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Choosing An Investment Advisor
by Donald G. Henslee, Laura S. Fowler, Roy William Cabler III, Bret Jimerson

Why Should I Check Out My Investment Adviser?

All investing poses some degree of risk, but bad advice and/ or shady advisers poses problems of unconscionable proportions. Protecting yourself through a stringent adviser evaluation process minimizes the chance of being defrauded or losing everything because of bad investments. Currently, there are people all across Texas that rue the day they made investments without doing their homework.
Do the Wicked Prevail?
We have all welcomed people into our office that a friend has recommended. Usually, that is a great way to hire people. However, an investment adviser referred by a friend, or even someone you already know, should go through the same evaluation process as someone you have never heard of. Evaluating an adviser’s credentials and experience based solely on whom he associates with is not a good practice. Besides, the adviser that has nothing to hide will not mind being stringently evaluated. Recently, many investors decided not to evaluate who they invested their money with and ended up losing millions.

For instance, in July 2000 an Austin, TX businessman was indicted for stealing millions of dollars from investors. The businessman married a small-town beauty queen and exploited her relationship with other townspeople. Because of whom he was married to, over 38 people, some of whom were sophisticated and experienced investors, invested large sums of money with a company he controlled. What these Texans did not know was that this gentleman had already attempted to defraud two overseas corporations, and had been discharged from the National Guard for defrauding fellow soldiers out of thousands of dollars. He told investors that he was a certified master trader, a certification that does not exist, with an extensive military background. He told them that he would invest their money in foreign bond markets, and presented forged documents to make investors believe that the bonds were insured. Of course, none of this was true and the investors lost millions.

Then there was another Austin businessman, and former University of Texas football star, that used his notoriety to swindle investors out of $50 million in 1999. This gentleman talked people into investing their money in a foreign currency scheme, falsified documents to show a return on the investment, then paid illusory profits to the original investors with new investor funds. A simple phone call to the State Securities Board would have shown that not only was the man not registered, but also the securities he was promoting were not either.

Another example was the "prime bank scheme" executed in 1999 by a Houston, TX businessman. The "prime bank scheme," also known as a "Secured High Yield Investment Program," was supposed to return large profits by entering into a "Joint Venture/ Profit Sharing Agreement." The only profit was made by the Houston businessman, and he only shared with himself.

Finally, there is the 1998 case of the San Marcos, TX stockbroker that was sentenced to just over 4 years in prison for misusing brokerage clients’ funds. The stockbroker misapplied and diverted client funds, while reassuring those clients that their money had been properly invested. The State Securities Board decided that the stockbroker’s bank account was hardly a secured investment.

A few phone calls to the sources listed on pages 6 through 12 likely would have dissuaded many investors from giving their hard-earned dollars to these people. In any event, always call the SSB when evaluating a potential investment adviser. A legitimate adviser has nothing to hide and will not mind being evaluated. If the adviser does mind, DO NOT DO BUSINESS WITH HIM.

Consider the Source
Not only does an investor have to trust the adviser, but the investor must also trust that the advice is sound. Just because an adviser is trustworthy does not mean the advice is. Evaluating the adviser’s background should reveal a history of solid, or not so solid investment advice. Evaluate the adviser before accepting the advice, because the consequences could be severe.

The most notorious investment advice debacle was the investment pool managed by Orange County, California. Over 180 government entities, including some school districts, invested in the pool. The pool manager invested much of the fund into high-risk derivatives, which are considered hard to understand for even the most seasoned adviser. The returns were potentially great, but the losses were devastating. The fund eventually lost $1.5 BILLION, and Orange County filed for bankruptcy while being sued by other pool investors.1

However, Orange County was not the only public entity devastated by derivatives trading. In 1994, Odessa Junior College District lost $11 million to these derivative investments. Due to the losses, the college had to borrow $10.5 million, increase tuition, raise taxes, and substantially lower its operating budget. In addition, the college president had to forego his salary for a year. The president of finance, who was ultimately responsible for the investments, quietly resigned and moved away.2

Odessa College was not the only Texas school to fall prey to derivatives trading. Southwest Texas State University, Midwestern State University, Sul Ross State University, and East Texas State University among others, also invested in derivatives. However, unlike Odessa College and Orange County, these schools were able to wait until interest rates went back down in order to break even. Most school officials agreed that the investments were inappropriate and the losses could have been devastating.3

The common excuses? They did not know what they were doing, and they fell prey to slick salesmen with aggressive investment strategies. The moral of the story? Stringently evaluate your investment adviser to avoid these catastrophic disasters.

How to Choose an Investment Adviser
Generally, all firms and persons must be registered with the State Securities Board (SSB) or the Securities and Exchange Commission (SEC). That means anyone within the chain of sale, from dealer to adviser to salesperson, must register. If they are paid for their services, they have to register. The SSB and SEC goal is to ensure that investment advisers meet certain ethical standards and financial solvency. Exemptions are few and far between, so if an adviser says he is exempt from registering, take good notes and call the SSB.

The first step in evaluating an investment adviser is to IMMEDIATELY ask for a Form ADV (Uniform Application for Investment Adviser Registration). Form ADV is a significant disclosure document that requires the applicant to provide specific information about his professional history and approach to investing. Part I requires disclosure of prior business practices and background. Part II requires disclosure of the adviser’s services, fees, and strategies.

The adviser is required by law to disclose Part II of the Form ADV, but also request Part I and thoroughly review both. Both Parts are public information, so if the adviser will not provide a copy, the SSB or the SEC most certainly will. If the adviser refuses, or is even hesitant to provide Part I, DO NOT DO BUSINESS WITH HIM.

The next step is to evaluate the adviser just as you would a potential employee. Ask for references, then contact and question each one. Conduct a background check with the SSB or National Association of Securities Dealers, Inc. (NASD). Then conduct a face-to-face interview, asking direct questions and taking diligent notes.

In an interview, the very first question is with whom the prospective adviser is registered, either the SSB or the SEC. Then contact that agency to verify the registration and to conduct a thorough background check. If the adviser says he is not required to register, or is exempt from registering, call the SSB to verify. The SSB will explain if and how an exemption applies.

The next step is to scrutinize the adviser’s background. Inquire about his training and experience, schooling, recent employment history, and how long he has been advising. Then ask if he has ever had any disciplinary actions taken against him, or if a client has ever sued him. Also, ask if the adviser holds any licenses or certifications listed on pages 10 through 13. If so, contact the professional organization that regulates the license or certification to verify the adviser’s designation as well as any other information they may have about him.

Ask about the products and services the adviser is allowed to sell. If he is only allowed to sell a limited number, ask why. Also, ask how the adviser is compensated, whether by an hourly rate, flat fee, commission, or a combination of commission and fee known as "Fee-based" or "Fee off-set." How the adviser is compensated may reveal potential problems.

For instance, a potential problem of hiring a Fee-offset or a commissioned adviser is a conflict of interest. Since the adviser is compensated according to what he sells, the client’s best interest could be compromised. Alternatively, advisers paid an hourly rate or a flat fee could remain unbiased.

The SSB recommends taking diligent notes of every conversation and meeting with a prospective adviser or a current investment adviser. If any contradiction or dispute arises, articulate notes will ensure a satisfactory resolution. Once an adviser is selected, obtain a copy of the form "When Your Broker Calls, Take Notes!" from the SSB web page. Using this form will ensure that all necessary information is obtained and documented of each conversation with an adviser. The form is located at: http://www.ssb.state.tx.us/takenotes.html.

At some point during the evaluation process, consult the State Securities Board. One simple phone call may save a lot of misery. Remember, you are the one responsible for the district’s money, so protect your investment dollars. Furthermore, know your rights. The SSB has an "Investor Bill of Rights" that enumerates what every investor has a right to know. The "Investor Bill of Rights" is located at: http://www.ssb.state.tx.us/billof.html.

Texas State Securities Board (SSB)
The Dealer Registration Division of the SSB requires that all firms and persons with less than $25 million in assets under management register with them. That means anyone within the chain of sale, from dealer to adviser to salesperson, must register. If they are paid for their services, they have to register. The SSB goal is to ensure that investment advisers meet certain ethical standards and financial solvency. Exemptions are few and far between, so if an adviser says he is exempt from registering, take good notes and call the SSB.

The application process for the SSB is quite extensive. Applicants must undergo an extensive background check, pass an exam on securities principles and state laws, and meet record keeping and disclosure requirements.

The applicant must fill out the Form ADV (Uniform Application for Investment Adviser Registration) Parts I and II and the Form U-4 (Uniform Application for Securities Industry Registration or Transfer). These are significant disclosure documents that require the applicant to provide specific information about his professional history and approach to investing. Part I requires disclosure of prior business practices and background. Part II requires disclosure of the adviser’s services, fees, and strategies.

By law, investment advisers must provide a disclosure document, which is the ADV Part II. The adviser should provide a copy, if not, ask for one. Also, the investor may request a copy of Part I. If the adviser is at all hesitant about providing any of the disclosure documents, red flags should immediately fly. The SSB will provide a copy of all three documents upon written request by fax, e-mail, or postal mail.

While reviewing applications for registration, the SSB conducts background checks with the CRD (Central Registration Depository), the American Stock Exchange, and the New York Stock Exchange among others. The CRD is a registry that maintains information about brokers, investment advisers, representatives, and firms. The SSB also conducts criminal background checks with the Department of Public Safety and maintains a record of any valid complaints or infractions levied against the adviser or firm. Basically, if the applicant has a negative history it should show up.

Finally, state law requires anyone offering or selling securities, or giving and/ or selling investment advice, to take a written exam to determine the applicant’s qualifications and competency. The two-part exam requires proficiency in general securities principles, as well as state securities laws. Advisers holding the designations of Chartered Financial Consultant (ChFC), Certified Financial Analyst (CFA), Chartered Investment Counselor (CIC), Personal Finance Specialist (PFS), or Certified Financial Planner (CFP) do not have to take the general securities exam, but do have to pass the state securities law exam. Once again, if someone says he is exempt, diligently note everything he says then contact the SSB.

At some point in choosing an investment adviser, contact the SSB at:

State Securities Board
P.O. Box 13167
Austin, Texas 78711-2167
Ph: (512) 305-8300
Fax: (512) 305-8310

In addition, the SSB web page provides invaluable information about how to make educated investment decisions. Visit their web page at: http://www.ssb.state.tx.us

Securities and Exchange Commission (SEC)
Generally, all firms and persons with more than $25 million in assets under management must register with the SEC. The SEC requires investment advisers to file a Form ADV, meet record keeping and disclosure requirements, and be subject to inspection and examination by the SEC.

Contact the State Securities Board or the National Association of Securities Dealers (NASD) Regulation, Inc. to conduct a CRD check on any adviser registered with the SEC. The SEC will provide a copy of any investment adviser’s Form ADV that is registered with them at a cost of 24 cents per page. To get a copy of the Form ADV, contact the SEC at:

Office of Public Reference
450 5th street, NW, Room 1300
Washington, DC 20549-0102
Ph: (202) 942-8090
Fax: (202) 628-9001
e-mail: publicinfo@sec.gov

For additional information, contact the SEC Office of Investor Education and Assistance at:

Office of investor Education and Assistance
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0213
Ph: (202) 942-7040
Fax: (202) 942-9634
e-mail: help@sec.gov

Also, the SEC web page provides invaluable information about how to make educated investment decisions. Visit their web page at: http://www.sec.gov

National Association of Securities Dealers, Inc. (NASD)
The NASD is a securities industry self-regulatory organization. Through its subsidiary, NASD Regulation, Inc., the NASD assists investors in the selection of brokers and firms through its Public Disclosure Program (PDP). All information contained in the PDP is stored in the Central Registration Depository (CRD). The PDP reports information such as employment history, criminal history, suspensions, complaints, and actions brought by a regulatory authority.

When requesting the free information about a firm or individual, you will need the firm or broker’s name and the individual’s office address. Then contact NASD Regulation at:

Ph: (800) 289-9999
Or visit their web page at: www.nasdr.com

Government Finance Officers Association (GFOA)
The Government Finance Officers Association (GFOA) is an association of public-sector finance professionals and provides support to state and local governments. GFOA also has a Texas subsidiary, the Government Finance Officers Association of Texas (GFOAT). The GFOA and GFOAT web sites have excellent information on many subjects of governmental and public finance, including selection of an investment adviser.

For more information, contact the GFOA at:

Government Finance Officers Association
180 N. Michigan Ave., Suite 800
Chicago, IL 60601
Ph: (312) 977-9700

Or visit their web page at:
http://www.gfoa.org/

Or contact the GFOAT at:

Government Finance Officers Association of Texas
1821 Rutherford Lane, Suite 400
Austin, Texas 78754-5128
Ph: (512) 719-6300
Fax: (512) 231-7494
e-mail: webmaster@gfoat.org

Or visit their web page at:
http://www.gfoat.org/

Chartered Financial Analyst (CFA)
The CFA program is conducted by the Association for Investment Management and Research (AIMR), a nonprofit professional association.

Requirements:

  1. Pass three sequential examinations over a minimum of three years

  2. Work in the investment profession analyzing or managing investments for at least three years

  3. Agree to abide by AIMR’s Code of Ethics and Standards of Professional Conduct, and reaffirm that commitment each year.

For more information about the designation or someone holding this designation, contact AIMR at:

Ph: (800) 247-8132
Fax: (804) 951-5262
e-mail: info@aimr.org

Or visit their web page at:
http://www.aimr.com

Certified Financial Planner (CFP)
The CFP Board is a nonprofit regulatory organization that fosters professional standards in personal financial planning, and is the owner and licensor of the CFP certification.

Requirements:

  1. Completion of a financial planning curriculum from a college or university

  2. Pass a two-day, 10 hour CFP Certification Exam

  3. At least three years of prior experience counseling clients

The CFP Board web page contains a list of currently licensed CFP professionals, as well as those individuals whose license has been revoked or suspended. The address is: http://data.cfp-board.org/nd_licensee_us_form.asp

For more information about the designation or someone holding this designation, contact the CFP Board at:

CFP Board
1700 Broadway, Suite 2100
Denver, Colorado 80290-2101
Ph: (303) 830-7500
Fax: (303) 860-7388
e-mail: mail@CFP-Board.org

Or visit their web page at:
http://www.cfp-board.org/

Chartered Financial Consultant (ChFC)
The ChFC program provides financial planners and others in the financial services industry with in-depth knowledge of the skills needed to perform comprehensive financial planning for their clients. The American College awards this designation to those completing their academic course of study.

Requirements:

  1. Eight-Course Curriculum

  2. Approximately three years of business experience

  3. Maintain ethical standards

  4. Comply with the American College’s Code of Ethics and Procedures

  5. Comply with continuing education requirements

For more information about the designation or someone holding this designation, contact The American College/ Office of Student Services:

Ph: (888) 263-7265
Fax: (610) 526-1465
e-mail: studentservices@amercoll.edu

Chartered Investment Counselor (CIC)
The Investment Counsel Association of America, Inc. (ICAA), regulators of the CIC program, is a nonprofit organization whose membership consists exclusively of federally registered investment adviser firms.

Requirements:

  1. Must be employed by an ICAA member firm

  2. A minimum of five years of work experience in an eligible occupational position

  3. Must hold the Chartered Financial Analyst (CFA) designation

  4. Provide work and character references

  5. Must endorse the ICAA’s Standards of Practice

  6. Complete a professional ethical conduct questionnaire

For more information about the designation or someone holding this designation, contact the ICAA at:

Investment Counsel Association of America, Inc.
1050 17th Street, NW
Suite 725
Washington, DC 20036-5503
Ph: (202) 293-4222
Fax: (202) 293-4223
e-mail: ICAA@icaa.org

Or visit their web page at:
http://www.icaa.org

Personal Finance Specialist (PFS)
The PFS designation is designed for CPA’s who specialize in personal financial planning and is awarded to American Institute of Certified Public Accountants (AICPA) members who have demonstrated considerable experience and expertise in that area.

Requirements:

  1. Hold a valid CPA certificate and are members in good standing of the AICPA

  2. At least 250 hours of experience per year for three years preceding PFS application

  3. Pass a comprehensive exam

  4. Provide references from colleagues and clients to substantiate professional experience in personal financial planning.

  5. Must be re-accredited every three years

For more information about the designation or someone holding this designation, visit the CPA/PFS web page at:
http://www.cpapfs.org

Or visit the AICPA web page at:
http://www.aicpa.org


This article is reprinted with the permission of:
The law firm of Henslee, Fowler, Hepworth and Schwartz
816 Congress Avenue
Austin, Texas 78701
(512) 708-1804


1 John O'Dell, Derivatives: Risky Business?, Los Angeles Times, Dec. 2, 1994, at 22.
2 G. Bruce Knecht, I Owe U.: How a Texas College Mortgaged Its Future in Derivatives Debacle, The Wall Street Journal, Sept. 12, 1994, at A1.
3 Jeff D. Opdyke, Derivaties Crisis Faces as Rates Fall, The Wall Street Journal, June 7, 1995, at T3.