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ACCOUNTANTS SERVING AS SECURITIES INDUSTRY PROFESSIONALS: SOME CAUTIONARY NOTES

By: Peter D. Hutcheon

New rules adopted by the New Jersey Board of Accountancy which permit persons licensed to practice accountancy in New Jersey to receive contingent fees, commissions, performance fees and referral fees became effective on November 16, 1998. Those new rules are codified at New Jersey Administrative Code (N.J.A.C.) at 13:29-3.8 and 3.12. They reverse a long history in which such fees were not permitted. Section 3.8 permits an accountant to receive a contingent fee so long as the accountant does not perform for that client: (i) an audit or review of a financial statement; (ii) a compilation of a financial statement accompanied by a report; or (iii) an examination of prospective financial information. Contingent fee is defined in Section 3.8 as

…a fee…pursuant to an arrangement in which no fee will be charged unless a specified finding or result is attained, or in which the amount of the fee is otherwise dependant… [upon the success of the situation]

Section 3.12 permits an accountant to receive Commissions, performance fees and referral fees (a performance fee is defined as compensation on the basis of the appreciation of the funds or assets of a client), if the accountant is similarly not performing for that client: (i) an audit or review of a financial statement; (ii) a compilation of a financial statement accompanied by a report; or (iii) an examination of prospective financial information. However, in order to receive this type of compensation the accountant must disclose in writing to his or her client that the accountant will receive a commission, performance fee or a referral fee and the client must acknowledge the receipt of the disclosure in writing.

The two most important things for any accountant and for any attorney advising an accountant to remember are:

  1. The new rules and their implications for the independence of an accountant performing audit services are not controlling in any case involving a client which is a public company, subject to the regulatory jurisdiction of the U.S. Securities and Exchange Commission (ASEC); and
  2. The new rules spell out the types of compensation accountants are authorized to receive without risking their licensure as accountants in New Jersey. The new rules do not authorize an accountant to engage in any other regulated business (e.g., as an insurance producer, realtor, securities salesperson or investment advisory representative) without obtaining all the licenses and regulatory approval anyone would have to obtain to engage in that regulated business.

Background and Scope

The new rules are the result of a multi-year effort by the American Institute of Certified Public Accountants (AICPA) to expand the permitted revenue base of accountants to encompass the already significant trend towards providing consulting and other business services, some of which are quite removed from the traditional tax and audit functions. The AICPA, functioning as the trade association for the profession, sought to allow accounting firms of all sizes to receive performance-based or transaction-based compensation in connection with this service line diversity. Other states have adopted similar revisions to their professional licensure laws and regulations governing the practice of accounting.

Traditionally, accountants have been seen as professional advisers with no personal stake in the outcome of a client’s business, investments or transactions other than compensation for the time spent (hourly basis) or the task performed (fixed fee). Specifically arising out of the independence requirement for accountants performing audits, the AICPA and state licensing authorities had, until the 1990’s, proscribed arrangements which made an accountant a participant in a client’s business investments or transactions. Indeed, the Statement of Auditing Standard No. 1 requires that an accountant performing audit service must maintain an independence in mental attitude and requires the accountant to Abe without bias with respect to the client.

Once an accountant has an economic interest in the outcome of a client’s business (in the nature of a contingent fee, or participation fee, for example), or in a client’s investment (again in the nature of fund management fees, investment performance fees or referral fees) or in a client’s transaction (in the nature of a contingent fee or commission), all of that changes.

The new rules attempt to draw distinctions based upon the type of relationship the accountant has with a client. When accountants render an opinion on the financial statements of a client, accountants refer to that client as an attest client. The new rules do not permit accountants to receive contingent fees, commissions, performance fees or referral fees from an attest client. The new rules actually extend the attest concept to clients for which the accountant provides compilation financial statements, if those statements are accompanied by an opinion.

The position taken in the New Jersey rules is even stricter than that recommended in the AICPA Model Rules, which did not treat compilation clients as attest clients. However, Section 3 of P.L.199 c.215 signed into law on September 20, 1999, and effective in part on March 19, 2000, now codifies the New Jersey Board of Accountancy’s administrative position by defining attest to include compilation financial statements accompanied by an opinion.

In any event, NJAC 29:13-3.8 and 3.12 are understood to allow an accountant to perform audit services for one entity — such as an audited or review opinion on the financial statements of an operating business — while receiving performance-based fees or commissions for services rendered to affiliates — such as investment advisory services or selling insurance to the principals of the corporation. It is clear that the new rules and the accountant-client relationships that are developing as a result represent a move far from the model of independence reflected in SAS No. 1 and in the long-standing prohibitions on contingent or success-based fees.

SEC Independence Implications

If an attest client of an accountant is a reporting company under the Securities Exchange Act of 1934, as amended, rules promulgated by the SEC control the requirement for financial statements, including the independence required for the accountant. Federal law grants the SEC express authority to define the term independent, and the SEC has exercised that authority.

Due, in part, to the actions of the AICPA and the states, the SEC has recently proposed significant revisions to its rules addressing auditor independence. The proposed release discusses at length the importance of independence to the capital markets and securities regulations and asserts the need for heightened attention to this issue. The proposed SEC rule revisions confirm that independence is impaired if the accountant performs broker-dealer, investment adviser, or investment banking services for an affiliate of an audit client or receives a contingent fee, where contingent fee is defined as any performance or success based fee and where affiliate of an audit client is defined as anyone who has significant influence over the audit client.

So, for example, if an accounting firm audits the financial statements of a public company, that accounting firm could not provide investment advisory services to directors or principals of that public company. Accordingly, the line drawn under New Jersey law between attest clients and non-attest but affiliated clients, is irrelevant for purposes of being independent under SEC pronouncements.

Other Regulated Industries

The second key point for accountants and their legal advisers to recognize is that the new rules only cover the scope of compensation arrangements permissible for accountants. The new rules do not empower accountants either to provide the same services as, or to act as, a member of some other regulated industry or profession.

For example, if a New Jersey accountant were approached by a non-attest client who owned a piece of commercial real estate and was asked to represent that client in the sale of the client’s business, including the real estate, for a fee equal to 10 percent of the sales price and the accountant agreed, then (assuming an asset sale) the accountant would be in violation of the law, at least with respect to the sale of the real estate. New Jersey law permits only duly licensed realtors to receive a commission with respect to any sale of real estate, i..e. there is no isolated transaction exemption.

The new rules expressly advert to the possible application of the laws of other regulated industries and professions. Sections 3.8 (f) and 3.12 (g) specifically refer to the federal and state securities laws. The parts of the securities laws most likely to be relevant to expanded services by accountants are (a) those involving brokers (but probably not dealers) and (b) those involving investment advisers.

Under Federal securities laws a broker is any person engaged in the business of effecting transactions in securities for the accounts of others. This contrasts with a dealer who is a person engaged in buying and selling securities for his own account… The definitional provisions of the New Jersey version of the Uniform Securities Act essentially parallel the Federal definitions.

It is possible, but unlikely that an accountant will act as a dealer. Accountants are seldom involved with a client where the accountant acts as a principal selling a security (such as an investment partnership, etc.), that the accountant owned.

Accountants may, however, find themselves having to address whether they are functioning as brokers. This can occur in two ways.

First, an accountant may (with the ability under the new rules to charge a commission or success fee) act as a business broker or finder, arranging the purchase or sale of businesses or parts of businesses for clients. A person being paid in connection with the purchase or sale of securities is a broker. If the purchase or sale of a business is structured as the purchase or sale of securities (e.g. corporate stock, limited liability company interests, etc.), the accountant is paid in connection with the transaction, and either the volume or magnitude of the transactions is sufficient to say that the accountant is engaged in the business of those types of purchases and/or sales, then the accountant is a broker. The law is settled that there is no difference in treatment just because the purchase or sale of an entire business is involved.

Second, it is possible that an accountant, while not functioning as a business broker or finder, will refer clients or assist clients in the purchase or sale of securities, particularly mutual funds, variable annuities and tax sensitive investments.

In each of these situations, if the accountant expects to receive compensation based on the securities purchase or sale transaction, he or she must be licensed as a registered representative. The SEC, in Rule 2420 the National Association of Securities Dealers (NASD), prohibits the payment of securities brokerage commissions to anyone who is not a licensed, (i.e., registered) securities professional.

Acting as an unregistered broker when registration is required under applicable law can have both criminal and civil consequences. At the least, the accountant would be subject to enforcement action by the SEC or a state regulator seeking an injunction against the wrongful activity and probably seeking a bar on that person becoming a registered broker for some period into the future. The client might well have grounds to recover commissions paid and, worse, the counter party to the client could have a basis to rescind the transaction tied solely to the unregistered status of the accountant, something unlikely to endear the accountant to the erstwhile client. These acts would pose the risk of substantial civil liability, forfeiture or suspension of the capacity to perform those services and the loss of clients. In extreme cases, especially where other abuses are present, criminal sanctions might be sought against the accountant.

In order to be a registered broker licensed to sell securities, an individual must be employed by a registered broker/dealer firm (e.g., Merrill Lynch & Co, Inc., Ryan Beck & Co., Inc., Prudential Securities, Inc., etc.). Once employed or retained on a probationary basis, the individual must study and pass an examination, typically the Series 7 (general securities representative) or, if only mutual funds and annuities are involved, the Series 6 (investment company products/variable contracts representative) given by the North American Securities Administrators Association (NASAA) in conjunction with NASD.

The examination requirement is imposed and enforced by the state securities regulators in the several states (the Bureau of Securities in the Division of Consumer Affairs of the Department of Law and Public Safety in New Jersey). The broker/dealer firm must have an up-to-date registration statement on Form BD on file with the SEC and with the state securities administrators in the states where the firm does business. In addition, the individual must have completed and filed an up-to-date Form U-4 with the appropriate state regulators. This is usually accomplished by filing the form with the Central Registration Depository (CRD) maintained by NASD. If the accountant wishes to continue to practice as an accountant, he or she must secure written dual employment authorization from both the broker/dealer firm and the accounting firm. The broker-accountant must also comply with significant books and records requirements and be able to pass muster in compliance examinations conducted by federal and state regulators.

An accountant who practices in a 10-partner firm and is also a duly registered broker with a registered broker/dealer may not directly or indirectly share his or her commission income with the accounting firm or the other partners. The broker/accountant can pay rent for space and utilities and pay for accounting services for his or her broker activities, but these charges must pass muster as both arm’s length and as unrelated to the volume or magnitude of his or her commission income. This will frequently pose substantial issues for accounting firms considering expansion into these types of securities brokerage services.

A related area of securities industry activities for accountants is providing investment advisory services. Here, (although ultimately more hospitable) the regulatory landscape is a bit more complex. Until October 1996, an accountant wishing to provide investment advice for compensation had to be sure his or her investment adviser firm was registered with the SEC, unless the firm was exempt from registration. In addition, the firm had to file a parallel registration in the states where the firm did business. The states (but not the SEC registration) imposed certain examination requirements on the principals of the firm. In October 1996, Congress enacted the National Securities Markets Improvement Act (NSMIA), which was promptly signed into law. Under NSMIA, only investment advisory firms with $25 million or more under management register with the SEC. Smaller investment advisory firms register in their headquarters state, with notice filings in the other states where the firm does business. Accordingly, for most New Jersey accounting firms the relevant regulator is the New Jersey Bureau of Securities.

There is another historical wrinkle of relevance to New Jersey accountants. Many accountants considering expanding into fee-based investment advisory services do not envision managing client assets themselves. Rather, they envision referring clients to reputable, well-recognized investment advisory service providers and receiving a finders or referral fee in return. SEC rules have long recognized the existence of these “solicitors” in the market place. Solicitors were not and (after NSMIA) are not required to register as investment advisory firms with the SEC. The SEC rules, adopted under general SEC anti-fraud authority, require only that: (i) the solicitor have a written agreement with the registered investment advisory firm spelling out the compensation arrangement for the solicitor; (ii) the solicitor makes a written disclosure to the solicited client, setting forth the solicitation relationship, attaching a copy of the solicitation fee agreement and stating whether the client will or will not pay a higher investment advisory fee because of the involvement of the solicitor; and (iii) that the client acknowledge receipt of the solicitor’s written disclosure.

The New Jersey Bureau of Securities has, for a long period of time, taken the administrative position that a solicitor is acting as an investment adviser under New Jersey law. Neither NSMIA nor the Bureau of Accountancy’s new rules affect that analysis. Accordingly, New Jersey accountants thinking of entering into solicitor-agreements with investment adversary firms must themselves register as investment advisory firms with the New Jersey Bureau of Securities.

New Jersey law and regulations require an investment advisory firm seeking registration in New Jersey to file a completed Form ADV (the same form devised and used by the SEC). In addition, each principal of the investment advisory firm must take and pass either a NASAA Series 65 (uniform investment advisor law) Examination or a Series 66 (uniform combined securities agent and investment advisor law) Examination, in conjunction with a Series 7 Examination. In order to take the exam, an individual must be employed or retained or be a principal of a registered investment advisory firm. Thus, an accountant wishing to take one of the requisite exams must have an affiliation with a registered investment advisory firm and obtain written consents akin to the dual employment letters required for accountants who become registered representatives of a broker/dealer firm. The accountant will also be subject to substantial books and records requirements and to examinations by the regulators.

On Christmas Eve 1997, Governor Whitman signed into law the New Jersey Uniform Securities Law (1997). The 1997 Act included provisions requiring the registration of investment advisory representatives (the investment advisory firm cognate to the registered representatives of registered broker/dealer firms). Thus, in addition to provisions requiring that the principals of investment advisory firms take and pass the requisite NASAA exams, those individuals actually providing investment advisory services are statutorily required to register with the New Jersey Bureau. NASAA, in conjunction with the NASD, has established the Investment Advisor Registration Depository (IARD), the investment advisor cognate of the Central Registration Depository System.

The New Jersey Bureau of Securities expects to publish proposed implementing regulations for comment in the near future. Until implementing regulations are adopted in New Jersey, registration of individuals as investment advisory representatives will not be possible in New Jersey, and New Jersey will remain unable to participate in the IARD. When implementing regulations are adopted, the individuals providing advisory services in investment advisory firms registered in New Jersey will be required to register with the bureau.

An accountant who is a partner in a 10-partner accounting firm again faces the question, may the investment advisor fees generated from advising the accounting firm’s clients accrue to the benefit of the accounting firm or only to the benefit of the individual accountant? The NASD has, at the federal level, acknowledged that the traditional ban on fee-splitting of securities commissions does not extend to investment advisory fees earned by accounting firms or their affiliates. The SEC has not directly addressed this issue recently, but in view of the SEC tolerance of solicitors as unregistered participants in the investment advisory process it seems unlikely that the Commission would have any concern about how an entity functioning as a solicitor and the individuals in that entity divide up referral fee income. If the accountants are actually managing client investments, the SEC would have a direct basis for imposing regulatory-related conditions. The SEC has not to date directly addressed whether the investment advisor function can be separated from an accounting firm, with the accounting firm still receiving the net profits from the investment advisor.

The New Jersey Bureau of Securities has indicated a willingness under certain conditions to allow fee income from investment advisory services to be transmuted into a component of the general revenue of an accounting firm. The bureau has accepted situations where an accounting firm has organized a separate business entity (typically a single-member limited liability company, of which the accounting firm is the member) and the separate entity registers as an investment advisory firm. The managers of the registered investment advisory firm must have to have passed a Series 65 or Series 66 examination in conjunction with a Series 7 examination.

In addition, the bureau has required (as a condition to accepting registration of the separate entity but not of the accounting firm), that the accounting firm undertake: (i) to cause any investment advisory service to be handled only by the affiliated entity; (ii) to have the individuals serving in the investment advisory firm receive reasonable compensation from that firm; (iii) to have dual employment letters in place; (iv) to treat the net earnings of the investment advisory firm as passive distributions to the accounting firm, so that no special compensation is received by any partner or employee of the accounting firm for bringing in an important investment advisory client; and (v) to provide sworn background information about each principal of the accounting firm akin to what would have been provided if the accounting firm itself had registered.

One related matter should also be noted. The new Board of Accountancy rules allow accountants to receive performance fees. In general though, investment advisory firms are not permitted under either federal or state (including New Jersey) law to charge performance-based fees for investment services, i.e., the investment advisory firm cannot receive increased compensation based on the amount of increase in the value of the investments. Certain exceptions however, may be available.

In order for an accounting firm to receive many of the expanded types of compensation (specifically commissions, performance fees and referral fees) permitted under the Board of Accountancy’s new rules, the accounting firm must also make certain written disclosures to the accounting firm’s client. It is important to remember this requirement and to recognize that this rule requirement is not met by disclosures by the investment advisor or by provisions in an investment advisory contract. If accounting firm has set up an affiliated investment advisory firm, the investment advisory contract disclosures are made by the investment advisor affiliate, not the accounting firm. The accounting firm must still disclose its receipt of income from the investment advisory services (so in the case of an affiliated business entity, the accounting firm must disclose its ownership of the business entity, that the entity received fees from the client and/or referral fees or payments from third parties, and that the monies received by the entity, net of the entity’s operating expenses, will be distributed to the accounting firm). Consistent with the rule requirements, the client must give a written acknowledgment of receipt of the required disclosure.

Conclusion

As accounting firms expand their scope of services and the type and range of fees they charge for the services provided, they will encounter significant and often complex regulatory requirements applicable to participation in other regulated industries and professions. Disclosure to their clients and compliance with technical regulatory requirements will be a necessary precondition of such expansions.

This article is reprinted with permission from the December 2000 issue of New Jersey Lawyer, the Magazine, a publication of the New Jersey State Bar Association.

END NOTES

1. 30 New Jersey Register (ANJR) 4055(b), November 16, 1998.

2. See the Proposing Release, 29 NJR 4737(a), November 14, 1997

3. N.J.A.C. 13:29-3.8(c)

4. N.J.A.C. 13:29-3.8(a)

5. N.J.A.C. 13:29-3.12(b)

6. N.J.A.C. 13:29-3.12(e) and (f)

7. AICPA Codification of Statements on Auditing Standards (ASAS) No.1, AUS220.03

8. N.J.A.C. 13:29-3.8(c) and 3.12(b)

9. Ibid.

10. 30 NJR 4056

11. Codified at N.J.S.A. 45:2B-44

12. 15 U.S.C. 77aa(25) and (26); 15 U.S.C. 781 and m; 17 CFR 210.3-01 (Article 3 of SEC Regulation S-X)

13. 15 U.S.C. 77s(a) and 15 U.S.C. 78c(b); 17 CFR 210.2-01

14. Release No. 33-7870, June 30, 2000 65 Fed. R. No. 134, pp. 43148-43203, Current, CCH Fed. Sec. L. Rpts. & 86, 315. See especially Appendix B for changes in revenue sources for the profession.

15. Ibid, 65 Fed Reg at 43149-43157

16. Ibid, 65 Fed Reg at 43159-43164, 43174-5 and 43178-43179

17. N.J.S.A. 45:15-1 and 15-3

18. N.J.S.A. 45:15-2 and see Silverman & Kost P.C. v. Catsimatidis et al. Unpublished opinion Civ. No. 98-2934 (D.N.J. 1999) and cases cited therein including Tanenbaum v. Sylvan Builders, Inc. 63, 71 (1959)

19. 15 USC 78c(a)(4)

20. 15 USC 78c(a)(5)

21. N.J.S.A. 49:3-49(c)

22. Landreth Timber Company v. Landreth 471 U.S. 681 (1985)

23. UFITEC, S.A. v. Carter 142 Cal Rptr 279 (1977); Ruth H. Quigley (SEC, 1973) 1973 CCH Fed. Sec. L. Rep. Transfer Binder & 79, 474; Davenport Management, Inc. (SEC 1993) 1993 CCH Fed Sec. L. Rep. Transfer Binder & 76, 643; In the Matter of Steven M. Scarano, CPA 67 SEC Docket 2033 (Sept. 9, 1998); and National Association of Security Dealers (ANASD), Manual, 4321 et seq.

24. In the Matter of Steven M. Scarano, CPA 67 SEC Docket 2033 and see SEC v. Zubkis F. Supp. (S.D.N.Y., 2000) Current CCH Fed. Sec. L. Rep. & 90,769

25. See N.J.S.A. 49:3-71(a)(1) and (c) which gives the purchaser of a security the right to rescind the transaction when an unregistered person, who should be registered as a broker, effects the purchase transaction.

26. N.J.S.A. 49:3-57(f)(1) and N.J.A.C. 13:47A-4.1 and 4.2. See also New Jersey Bureau of Securities Notice of New Exam Requirements, Jan. 1, 2000 2A CCH Blue Sky L. Rpts. & 40, 691V

27. 15 USC 780 and see e.g. N.J.S.A. 49:3-56 and 57

28. See e.g. N.J.A.C. 13:47A-3.1 and 3.2

29. N.J.A.C. 13:47A-1, 9(d) and 3.2(a)

30. See NASD Rule 3030, NASD Manual at 4838

31. 15 USC 780(c), N.J.S.A. 49:3-59 and N.J.A.C. 13:47A-2.6

32. Pub. L. 104-290, Title III, Oct. 11, 1996

33. 15 USC 80b – 3a

34. Ibid.

35. CFR 275.206(4) – 3

36. Ibid.

37. New Jersey Bureau of Securities No-Action Letter May 19, 1992, 2A CCH Blue Sky L. Rpts. & 40,610

38. PL 1997, c. 276 The 1997 Act was the work product of the Securities Advisory Committee (ASAC) to the New Jersey Bureau of Securities (created by the Attorney General in September, 1993), in conjunction with the Bureau of Securities. The author is one of the original members of SAC and, since November 1994, has been its Chair.

39. N.J.S.A. 49:3-56 and 57

40. See SEC Release IA – 1862, April 5, 2000, Current, CCH Fed. Sec. L. Rpts. & 86,301

41.NASDR Interpretive Letter of Sept. 16, 1998 to A.G. Edward & Sons, Inc. available at http://www.nasdr.com/2910/2420

42. See SEC Release IA-1-92, Oct. 8, 1987 and Kensia Oil Company (SEC 1982) 1982 CCH Fed. Sec. L. Rpts. Transfer Binder & 77, 224

43. Informal discussions with the Bureau Chief and staff of the New Jersey Bureau of Securities.

44. 15 USC 80b – 5 and N.J.S.A. 49:3-53(c)

45. 15 USC 80b – 5 and CFR 275, 205-1, 205-2 and 205-3; N.J.A.C. 13:47A – 2.10

46. N.J.A.C. 13:29 – 3.12(e) and (f)