Don’t Go There!

My clients are familiar with several pet phrases that I use to state my opinion in a short, yet definitive manner.  One of those phrases that I find myself using a lot is “don’t go there.” 

As a compliance consultant I am naturally more conservative than my RIA clients.  I am also a firm believer in most of the principles set out in the classic, “The Art of War.”  One of the basic principles in the book is the value of preparation before engaging the enemy, the idea of winning the confrontation before it even begins through careful preparation.

One of my favorite stories involves a client who called me from a large national convention regarding a seminar he had just attended.  The client said that the speaker had suggested that RIAs could provide non-monetary items to existing clients for referrals.  This was in direct conflict with what I tell all of my clients about applicable compliance standards regarding gifts to existing clients.

First, the speaker was obviously unaware of or simply ignoring an earlier SEC release regarding the commission’s position on such non-monetary gifts.  Naturally, the commission warned against such actions, citing the actual or potential conflicts of interest questions that could result and the potential for violations of the anti-fraud provisions of Section 206 of the Advisers Act is such compensation plans were not disclosed to a potential client.

This does not mean that an RIA can never give an existing client tickets to a sporting event or a play or some something similar.  As long as the occasional gift is just that, occasional, and is not the quid pro quo for referrals, then the RIA should be fine.  A continuing pattern of such gestures and/or the value of such compensation will most likely raise questions and reviews from regulators.

I had a similar situation recently where a client called to ask me about a new mutual fund that was being launched by one of his former college roommates.  The friend was asking him to invest in the fund to help it get established.  The concept appeared to be sound and the former roommate’s record was clean.  The roommate was experienced in investing, however the concept he was advancing was relatively new.

My advice to my client was not to go there, at least not with any of his client’s money.  If he wanted to invest his own money, that was his decision.  To invest money in any new unproven, start-up venture is equivalent to showing the bull the red cape.  If there are problems, the RIA is going to hard time proving that the investment was suitable and that the RIA properly preformed the required due diligence on the investment.

I once heard a speaker suggest that the relevant question to ask before taking an action or making a recommendation involving a client was whether you would do the same thing if your client was your mother-in-law.  I am not so sure that that is the proper guideline to use.  However, I do think advisers should honestly and properly consider all aspects of the situation and ask themselves whether, should this result in a worst case scenario, there are any precedents that cover such situations, precedents such as no-action letters and regulatory enforcement proceedings.

Even if there are no precedents, an adviser should practice the same drill most trial attorneys do in preparing cases, that being arguing both sides.  From the regulatory side, advisers should always be aware that most actions against brokers and advisers center on fraud, fundamental fairness, and proper disclosure of material information and/or issues involving conflicts of interest. 

I read a book recently that side that an investor’s time horizon was the most critical factor in determining suitability.  Trust me, it is not.  Suitability, both in terms of a client’s willingness and ability to bear risk, is the primary factor in determining suitability.  If a client is a millionaire, but indicates a little or no tolerance for risk, your recommendation had better be consistent with their wishes.  And if things go bad, forget all the technical assert allocation/ MPT arguments and just bring your checkbook.

“It’s the client’s money” is another one of my sayings.  If a client wants to be more conservative than you think they should be, document the advice you gave them and let them proceed.  If the client wants to engage in activity that you think is unsuitable, advise the client accordingly, decline to participate in the activity, and document the situation for your file.  I also recommend sending a letter to the client to evidence your warning to them and that it was their decision to go forward.  In either case, remember that “it’s their money” and protect yourself with proper documentation.  If you document the event at the same time, you should be able to use the documentation as evidence should they attempt to file a frivolous arbitration claim.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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