an element of the definition itself. Both limbs are written "for compensation," so advice given for no compensation at all does not meet the definition in the first place.

What Are the Four Prohibitions?

The provision states four prohibitions.

The first two both reach a prospective client, not only an existing one.

Exam Tip: Gotchas

• A prospective client is inside the first two prohibitions by name. Conduct during a pitch, before any advisory relationship exists, is reachable.
• The first and second prohibitions differ in what they require. One forbids employing a device, scheme, or artifice to defraud; the other forbids a transaction, practice, or course of business that operates as a fraud or deceit, which is about effect rather than about the instrument used.

What Must an Adviser Do Before a Principal or Agency Cross Trade?

The third prohibition reaches two capacities:

• As principal for his own account, knowingly to sell any security to, or purchase any security from, a client.
• As broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client.

As the statutory default, in either capacity and before the completion of the transaction, the adviser must disclose to the client in writing the capacity in which the adviser is acting and must obtain the client's consent to that transaction.

A separate federal agency-cross rule conditionally permits prospective written consent obtained after full written disclosure that the adviser will act as broker for, receive commissions from, and have a potentially conflicting division of loyalties and responsibilities regarding, both parties, when all of that rule's other conditions are met. That route does not cover a principal trade for the adviser's own account.

The paragraph then carries its own proviso. The prohibitions of the paragraph do not apply to any transaction with a customer of a broker or dealer if such broker or dealer is not acting as an investment adviser in relation to such transaction.

Exam Tip: Gotchas

• Both capacities carry the word "knowingly." The paragraph is written around a knowing sale, a knowing purchase, or a knowingly effected trade, so knowledge is part of what the words describe.
• A principal transaction subject to the statutory default needs consent to that transaction. A blanket authorization does not supply it; the conditional prospective-consent route applies to qualifying agency crosses, not to the adviser's own-account principal trade.
• The statutory default runs to completion of the transaction. Both the written capacity disclosure and the client's consent to that transaction have to be in hand before completion. A qualifying agency cross using the conditional route follows that route's prospective-consent conditions instead, and still needs a written confirmation to each client at or before the completion of each transaction.
• The proviso turns on capacity in that transaction. A firm's registrations do not decide it; the question is whether the broker or dealer was acting as an investment adviser in relation to the transaction in front of you.

What Should You Check on Exam Day?

• Ask whether the person was acting as an investment adviser in the transaction, and do not answer from the firm's registration status.
• On a broker-dealer, test both limbs of the exclusion: solely incidental advice, and no special compensation.
• On a principal trade subject to the statutory default, look for written disclosure of capacity and consent to that transaction before completion. On an agency cross, first ask whether the conditional prospective-written-consent route applies.
• Check whether the counterparty was a prospective client; the first two prohibitions name them expressly.