Do’s and Don’ts for Investment Advisors

Hari Dwivedi | corplaw@vinodkothari.com

Introduction

SEBI, the regulatory body overseeing various intermediaries in primary and secondary markets, such as merchant bankers, portfolio managers, research analysts, debentures trustees, underwriters, stock brokers, sub brokers, bankers to an issue, investment advisors, registered custodians, and more, has registered over 33,000 intermediaries as per SEBI’s recognized intermediaries data. Among them, there are 1331 Investment Advisors (referred to as “IA”) as on 24^th September, 2023. In this article, we will discuss the role of IA in the securities market and outline some important do’s and don’ts for them, given their significant role.

IA plays a pivotal role in facilitating prudent financial decision-making for both individuals and institutions. Their expertise, customized strategies, and risk management proficiency are instrumental in aiding clients to realize their financial objectives and navigate the intricacies of financial markets. This client-advisor relationship hinges on a foundation of trust, invoking a stringent fiduciary obligation upon IA. They are ethically and legally mandated to prioritize the best interests of their clients, entailing the provision of transparent and candid counsel, the avoidance of conflicts of interest, and meticulous disclosure of any potential conflicts. In fulfilling these responsibilities, it is imperative for IA to meticulously adhere to the regulatory provisions, observing both the prescribed protocols and constraints. This not only safeguards against penalties but also upholds client satisfaction, fostering a harmonious and productive relationship.

But before we delve into the do’s and don’ts for an IA, let’s first understand who is an IA under the applicable legal provisions.

Our other related and relevant write ups on similar issues can be read below:

• SEBI Guidelines for Investment Advisers
• Partitioning of advisory services from distribution activities
• SEBI proposes to regulate ‘Finfluencers’
• Snippet SEBI Consultation Paper (CP) to curb association of SEBI Registered Intermediaries (RIs) with unregistered Finfluencers

Who is an Investment Advisor?

An IA, as defined under Reg. 2(m) of the SEBI Investment Advisers Regulations, 2013 (hereinafter referred to as “the Regulations”), encompasses any individual or entity that, in exchange for compensation, is actively involved in the business of furnishing investment advice to clients or other individuals or groups. This definition also encompasses those individuals who present themselves as IA, regardless of the terminology used.

It is paramount to underscore that the entirety of this definition is contingent upon the term investment advice. Therefore, it is crucial to delve into the meaning of the term investment advice as delineated in the Regulations.

According to Reg. 2 (l) of the Regulations, investment advice means:

1. advice concerning investments, buying , selling or otherwise dealing in securities or other investment products;
2. advice on investment portfolios containing securities or investment products and;
3. includes financial planning irrespective of fact whether advice is oral, written or through any other means of communication for the benefit of the client.

Who can Register themselves as IA ?

Under the Regulations persons who can obtain registration has been categorized as individual and non-individual, under non-individual category following person has been mentioned:

1. Body Corporate which shall have same meaning as defined under the Companies Act, 2013
2. Firm which is registered under the Indian Partnership Act, 1932
3. Limited Liability Partnership which is registered under Limited Liability Partnership Act, 2008

Further person who wants to be registered as IA must also fulfill the following eligibility criteria:

• Individual IA, principal advisor in case of body corporate and firm shall have following minimum qualification at all times:
  • A professional qualification or post-graduate degree or post-graduate diploma (minimum two years in duration) in one of the following fields: finance, accountancy, business management, commerce, economics, capital market, banking, insurance, or actuarial science from a university or an institution recognized by the Central Government, any State Government, a recognized foreign university or institution, or association; or completion of a Post Graduate Program in the Securities Market (Investment Advisory) from NISM of a duration not less than one year or has obtained CFA Charter from the CFA Institute.
  • A minimum of five years of experience in activities related to advice in financial products, securities, fund management, or portfolio management.
  • Further Individuals affiliated with the IA must fulfill the qualifications outlined in point (a) and possess a minimum of two years of experience in activities related to providing advice on financial products, securities, or managing funds, assets, or portfolios.

• Individual IAs or principal officers of non-individual IAs, who are registered under these regulations, and individuals associated with providing investment advice must maintain a certification in financial planning, fund, asset, or portfolio management, or investment advisory services obtained from NISM or from another accredited organization or institution, including the Financial Planning Standards Board of India or any recognized stock exchange in India, provided that NISM accredits such certifications.
• IAs, whether individual or non-individual, are required to meet certain financial criteria. Non-individual IAs must maintain a minimum net worth of fifty lakh rupees, while individual IAs are mandated to possess net tangible assets valued at no less than five lakh rupees.
• IA and persons associated with investment advice working with him shall be fit and proper persons as per Schedule II of the SEBI (Intermediaries) Regulations, 2008.

Which regulations are applicable on Investment Advisors?

The regulatory framework for registered IA in India is given below:

1. SEBI Investment Advisor Regulations, 2013 and Code of Conduct made thereunder.
2. SEBI Intermediaries Regulations, 2008          
3. SEBI Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market Regulations, 2003
4. SEBI Circular on Measures to strengthen the conduct of Investment Advisers dated 27th December, 2019
5. SEBI Circular on Guidelines for Investment Advisor dated 23rd September, 2020
6. SEBI Circular on Publishing of Investor Charter and disclosure of Investor Complaints by Investment Advisers on their websites/mobile applications dated 13th December, 2021
7. SEBI Circular on Investment Advisory Services for Accredited Investors dated 21st December, 2021

Important Adjudications

In the world of finance, adherence to regulatory provisions is paramount, and IA are no exception. A failure to comply with the regulations can result in heavy penalties, as demonstrated by several adjudication orders issued against IA. These cases underscore the importance of strict compliance with legal requirements.

Charging Higher Fees:

On 23^rd September 2020, the Securities and Exchange Board of India (SEBI) issued a circular that laid out clear guidelines regarding the fees that IAs can charge their clients. There are two prescribed modes of fee calculation:

• Assets under Advice Mode: Under this method, the maximum fee an IA can charge a client annually is capped at 2.5% of the client’s Assets under Advice (AUA).

• Fixed Fee Mode: In this mode, the maximum fee an IA can charge a client annually is limited to Rs. 1.25 lakh.

However, instances of non-compliance have led to significant penalties. For example, in the case of M/s. MI Research, a penalty of Rs. 35 lakh was imposed for collecting unreasonably high fees and failing to meet the basic requirements set forth in the Regulations and the Code of Conduct for IAs. Similarly, Manu Chhabra, an Investment Advisor, faced a penalty of Rs. 4 lakhs for charging fees exceeding the maximum limit of Rs. 1.25 lakhs in the fixed fee mode and for neglecting to maintain client PAN details.

 Not Conducting Internal Audits:

Regulation 19(3) of the Regulations mandates that IAs conduct yearly audits to ensure compliance with the regulatory framework. The audit is typically carried out by a member of the Institute of Chartered Accountants of India (ICAI) or the Institute of Company Secretaries of India (ICSI).

In the matter of Banayantree Services Limited, an Investment Advisor, Banayantree Services Limited faced the consequences of not conducting internal audits. The adjudicating officer imposed a penalty of Rs. 3 lakhs for this failure, along with infrastructural deficiencies and non-compliance with qualification and certification requirements. Additionally, the IA’s activities were not properly segregated from other business operations.

 Not Redressing Client Grievances:

The responsibility to promptly address client grievances lies with IAs, as stipulated in Regulation 21 of the Regulations.

In the case of Capvision Investment Advisor, the IA faced a penalty of Rs. 16 lakhs for violating the code of conduct and Regulation 21(1) concerning the prompt redressal of client grievances. It’s worth noting that the penalty was later reduced to 8 lakhs by the Securities Appellate Tribunal (SAT), considering the IA’s status as a smaller investment advisor.

These real-world examples emphasize the critical importance of compliance for IAs, not only to avoid hefty penalties but also to uphold their professional integrity and protect the interests of their clients. Complying with regulations is not merely a legal obligation but a fundamental aspect of maintaining trust and credibility in the financial industry.

Do’s And Don’ts of Investment Advisors

Do’s for IA under the Regulations and Circulars issued by SEBI:

1. Act in a Fiduciary Capacity: Always prioritize the best interests of your clients and maintain a fiduciary relationship with them.
2. Maintain Arm’s Length Relationship and Segregate Activities: An investment adviser is required to keep a clear separation between its functions as an investment adviser and any other activities it may be involved in. Additionally, if the investment adviser engages in activities beyond providing investment advisory services, it must ensure that its investment advisory services are distinctly isolated from all its other operations, following the specified guidelines.
3.  Disclose Conflicts of Interest: Promptly disclose any conflicts of interest to clients as they arise.
4. Follow Know Your Client (KYC) Procedures: Adhere to KYC procedures specified by the regulatory authority.
5. Abide by Code of Conduct: Comply with the Code of Conduct as specified in the regulations.
6. Change Control Approval: Seek prior approval from the regulatory authority in case of any change in control of your investment advisory business.
7. Charge fees under either of two modes:
   • Assets under Advice (AUA) mode -The maximum fee charged under this method shall not exceed 2.5% of AUA per annum per client across all services offered by IA.
   • Fixed fee mode -The maximum charged under this method shall not exceed 1,25,000 per annum per client across all services offered by IA.
8. Demonstrate AUA with Supporting Documents: Ensure that AUA is supported with relevant documents such as demat statements and unit statements of the client when charging fees under the AUA mode.
9. Deduct Pre-existing Distribution Arrangement: Deduct any portion of AUA held by the client under pre-existing distribution arrangements with other entities when calculating fees under the AUA mode.
10. Consider Family of Client as a Single Client: If multiple family members are considered a single client, apply the fee limits accordingly for the entire family.
11. Charge Fees Annually: Charge fees from a client under either the AUA or Fixed fee mode on an annual basis, and do not switch between modes until at least 12 months have passed since onboarding or the last mode change.
12. Offer Advance Fee Payment Option: If agreed upon by the client, consider charging fees in advance. However, ensure that the advance payment does not exceed fees for two quarters.
13. Collecting information from the client: Ensure collecting all the information which is necessary for giving advice.
14. Process for assessing Client’s risk tolerance: Develop a comprehensive process for evaluating a client’s risk tolerance, considering their capacity to absorb losses, identifying any unwillingness or inability to accept capital loss, and ensuring that client responses to questions are interpreted appropriately without assigning undue weight to specific answers
15. Communication to the client: Risk profile of client must be communicated to the client after risk assessment is done and information provided by them must be updated periodically.
16. Align Investments with Client’s Risk Profile: Ensure that all investment recommendations match the risk profile of the client, considering their risk tolerance and capacity to absorb potential losses.
17. Document Investment Selection Process: Maintain a documented process for selecting investments based on the client’s specific investment objectives and financial situation.
18. Understand and Align with Product Risks and Client Objectives: Develop a comprehensive understanding of the nature and risks linked to recommended products or assets and ensure that all recommendations align with the client’s investment objectives and their capacity to bear associated risks.
19. Assess Client Experience and Knowledge: Determine that the client possesses the necessary experience and knowledge to comprehend the risks involved in the transaction.
20. Assess Complex Financial Products Appropriately: When advising on complex financial products, make recommendations based on a reasonable assessment that considers the client’s experience, knowledge, investment objectives, risk appetite, and capacity to absorb potential losses.
21. Provide Full Information: Disclose all material information about your business, disciplinary history, advisory service terms and conditions, affiliations with other intermediaries, and any other essential information to help clients make informed decisions.
22. Disclose Holdings: Inform clients about your holdings or positions, if any, in the financial products or securities you are advising on.
23. Reveal Conflicts of Interest: Disclose any actual or potential conflicts of interest arising from connections or associations with product or securities issuers. Provide all relevant information that may affect your objectivity and independence.
24. Share Material Facts: During investment advice, adequately disclose all material facts about the key features of the products or securities, particularly their performance track record.
25. Highlight Warnings: Draw your client’s attention to any warnings or disclaimers present in documents or advertising materials related to an investment product that you are recommending.
26. Maintain Comprehensive Records: Keep well-organized records, including Know Your Client information, risk profiles, suitability assessments, client agreements, investment advice provided (written or oral), the rationale for advice, and a client register detailing advice dates, nature, products/securities, and fees.
27. Preserve Records Securely: Maintain records in either physical or electronic format and store them securely for a minimum of five years. Digitally sign electronic records where required.
28. Conduct Yearly Internal Audit: Ensure an annual audit of compliance with regulatory requirements conducted by a qualified professional, such as a member of the Institute of Chartered Accountants of India or the Institute of Company Secretaries of India, and submit the required report to the regulatory authority.
29. Promptly address Client’s Grievances: All the clients grievances must be redressed promptly within a specified timeline of the respective portals on which such grievances have been raised.
30.  Establishment of Grievance Redressal Procedure: It is statutory obligation on IA to establish the grievance redressal procedure under the Regulations. IA shall ensure the established procedures are effective in handling the clients grievances.
31. Collaborate with Regulatory Authorities: Cooperate fully with regulatory authorities responsible for handling grievances related to specific financial products, ensuring adherence to regulatory requirements.
32. Consider Arbitration or Ombudsman Services: Encourage clients to explore dispute resolution options, such as arbitration or Ombudsman services offered by regulatory authorities, to provide clients with fair and impartial avenues for resolving disputes.
33. Implementation Services to Advisory Clients: IA shall provide implementation services to only its advisory client and shall not provide implementation services to any other person.

Don’ts for IA under the Regulations and Circulars issued by SEBI:

1. Receive Compensation from Third Parties: Do not accept remuneration or compensation from anyone other than the client for the products or securities you provide advice on.
2. Divulge Client Information Without Permission: Do not disclose confidential client information without the client’s prior permission, except as required by law.
3. Engage in Conflicting Transactions: Avoid engaging in transactions that conflict with the advice given to clients for a period of fifteen days after providing the advice.
4. Act Against Your Advice: Refrain from knowingly selling securities or investment products to, or purchasing them from, a client if it contradicts the advice you’ve given.
5. Restriction on Providing Distribution Services: An individual IA and his family shall not provide distribution services to clients and IA shall not provide investment advice services to a client who is receiving distribution services from his\her family members. Our article covering this topic in detail can be viewed here.
6. Charging for Implementation Services: IA has been allowed to provide implementation services to their clients but they are specifically prohibited from charging any consideration including any commission or referral fees, directly or indirectly at individual level as well as family level. Further it has been specifically provided in the Regulations that IA or group or family of IA shall not charge any fee for implementation services to the clients.
7. Obligation on Client: Client shall not be under any obligation to avail implementation services from the IA. IA shall ensure that it in no way forces or persuades clients to avail implementation services from the IA.

Other Requirements to be followed by Investment Advisor

Other than Do’s and Don’ts we discussed above there are some other requirements which IA shall keep in his mind while providing services to the client as professional advisor:

1. Investment Advisors (IAs) must ensure that individuals associated with investment advice meet the following minimum qualifications at all times:
   1. Possession of a professional qualification as outlined in clause (a) of sub-regulation (1) of regulation 7.
   2. Accumulation of a minimum of two years of experience in activities related to providing advice on financial products, securities, funds, assets, or portfolio management.
2. If an IA discovers that any information or details previously submitted to the Board are inaccurate or misleading in a substantial manner or if there is a significant change in the previously provided information, they must promptly notify the Board in writing.
3. Non-individual IAs, such as corporate entities or partnership firms, are required to incorporate the term ‘investment adviser’ in their name.
4. IAs that are either corporate entities or partnership firms must designate a compliance officer responsible for overseeing the IA’s adherence to the provisions of the Act, regulations, notifications, guidelines, and instructions issued by the Board.

Concluding Remarks

Investment Advisors play a crucial role in guiding clients through the complexities of financial markets. To maintain trust and integrity in this relationship, IAs must adhere to stringent regulations and ethical standards. The do’s and don’ts outlined in this article serve as a comprehensive guide for IAs to navigate the regulatory landscape effectively and prioritize the best interests of their clients. Compliance with these rules not only safeguards against penalties but also upholds the professional integrity and credibility of the financial industry.