Introduction

Registered investment advisors (RIAs) have emerged as a significant sales channel for many distributors of structured products. RIAs advise investors with a variety of investment needs, and often help generate some of the most interesting ideas for new structured products. This article discusses RIAs, some aspects of the regulatory regime that applies to them, and the documentation used in connection with sales through this channel.

What Are RIAs?

A RIA is a professional advisory firm that provides financial advice to clients. The advice is typically intended to be personalized for a particular investor’s needs. An investment adviser that meets certain criteria is required to register under the Investment Advisers Act of 1940 (the “Advisers Act”),7 hence the term, “registered” investment adviser. In many cases, the accounts advised by RIAs represent affluent investors, or significant investment funds. After a RIA learns about a new type of product, and concludes that it is appropriate for one of its accounts, it will often consider additional accounts for which that product or similar products may be worthwhile. Accordingly, RIAs have emerged as an important distribution channel for many broker-dealers that offer structured products.

Unlike broker-dealers, which are required to undertake a suitability determination before recommending a security to an investor, investment advisors are subject to fiduciary duties in making a recommendation. Of course, this distinction between broker-dealers and investment advisers is subject to new rulemaking as a result of the Dodd-Frank Act, and may change in the not-so-distant future.

How Sales Are Made Through RIAs

RIAs may be authorized by contract to make investment decisions on behalf of investors (a “discretionary account”). Alternatively, an RIA may simply provide investment advice, and in connection with any particular sale, the investor advised by the RIA may make the actual investment decision. In either case, the broker-dealer’s communications are typically conducted with the RIA, and the offering documents are provided by the broker-dealer through the RIA.

In connection with structured product sales, products offered on a weekly or monthly calendar basis may be offered to RIAs. In addition, many RIAs are involved in “reverse inquiry” transactions, in which an RIA approaches a broker-dealer with a request for a particular structure, or approaches multiple broker-dealers with a request for “competitive bids.”

RIAs and FINRA’s Suitability Rules

Accounts advised by RIAs are deemed to be “institutional accounts” under the FINRA rules.8 Because of these relationships, the broker-dealer that offers the product is subject to a more limited set of suitability requirements under FINRA Rule 2111 when selling to accounts that are advised by RIAs. A broker-dealer fulfills the customer-specific suitability obligation for an institutional account if:

  • the broker has a reasonable basis on which to believe that the institutional customer is capable of evaluating investment risks independently; and
  • the institutional customer affirmatively indicates that it is exercising independent judgment in evaluating the member’s or associated person’s recommendations.

Rule 2111 does not require a broker-dealer to have a hard-copy agreement on file showing that an institutional customer intends to exercise independent judgment; a firm can take a risk-based approach to documenting it.9

We note that this reduced suitability requirement relates to customer-specific suitability. The broker-dealer remains subject to FINRA’s reasonable basis suitability requirements with respect to the development and offering of the product itself.10

RIAs and FINRA’s Communications Rules

Communications from broker-dealers to RIAs are also subject to a somewhat easier compliance burden under FINRA’s communications rules. Communications designed exclusively for RIAs, as opposed to those for a typical individual investor, are deemed to be “institutional communications” under Rule 2210(a)(3) as opposed to “retail communications.”

RIAs and FWPs (A Little Alphabet Soup)

As discussed above, many RIAs have the ability to make investment decisions on behalf of the investors that they represent. Accordingly, in many cases, preliminary term sheets and other offering documents provided to RIAs will be “free writing prospectuses” for purposes of the Securities Act. However, these documents will not be subject to any filing requirement with the SEC:

  • many of these documents will be “preliminary term sheets” that are not subject to filing under Rule 433(d)(5)(i); and
  • many of these documents will be “underwriter free writing prospectuses” that are not subject to filing under Rule 433(d)(1)(i).

Agreements Between Brokers and RIAs

In light of the regulations outlined in this article, a variety of common provisions can be identified in the agreements that are often executed between broker-dealers and RIAs relating to the sales of structured products and other instruments.

First, we note that RIAs are often thought of as the “customers” of the broker-dealers who are selling to them. Accordingly, broker-dealers are sensitive to the possibility of rendering themselves unattractive to RIAs by offering up an over-detailed and lengthy agreement, particularly when an RIA does not have an in-house legal department that can review and negotiate these documents efficiently. Similarly, RIAs are not broker-dealers and are not acting like broker- dealers; accordingly, the typical “master selected dealer” or similar agreement will typically not be appropriate for a relationship with an RIA.

Representations. In addition to the possibility of customary housekeeping representations, the RIA will represent as to its registered status under, and compliance with, the Advisers Act.

Authority to Make Investment Decisions. A broker-dealer will typically communicate with the RIA, as opposed to with the accounts that the RIA represents. Accordingly, the RIA will often represent that it possesses the authority to make investment decisions on behalf of its customers.

Investment Judgment. In selling through the RIA network, RIAs would prefer to be subject to the reduced suitability standard that FINRA applies to institutional accounts. As a result, a typical agreement with an RIA will have the RIA confirm that it is exercising independent judgment in making an investment decision with respect to the relevant instrument.

Offering Materials. An RIA will agree to provide on a timely basis to the relevant accounts any offering materials and securities confirmations provided by the broker-dealer. In order to help ensure that any materials prepared for institutional accounts only do not inadvertently become subject to FINRA’s retail communications rules, the RIA will typically also agree not to provide any materials to investors that the broker-dealer or issuer have not authorized for that purpose.

Any such agreement will be typically designed to refer over time to multiple offerings, and to be reaffirmed at the time that each sale is made.

RIA Compensation and Structured Notes

RIAs are often compensated by investors based upon their assets under management. Typically, they will not receive a brokerage or similar fee at the time of a pricing or settlement, as broker-dealers do. Accordingly, sales through this channel can often be made at a lower purchase price, or with slightly improved offering terms, as compared to sales in which brokerage fees need to be factored into the economics.

In the case of registered structured notes, these arrangements will often result in securities that have an estimated initial value that is closer to par than that of some other types of offerings. In addition, where securities are sold at par through brokerage accounts, and simultaneously at a discounted price to advisory accounts, the cover page of the offering documents will disclose this differential in order to comply with FINRA’s fixed price rules.