Hiring Your First Employee: What You Need To Know To Cover Your Compliance Obligations

While starting a new business can be fulfilling, there comes a point when firm owners realize they can't handle everything alone. This realization should be backed by a thorough assessment of workload, budget, service quality, and growth potential. After crunching the numbers and identifying the firm's needs, it's crucial to delve into the legal and compliance requirements that come with a first hire. This understanding will not only help new owners avoid potential legal issues but also ensure the smooth operation of the business.

The first step is for owners to define what they need in a new hire. While a new hire's job responsibilities and level of autonomy will help grow the business, they can also drive legal and tax obligations. Thus, it's crucial to understand the implications of hiring a new person and make an informed choice about the responsibilities being delegated.

For example, if the firm owner has more clients and prospects than they can handle, then they may need an administrative assistant to help with scheduling, returning calls and emails, and entering data. A person filling this role may be required to keep regular working hours and work onsite at the business, so it might make the most sense to hire an employee (and not an independent contractor). Furthermore, if this new hire will not be advising clients, they probably won't have any need to register as an Investment Adviser Representative. 

However, if the owner is struggling to grow the business, then they may want to bring in another adviser, who would need to meet registration requirements as an Investment Adviser Representative (IAR) to bring in more clients, or partner with another IAR who has their own clients to grow the firm.

The Hiring Decision: Independent Contractor Vs Employee

Once the owner has decided what they need, the next decision is whether the new hire should be an employee or an independent contractor. This decision is pivotal and can impact the business. Understanding the implications and making an informed choice is crucial because employees and independent contractors are treated differently under wage and hour laws and for tax purposes. 

Specifically, when a firm hires an employee, it must pay income and withhold Social Security, Medicare, and unemployment taxes (See the IRS website for more information on employer tax obligations). On the other hand, independent contractors are responsible for their own tax obligations. When a firm misclassifies an employee as an independent contractor, there can be significant penalties, including back wages, tax arrears, and other fines.

According to the IRS website and the Fair Labor Standards Act, the difference between an employee and an independent contractor boils down to the following factors: 

1. Behavioral control. Employees work specific hours and use the company's tools and resources (e.g., laptops and software) to perform their duties. 
2. Financial control. Employees are paid an hourly wage or salary. The employer withholds tax contributions and determines the frequency of payment. 
3. Relationship. Employees are likely to dedicate their working hours to the company and receive certain benefits (e.g., pension plan, insurance, vacation pay, etc.). Contractors may work for other clients and perform specific tasks as agreed to by contract.

For example, if a new hire is required to work specific hours from a specific location using standard operating procedures and equipment supplied by the firm, they would be considered an employee based on the 3 factors listed above. 

Other indicators of employee status include firm reimbursement of the new hire's business expenses and a benefits package. Factors that might indicate that an IAR is an independent contractor include the opportunity for profit or loss based on their own efforts to gain clients and assets under management; responsibility for purchasing their own tools, technology, and resources to perform their duties; and their autonomy.

The following chart provides a brief overview of factors considered when making the employee versus independent contractor determination.

Determining whether a new hire would be considered an employee or an independent contractor can be based on complicated factors. Some business owners may consider getting legal advice to make the correct determination. While the IRS can also make this determination for employers filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, it may take anywhere from 6 months to a year to receive a response. 

When a firm owner goes from operating as a sole proprietor to an employer, some red tape is involved at the Federal and state levels. On the Federal level, the firm must obtain an Employer Identification Number (EIN) to use on tax returns and documents submitted to the IRS, which can be obtained by completing IRS Form SS-4, Application for Employer Identification Number. States also impose regulations on employers, including paying unemployment taxes, obtaining workers' compensation insurance, periodic reporting of wages, and notification to the state hire reporting agencies. There are other legal obligations associated with being an employer, so business owners need to seek expert advice (e.g., from an employment attorney, accountant, or business consultant) to ensure that they are taking all the steps required to hire a new employee. 

Registration Requirements For Investment Advisers 

In addition to the red tape that all new employers must contend with, advisory firm owners must also determine whether the new employee (or independent contractor) would be considered an Investment Adviser Representative (IAR) based on the new hire's duties and compensation. If a new hire performs certain activities or functions, they could be deemed an IAR subject to state-imposed qualification, licensing, and registration requirements. 

Determining When A New Hire Will Act As An IAR

 The North American Securities Administrators Association (NASAA) offers the following helpful summary of how most states define an IAR:

An investment adviser representative generally is a person who, for compensation, (1) makes any recommendations or otherwise renders advice regarding securities; (2) manages accounts or portfolios of clients; (3) determines which recommendation or advice regarding securities should be given; (4) solicits, offers, or negotiates for the sale of or sells investment advisory services, or (5) supervises employees who perform any of the foregoing.

If a new hire is expected to solicit new clients, manage client accounts, and provide investment advice, then licensing and registration as an IAR will likely be required.

While investment advisory firms are required to register with either the SEC or a state (or states), but not both, IARs are generally required to register with state regulators. As noted in Chris Stanley's previous blog post, How to Register Your RIA: State Vs SEC Registration and When Notice Filing is Required, individual IARs are subject to state regulation in the states where they do business and have clients, regardless of whether they are associated with a state-registered or SEC-registered investment adviser firm. 

Registering As An IAR

There are different definitions of IAR, depending on whether they work with a Federal or state-registered investment advisory firm. For SEC-registered firms, an IAR must meet the following conditions (as defined in the Advisers Act Rule 203A-3):

• Be a "supervised person" of an investment adviser (as defined in Advisers Act Section 202(a)(25));
• Solicit, meet, or communicate with clients on a regular basis (excluding those that only provide impersonal investment advice); and
• Have more than 5 clients who are natural persons and are not "qualified clients" (as defined in Advisers Act Rule 205-3(d)(1)). 

An individual working with an SEC-registered investment adviser who only serves qualified clients or has fewer than 5 individuals (natural persons) as clients is not subject to state IAR registration requirements. Supervised persons who provide only impersonal investment advice or do not meet with clients on a regular basis would also be exempt from state IAR registration requirements. 

For individuals working with state-registered investment advisers, state law governs. IARs for state-registered investment advisory firms typically must register in any state where they have an office or where they have a certain number of retail clients, typically more than 5. Employers can contact their state securities department for specific requirements and filing fees.

IARs register using Form U4, the Uniform Application for Securities Industry Registration, on FINRA's Central Registration Depository (CRD) system. Typically, the advisory firm makes the Form U4 filing on behalf of an IAR through the FINRA Gateway. (For more details on Form U4, see Form U4: Common Missteps And Best Practices For RIAs.) 

In addition to filing the registration form, IARs must meet specific qualification requirements. Many states require that IARs pass either 1) the Series 65 Uniform Investment Adviser Law Examination or 2) the Series 7 General Securities Representative Examination combined with the Series 66 Uniform Combined State Law Examination. 

States may also grant waivers to these requirements for IARs with certain professional designations, including Chartered Financial Analyst (CFA), Chartered Investment Counselor (CIC), Certified Financial Planner (CFP), and Chartered Financial Consultant (ChFC). States may also require IARs to submit a copy of their fingerprints to the licensing division for criminal background checks. 

Disclosures Required At The Firm Level: Form ADV Part 1A, Part 2B, And Form CRS

When hiring new employees, firm owners should consider revising Form ADV, regardless of whether the firm is registered with the state or SEC, as the form requires disclosure of several items that may need to be updated because of changes resulting from new hires. Refer to this downloadable document for a checklist of potential disclosures that may be needed on Forms ADV, U4, and CRS. 

Form ADV Part 1

Item 1 of Form ADV, Part 1A ("Identifying Information") may need to be updated if hiring a new employee or independent contractor results in a new address, a different number of firm offices, or if there are changes to the location of required books and records, website addresses, or social media accounts attributable to the firm.

Additionally, Item 5 ("Information About Your Advisory Business") should be updated to reflect any new employees (or independent contractors) and disclose whether they will be performing investment advisory functions and whether they are registered with a state (or states) as an IAR. Notably, the Form ADV glossary states that independent contractors who perform advisory functions on behalf of an advisory firm are considered "employees" when responding to Item 5.

If the new hire will be an executive officer or director, or have an ownership interest in the firm, then the firm should amend Form ADV Part 1, Schedule A ("Direct Owners and Executive Officers"). To make this amendment, the firm must complete Schedule C to amend Schedule A. The Schedule A instructions provide more details about who should be listed on this schedule. 

If new hires are bringing clients with them to the firm, firm owners should determine whether to "notice file" in other states (in Item 2 of Form ADV part 1A, "SEC Registration"). Information about the new clients, the firm's assets under management, and compensation arrangements disclosed in Item 5 may also need to be updated. Additionally, the firm should also review its responses to Item 9 regarding custody for the new hire's clients. Finally, finding out about the new hire's disciplinary history is important to determine whether responses to Item 11 need to be updated. 

According to the Form ADV instructions, updates should be made "promptly" by submitting an "other-than-annual" amendment when the information provided in response to the following items becomes inaccurate in any way:

Part 1A:

• Item 1 (except 1.O. and Section 1.F. of Schedule D);
• Item 3; 
• Item 9 (except 9.A.(2), 9.B.(2), 9.E., and 9.F.); or 
• Item 11.

Part 1B:

• Item 1;
• Items 2.A. through 2.F.; or 
• Item 2.I. 

Schedule R:

• Section 1; or 
• Section 3.

Although it is not a hard and fast rule, "promptly" is usually considered within 30 days. There is no charge associated with submitting an "other-than-annual" filing.

Updates must also be made if the information provided in response to the following items becomes materially inaccurate: 

Part 1A:

• Item 4;
• Item 8; or
• Item 10.

Part 1B: 

• Item 2.G. 

Section R: 

• Section 4.

If changes to these sections are not material, then an update can wait until the annual amendment to Form ADV. 

Form ADV Part 2A

SEC-registered investment advisers should also review their Form ADV Part 2A, also known as the "Brochure," when hiring a new IAR. For example, if the firm begins offering additional advisory services, changes its fee schedule, or provides new investment strategies, then Form ADV Part 2A must be updated to reflect these changes. 

If the new hire has a disciplinary history, the adviser must decide whether additional disclosure is required. The Form should also include disclosures of any additional conflicts of interest that can affect clients resulting from the new hire.

Form ADV Part 2B

Part 2B of the Form ADV is the "Brochure Supplement". If the new hire is an IAR, then this document must be provided to individual clients who will be interacting with the new hire. The SEC requires that an "investment adviser must give a client a brochure supplement for each individual that it supervises who: (1) formulates investment advice for that client and has direct client contact; or (2) makes discretionary investment decisions for that client's assets, even if the supervised individual has no direct client contact." 

The Brochure Supplement is not filed with the SEC but must be maintained as part of the firm's official books and records. The Brochure Supplement does not have to be delivered to clients annually but must be delivered when the relationship begins, when there is a new disclosure of a disciplinary event, or when there is a material change to disciplinary information previously disclosed, accompanied by a statement describing the revised material facts. 

The brochure supplement discloses background information for individuals providing investment advice, including their education, business experience, professional designations, disciplinary history, other business activities, and material conflicts of interest. The brochure supplement also discloses any additional compensation earned, how the individual is supervised, and the direct supervisor's contact information. The document must be delivered to clients before or when the individual begins to provide investment advice to the client. The disclosures in the Brochure Supplement should be consistent with those in the IAR's Form U4. 

The SEC permits disclosure of an IAR's professional designations, provided that the form includes a sufficient explanation of the minimum qualifications required for each designation so that clients can understand its value. The explanation should address the designation's learning objectives, required coursework, and other qualifications, such as experience, continuing education, and ethics requirements.

Form ADV Part 3: Form CRS

SEC-registered investment advisers that serve retail investors must file Form CRS (also known as the Client Relationship Summary) with the SEC and post it on the firm's public website (if the firm has one). Form CRS is filed through the Investment Adviser Registration Depository (IARD) as Part 3 of Form ADV. Advisers are also required to provide Form CRS to retail clients under the following circumstances:

• Before entering into an advisory agreement;
• Before opening a new account with any client;
• When recommending a rollover of assets from a retirement account into a new or existing account; or 
• Recommending or providing a new advisory service that does not necessitate opening a new account. 

The instructions for Form CRS are available from the SEC. 

Form CRS is meant to be a plain-language summary of an advisory firm's services, fees, conflicts of interest, and applicable standards of conduct. It must disclose whether the firm and its financial professionals have a reportable legal or disciplinary history and how prospective clients can obtain additional information about the firm.

SEC-registered advisers are required to update Form CRS within 30 days if the information included becomes materially inaccurate. The amended Form CRS must be provided to existing clients within 60 days after the updates are required. When bringing a new IAR, the firm should review Form CRS to determine whether changes are required. For example, if the firm now offers additional advisory services or has changed its fee schedule, then Form CRS must be updated to reflect these changes. 

If the new hire has a disciplinary history, the adviser must decide whether additional disclosure is required. Form CRS should also include disclosure of any additional conflicts of interest that can affect clients resulting from the new hire.

Determining How New Hires Will Be Supervised

Another important consideration when bringing on a first new hire is supervision. For SEC purposes, whether the new hire is an employee or an independent contractor does not matter. The Commission (and examination staff) will consider the new hire to be under the firm's supervision, which means the firm owner will presumably be considered the supervisor. 

Assuming that the advisory business is set up and registered as an investment adviser with the state or the SEC, the firm should have adopted a compliance manual. This manual should be reviewed to determine whether the procedures for supervising a new hire's activities are appropriate or need to be updated. Consider the new employee's job responsibilities and the associated risks to determine the level of supervision required. 

The Risk Alert: Observations from Examinations of Investment Advisers: Compliance, Supervision, and Disclosure of Conflicts of Interest, released in July 2019 by the SEC Office of Compliance Inspections and Examinations, provides insight into the Division of Examination's expectations regarding supervision. Their review of several SEC-registered investment advisers that had employed "any individual with a history of disciplinary events" revealed that, in instances where supervisory practices were considered inadequate, "advisers' policies and procedures did not sufficiently document the responsibilities of supervised persons or did not clearly outline the expectations for these individuals." 

Specific examples of their examination findings include advisers' failure to do the following:

• "Oversee whether fees charged by supervised persons were disclosed or assess whether the services clients paid for were performed….
• Have advertising policies and procedures that provide sufficiently specific guidance to supervised persons who prepared their own advertising materials and websites…
• Include reviewing activities of supervised persons, including those with disciplinary histories, working from remote locations as part of its monitoring activities."

Reviewing and updating the firm's compliance manual to include appropriate supervision procedures may seem overwhelming. To get started, business owners should focus on the higher-risk areas first. These include the following:

• Maintaining the confidentiality of clients' personal, non-public information. Ensure the new hire understands the regulatory requirements regarding safeguarding client information and the firm's resources and procedures for maintaining confidentiality as required by Regulation S-P. The firm should also ensure that the systems used to retain the new hire's communications capture and retain them. 
• Capturing and maintaining written communications with clients. Firms are required to retain specific client communications as required under the Advisers Act Rule 204-2. New hires should be required to use a firm email address and other firm resources and tools to ensure this documentation is retained within the firm. Firm owners should also consider how to supervise these communications, such as periodically reviewing the employee's email and any other approved forms of communication.
• Ensuring that any marketing materials mentioning the firm and promoting its services meet the requirements of the Advisers Act Marketing Rule (Rule 206(4)-1). If new hires are responsible for advertising, then all marketing materials, such as radio or TV advertisements, email blasts, and information provided on websites and social media accounts, should be reviewed for compliance before distribution and retention of the ads. 
• Limiting access to the firm's trading platform to employees with the authority to enter trades. Consider controlling access to the firm's trading platform so that only authorized traders can use the system. This could include reviewing system logs to ensure only authorized users have accessed the system or setting up the system to require a supervisor's approval before any trades are entered.
• Limiting the ability to move funds from the firm's or any client's accounts. Depending on the new hire's role, the firm should consider instituting controls to ensure that any money movement requires additional approvals.
• Limiting the communication and negotiation of terms with vendors and sub-advisers to employees or officers who have received written authorization. Depending on the new hire's role, firm owners should consider how much authority they should have and clearly communicate the limits.
• Providing access to and securing certain firm documents. Some documents, such as the standard advisory contract, initial investor/client questionnaire, account opening documentation, Form ADV Part 2A, 2B, and CRS, have been carefully crafted to meet the firm's business needs and regulatory requirements. While they should be made available to firm employees, they should also be secured so that they cannot be manipulated in any way that would circumvent their purpose and put the owner at legal risk.
• Investigating the new hire's background. If a new hire has access to client information, it is especially important to verify the information on their resume or job application and to find out whether they have any negative regulatory history or legal issues. Moreover, if the new hire is an IAR, it is important to know whether they have any regulatory issues that must be disclosed. Regulators expect to see "heightened supervision" procedures for employees with disciplinary histories. See the Risk Alert: Observations from Examinations of Investment Advisers: Compliance, Supervision, and Disclosure of Conflicts of Interest for more details.
• Asking about conflicts of interest. Before hiring a new employee or independent contractor, developing a questionnaire can help obtain disclosures of any outside business activities that may need to be reported as conflicts of interest. The firm's compliance program should address conflicts of interest, such as outside business activities or relationships with clients or vendors.

Code Of Ethics

When a firm makes its first new hire, it must supervise that individual's compliance with its code of ethics. All Federally registered investment advisers are required under Advisers Act Rule 204A-1 to establish, maintain, and enforce a written code of ethics. (For more details on the requirements, see RIA Code Of Ethics: Important Nuances To Note In Relatively Straightforward Requirement.) Many states have also adopted a similar requirement. 

According to the Adopting Release for Rule 204A-1, access persons include "employees who are in a position to exploit information about client securities transactions or holdings." A firm's first employee will likely have access to this information and should, therefore, be covered by the firm's code of ethics. 

New employees must provide a list of their personal securities accounts and holdings within 10 days of employment and annually. Every quarter, the employee must report all "reportable securities" transactions executed in their personal securities accounts. The employee's supervisor must review these reports and compare them against the holdings and transactions in client accounts to identify any conflicts of interest. Additionally, the employee will need to ask for approval before acquiring an ownership interest in any security in an initial public or a limited offering.

Although individuals who have worked in the financial services industry may already understand these requirements, anyone new to the field may (understandably) find these reporting and preclearance requirements onerous and invasive of their privacy. However, having and enforcing a code of ethics that meets the requirements of Rule 204A-1 is non-negotiable. Federal and state regulators almost always include a review of the firm's code of ethics as part of routine examinations and expect to see both the personal securities transaction reports and proof that they have been reviewed internally.

For small firms, it may be easiest to request employees' most recent brokerage statements each quarter and have duplicate securities transaction confirmations sent directly to the office. It is also a good idea to have the reporting employee certify that either they have not opened any new accounts during the period or, if they have, to provide the information about the new accounts.

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Hiring the first employee is a significant milestone for any new business. By assessing the firm's needs, understanding the legal and compliance requirements, and making informed decisions regarding the classification of new hires, business owners can ensure a smooth transition from sole proprietorship to a more robust operational structure. Considering the responsibilities and registration requirements while following regulatory guidelines can help avoid legal issues and lay a strong foundation for sustainable growth.