September 1999

The CPA Journal Millennium Series


Regulatory and Other Dangers

By Dan L. Goldwasser and Michael J. Crisafulli In Brief

Look Before You Leap

As part of this special millennium section of this month's The CPA Journal, two attorneys examine, in detail, the regulatory aspects of operating a practice that not only provides financial planning services but also has the capability of bringing a financial plan into fruition through the purchase of securities and insurance products. Finally, an article that removes the mystery from what it takes to be able to earn commissions while providing professional services to clients. It is also a reality check--the ability to earn commissions and similar fees comes with a price.

The authors examine the special rules and requirements of conducting a securities advisory business, the unique aspects of commission sharing with insurance policies, the form of entity to use in providing new services, and the need for risk management. A sidebar gives background on recent changes to the regulatory environment and legislation pending in New York.

More and more small and medium-sized accounting firms are forming new business entities designed to provide an array of business and personal financial services, including investment advisory services, insurance-related services, and the services involving the purchase and sale of securities. Rather than render advisory services on a casual (and often uncompensated) basis, CPAs have begun to treat such activities as professional services, applying the same standards of competence and diligence to these activities that they have traditionally applied to their other services.

Many accountants also believe that in order to maintain their current client relationships against the threat of competition from accounting firm consolidators, they must be able to meet the full panoply of their clients' needs for high-quality professional business and financial services. Moreover, it has become increasingly apparent that greater profitability is more easily achieved by expanding the scope of services provided to existing clients than by seeking new clients for traditional accounting services. Accountants may have been willing to refer their clients to other financial services providers in the past. But the current competitive environment makes such referrals both undesirable and dangerous.

Facilitating the movement into financial services is the relaxation of long-standing regulatory restrictions on non-CPA ownership of accounting firms, commissions and referral fees, and contingent fee arrangements. Heretofore, these restrictions significantly limited the ability of CPAs to effectively operate in other businesses, particularly those that traditionally used contingent compensation arrangements.

In venturing into the financial services areas, accounting firms are confronted with several choices:

* Furnish such services through their existing firms;

* Enter into a joint venture with persons who may already possess the necessary registrations and/or licenses to provide regulated services; or

* Refer their clients to established providers of such services under arrangements that will permit the firm to share in the compensation.

In making the choice, firms need to understand recent changes in the regulatory environment, the special rules and requirements of conducting a securities advisory business, the unique aspects of commission sharing with insurance policies, the form of entity to use, and the need for risk management.

Regulatory Considerations for Specific Financial Services

Many of the new services that accountants are contemplating--particularly investment advisory services, securities brokerage services and insurance-related services--are themselves regulated under state or federal law.

Investment Advisors

In October 1996, Congress eliminated Federal registration of investment advisors that hold under $25 million of assets under management. Such advisors (or advisory firms) are now regulated solely by the states. Today, all states except Colorado, Iowa, and Wyoming have some form of regulation covering investment advisors, a term generally defined to include persons and entities in the business of offering advice regarding investments in securities. Investment advisory firms that have more than $25 million under management are now exclusively registered with the Securities and Exchange Commission (SEC) as registered investment advisors (RIA).

Although there are currently no educational requirements imposed upon investment advisors under state or Federal law, a number of states require investment advisors to take qualifying tests such as the Series 65 examination given by the NASD. In addition, both state and Federal laws require that all firms (as well as individuals) that come within the definition of an investment advisor must register with the SEC or state regulatory agency and comply with its rules. Notably excluded from this requirement are attorneys and CPAs who render investment advice which is solely incidental to "the rendering of accounting services." This exception, however, is very narrowly construed by regulatory authorities and does not include personal financial planning services. Thus, any firm that offers investment advice as a separate service is likely required to register.

Investment advisors with less than 15 clients in New York State are exempt from the registration provisions. An investment advisor proposing to do business in New York may file a voluntary notification form with the Department of Law. All investment advisors with more than 40 clients in New York State, including those who previously filed a voluntary notification form, must apply to register as an investment advisor by completing and filing an investment advisory statement (Form NY-ADV) with the Department of Law. The statement requires information concerning such matters as the background of officers, partners and other persons responsible for investment policy; information about periodic publications on investment matters; and the advisor's schedule of fees and charges. The investment advisor is also required to provide a balance sheet dated within 90 days of its application.

The applicable law in New York (and in most other states) also requires an investment advisor to file copies of all investment advisory literature and advertising material provided to clients or prospective clients. Investment advisors are also required annually to send a statement to each client notifying that a copy of its investment advisory statement is available upon request.

Investment advisors registered with the SEC must file an annual report disclosing information such as their financial condition and the type and amount of assets under management. In addition, in some jurisdictions, investment advisors may be required to disclose material customer claims made against them.

In most jurisdictions, including New York, an RIA is required to maintain a wide variety of business records, including a complete list of all cash receipts and disbursements as well as auxiliary ledgers reflecting the assets, liabilities, reserves, capital, income, and expenses of each advisory client.

In addition, investment advisors are often restricted as to the types of disclosures that they can make to their clients and prospective clients. They are usually not allowed to use testimonials regarding the quality of their services (although they are permitted to disclose their track records, if this information has been recorded and is verifiable). They may not, however, provide selective data regarding their track records.

Most state investment advisor statutes also tend to limit the types of compensation that an investment advisor may charge. For example, although investment advisors may charge a percentage of the assets under their management, they may not base their fees on the level of return they generate unless they manage in excess of $500,000 for the client. Even then, such arrangements are generally prohibited unless the incentive compensation arrangement includes unrealized losses in the compensation base and the compensation arrangement is fully disclosed to the client.

Most states, like New York, have modeled their investment advisor regulations after the Federal regulatory scheme administered by the SEC.

Registration as an investment advisor and as an investment advisory representative is generally required on both the firm and individual level, respectively; more pervasive requirements are applied at the firm level. This means that CPAs wishing to offer investment advisory services can do so either by establishing their own registered investment advisory firm or by having their members associate with an established investment advisory firm.

Because both state and Federal regulations of investment advisors apply on a firm-wide basis, it is generally prudent to organize an investment advisor as a separate legal entity even though it may be owned by or have common ownership with a CPA firm. In this way, the firm will not have to make public disclosures regarding its overall activities.

Securities Brokers/Dealers

While most CPA firms will probably not wish to engage in a retail securities business a la Merrill Lynch or Charles Schwab, they may wish to assist clients in buying or selling securities and in seeking a commission for their services. Such activities, if conducted on a routine or frequent basis, may place the firm in the securities business. In order to engage in the business of buying and selling securities for others, a person or entity must register as a broker/dealer with state and Federal securities regulators, and the employees actually engaged in securities transactions must be licensed as registered representatives or agents of the broker/dealer. As in the case of insurance and real estate sales, licensure is required in every state in which the entity is deemed to be engaged in the business of buying and selling securities for others.

Merely holding out as conducting a securities business is likely to be sufficient to require registration. Therefore, CPA firms should be careful not to mention securities transactions in their promotional literature unless they are prepared to seek licensure as a broker/dealer.

For the purposes of these statutes, a firm conducts business where its office is located or where its customers are located. Accordingly, if an entity engages in securities transactions with New Jersey residents out of its New York office, it must be licensed in both New Jersey and New York.

In addition, in New York, employees of a broker or dealer who meet the definition of "salesman" must file a registration statement with the Department of Law. In order to register as a broker or dealer in New York, an entity must file a registration statement with the Department of Law every four years, file a "state notice" with the Department of State, and pay a fee.

Of particular concern to state and federal regulators is whether the applicant will be holding any customer funds. The Department of Law is authorized to impose minimal capital requirements and has the power to require that applicants be tested. All supervisory employees of a broker/dealer entity are required to pass the NASD "principal's exam."

Unlike investment advisors, agents of a broker/dealer must pass an examination that covers, among other things, regulations pertaining to securities transactions. Although these examinations are not difficult, they do require applicants to become acquainted with the regulatory requirements for executing securities transactions as well as the NASD Rules of Fair Practice. Licensure as a broker/dealer requires that at least one managerial employee pass the
principal's exam, which includes questions relating to the net capital regulations applicable to all registered

Registered broker/dealers who are not members of the NASD have additional filing requirements. New York's securities law (the "Martin Act") contains general anti-fraud and deception rules that parallel those in the Securities Exchange Act.

The regulatory burden for broker/dealers is not inconsequential, and most maintain extensive staffs to assure that they remain in compliance with the laws of all jurisdictions in which they operate. A CPA firm can avoid much of this burden by having one or more of its partners or employees become associated with a broker/dealer licensed in those states in which the firm has securities clients. While this may result in sharing commissions with the selected broker/dealer, it is likely to be more economical to partner unless the firm will be engaging in extensive securities transactions.

Insurance Services

Under New York Insurance Law, no person, firm, association or corporation shall act as an insurance agent or broker without a license issued by the superintendent of insurance. The sale of insurance is regulated by every state, and similar laws are found in every jurisdiction. These regulations pertain to the types of insurance that may be sold, the terms of the policies, the kinds of companies that may offer insurance products, and the licensure of insurance agencies and their sales employees.

While there is no prohibition against acting as an insurance consultant without the authority provided by a license, the New York Insurance Law prohibits an insurance consultant from holding out as such without first obtaining an insurance consultant license.

The law exempts from the licensing requirement imposed upon insurance consultants certain professionals, such as CPAs, who provide information and advice as long as they receive no compensation directly or indirectly on account of the insurance product that may result from the advice. This narrow exception will not apply to the fee-generating enterprise under consideration here.

It should also be noted that the New York Insurance Law requires licensure for insurance brokers. As in the case of securities broker/dealers, the requirements for licensure of insurance brokers is more rigorous than for licensure of insurance agents, including completion of a course of study and one year of recent regular employment in the insurance field.

In order to obtain a license from the superintendent of insurance, the prospective agent must complete a written application, submit a certificate of an insurer stating that it will appoint the applicant as its agent if the license is issued, and pass a written competency test administered by the superintendent. In order to qualify to take the written examination, an applicant is required to successfully complete a course or courses approved by the superintendent covering the principal branches of insurance as to which the applicant seeks a license. An agent is permitted to sell the particular products specified in the license and only for the insurer on behalf of whom the license is issued.

The law imposes licensing requirements on brokers similar to the requirements for licensure of agents.

How to Structure New Business Entities

The first step is to consider whether the services should be performed 1) by the existing accounting firm, 2) by association with an existing licensed entity, or 3) by forming a separate entity for the purpose.

Associating with a licensed service provider may avoid complex regulatory and licensing requirements if the licensee alone performs such services. Such associations, however, do exact a heavy payment by generally restricting the accounting firm's involvement in the management of the operation and precluding it from ensuring the quality of the services delivered to its clients.

While an accounting firm can avoid the disadvantages associated with affiliation by providing the services itself, there are circumstances that make such an arrangement undesirable. In order to be able to provide quality business services in areas outside traditional accounting practice, most accounting firms will need to attract individuals who possess the requisite expertise. Many such individuals, however, demand some form of ownership interest in the venture as a condition of association. Even though it is likely that non-CPA ownership of accounting firms will soon be permitted under certain conditions, offering an ownership interest in the existing firm to non-CPAs may be undesirable for a number of reasons. For example, the often delicate balance many firms have achieved (through great effort, no less) in management structure and firm operation may be strained or upset by the admittance of non-CPA owners. Similarly, existing compensation structures are not always appropriate for some of the new business ventures.

In most instances, therefore, accounting firms will want to create a separate entity to provide the new services. An important objective in structuring any business entity is to limit the owners' vicarious liability for the errors and misconduct of the entity and the co-owners. Accordingly, most firms will wisely choose to operate the new venture or ventures in some form of limited liability entity. State laws offer a wide variety of forms such as the business corporation, professional corporation, limited partnership, limited liability partnership, or the limited liability company. Unlike most states, New York law also provides for the establishment of "related limited liability partnerships" which are expressly designed for professional entities associated with limited liability partnerships.

Professional corporations and limited liability partnerships are limited in use to entities comprised solely of professionals. These forms of business organizations will likely not be available for many new business operations, because in most cases the entity will include among its owners non-CPAs who possess the needed expertise.

Similarly, the traditional corporate form, although offering protection to owners from vicarious liability, presents obstacles to achieving the attractive pass-through tax treatment. In order to achieve such treatment, a business corporation must comply with the limitations imposed on S corporations. Limited partnerships are generally an undesirable form in which to carry on new business services because of the requisite division in such entities between ownership and management.

Thus, in most instances, the preferred form of business organization will be the limited liability company (LLC), which provides owners with protection from vicarious liability, favorable pass-through tax treatment, flexibility in fashioning management, and versatile profit and loss sharing arrangements.

Those firms seeking to perform a variety of new business services may also choose to form a separate entity for each such service. The formation of separate entities offers the advantage of limiting the application of regulatory and reporting requirements to a smaller and specialized entity rather than to a larger, multi-purpose firm. In addition, providing the services through separate entities permits the allocation of rewards based on the performance of each constituent service entity.

In structuring entities to carry on new business ventures, careful consideration should also be paid to additional matters, such as the protection of the firm's client relationships through the use of noncompetitive and other appropriate restrictive covenants. In addition, it may be advisable to include a trial period for any individual or entity through which the services are performed. Similarly, buy-out, termination, and other exit provisions should be carefully negotiated and drafted. Additional issues peculiar to the type of service performed should be addressed in the operating and associated start-up agreements.

Risk Management Measures

Many accountants use a number of valuable risk management tools in connection with their accounting practices, which can also work well when performing any other business services. The accompanying article by Ron Klein on page 14 describes such measures in detail, including the use of engagement letters, well-designed operating procedures, and disclosure statements. The firm will also want to review its professional liability insurance coverage and consider the need for additional insurance to specifically cover the new services being offered.

For example, a number of insurers have begun to cover financial planning services, provided they did not include advice regarding the purchase of specific securities. The minimal coverage afforded by such policies will not afford adequate liability protection because most cases will likely include the recommendation of specific securities or other investments. If financial services are being provided by a separate entity, it will be necessary under the terms of most policies to obtain an endorsement to the policy naming that entity as an additional insured.

A Full Commitment is Required

While providing financial services may be a good way to enhance firm profitability, such activity requires compliance with a broad spectrum of regulation and cannot be undertaken on a casual basis. Accordingly, firms wishing to pursue these activities must carefully assess the amount of business they are likely to generate by providing financial services and then decide whether that business justifies the costs of complying with the applicable regulations as well as establishing and maintaining appropriate loss prevention systems. *

Dan L. Goldwasser and Michael J. Crisafulli are attorneys practicing with Vedder, Price, Kaufman & Kammholz, legal counsel to the New York State Society of Certified Public Accountants.


By Dan L. Goldwasser, Vedder, Price, Kaufman & Kammholz

Regulators of the accounting profession have historically prohibited the use of commissions, referral fees, and contingent fee arrangements. In addition, almost every state still prohibits CPAs from practicing in an entity owned even in part by non-CPAs.

Largely in response to the expansion of the profession's services into new areas, the AICPA and the National Association of State Boards of Accountancy (NASBA) reached an agreement to relax these long-standing prohibitions. The AICPA/NASBA accord is embodied in a new Uniform Accountancy Act (UAA), which covers a broad range of regulatory issues in addition to reforms relating to compensation restrictions. Essentially, the UAA permits CPAs to receive commissions and referral fees with respect to non-attest clients and permits contingent fee arrangements to be utilized with respect to all clients for whom the CPA does not perform attest services, so long as the engagement does not involve the preparation of an original income tax return.

Before these arrangements can be used, state licensing authorities must first adopt the reforms in practice structure and fee arrangements promulgated by the AICPA/NASBA. At present, approximately one half of the states have adopted fee reforms contained in the UAA; few, if any, states have adopted the proposal to permit non-CPA firm ownership.

The Situation in New York

In New York, the definition of the practice of accounting is limited under state law to essentially attest services. The State Education Department (SED), which administers the accounting law in New York, last year acknowledged that it does not have the authority to impose prohibitions on commissions and contingent fees with respect to clients for whom a CPA provides no attest services.

Since reaching this conclusion, the SED has drafted and submitted legislation that would broaden the definition of the practice of accounting. If passed, it would have the effect of reimposing the restrictions on compensation arrangements, such as commissions, for CPAs that hold out in offering professional services (as very broadly defined) for compensation to the public.

A second bill before the legislature is designed to incorporate many of the provisions of the UAA. It would retain the current limited definition of the practice of accounting and permit the payment of commissions and the use of contingent fee arrangements in connection with the performance of services for clients for whom no attest services are provided. The legislation would also permit non-CPA ownership of CPA firms, provided that "a majority of the ownership of the firm in terms of equity interest and voting rights of all partners, members, or shareholders, belongs to individuals who are licensed or otherwise authorized by law to practice public accounting."

A Word of Caution

It appears likely that many long-standing obstacles to the performance of a wide variety of new business services by accounting firms are about to be removed. It is partially in anticipation of the relaxation of these regulatory prohibitions that many accounting firms have begun preparations for offering a wide array of new financial services. But because of the investment of time and money involved, those beginning the preparations should fully understand the regulatory status of the jurisdiction in which they are practicing. *

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