RIA Compliance in 3-D

Regulators are stepping up their surveillance of RIA firms.  While RIA firms are complaining about the time and cost requirements to prepare and maintain an acceptable compliance program, most compliance issues can be reduced to one of three areas – disclosure, documentation and due diligence.

RIAs are fiduciaries and will be held to the higher fiduciary duty of “in the client’s best interests,” not the “suitability” standard of registered representatives.  Dually registered reps can expect to be held to the higher fiduciary standard,  even if they assert the lame two hats” position.  Regulators and the courts are deciding these cases by using a “totality of the circumstances” approach and not from a pure transactional approach.

The very essence of fiduciary law is disclosure, especially with regard to actual or potential conflicts of interest.  Failure to disclose actual or potential conflicts of interest, especially involving monetary incentives, can be expected to result in breach of fiduciary claims.  A failure to disclose material facts is also grounds for a breach of fiduciary claim.  The regulators and the court have generally defined “material facts” for an investor to be information that a normal investor would consider to be important in making an investment decision.  

Recent cases have involved questions regarding a fiduciary’s duty to disclose fees and revenue sharing arrangements.  The fee issue remains an ongoing question, as several cases are still pending.  The revenue sharing issue has basically been settled, as a number of broker-dealers and investment companies were fined millions of dollars for failing to disclose revenue sharing arrangement.  Regulations were also established requiring that revenue sharing arrangement be disclosed to potential investors.

Documentation involves not only preparing and maintaining the books and records required under the Investment Advisers Act of 1940 and the related regulations, but also documents defining the adviser-client relationship.  Advisers who simply adopt off-the-shelf cookie cutter materials can expect to be cited during an audit. 

Regulators expect an RIA to adopt policies and procedures that reflect the RIA’s actual practices and to comply with the policies and procedures adopted.  Big is not better when it comes to compliance manuals and compliance programs for small RIA firms.  The policies and procedures manual that my firm prepares for small to medium RIA firms is typically between 12-15 pages, including compliance forms.

Another area of documentation often overlooked by RIA firms is the preparation of an investment policy statement (IPS).  An IPS can be a valuable client management tool, as it establishes the expectations and responsibilities of the parties.  In a worst case scenario, an IPS can be a valuable litigation tool, often increasing the chances of quickly dismissing a disgruntled client’s claim.

A final area of concern regarding documentation involves policies and procedures involving the destruction of client information.  An RIA’s policies and procedures should include clear guidelines for ensuring the safety of client information, including the proper destruction of same.  RIAs should also check state laws regarding protection and/or of client records, as most states have passed laws and regulations regarding

Due diligence is an area that is gaining increasing attention from both regulators and the courts.  Emerging issues in due diligence involve “black box” financial planning, consistency between financial plans and product implementation,  the so-called “bait-and-switch” concern, and  “pseudo” diversification. 

Both investment advisers and registered representatives have a responsibility to conduct their own due diligence on a product before recommending that product to a client.  Blindly relying on materials prepared by others is no defense to an unsuitability or breach of fiduciary duty claim.

Attorneys are increasingly using a reverse engineering approach to financial planning and portfolio construction/optimization to expose due diligence issues.  Advisers who do not review calculations and asset allocation recommendations in their financial plans prior to distributing a plan to a client have little or no grounds for defense if a subsequent analysis of the plan reveals due diligence problems.

Many advisers have contacted me to inquire about possible ways to limit their exposure to due diligence claims.  Some attorneys and consultants have suggested that a disclosure should be effective in reducing potential due diligence liability exposure.  Section 206 of the ’40 Act, the Act’s anti-fraud section, has generally been interpreted to prohibit any attempt to waive any of an adviser’s responsibilities under the Act and the regulations.  Any attempt to waive such responsibilities has been construed as an act of fraud. 

Another factor in assessing the effectiveness of a disclosure regarding due diligence issues would be whether a client could sufficiently understand both the plan information and the legal obligations owed to them to make such a disclosure and waiver legally effective.  The regulators and the courts generally do not look favorably on an attempt by a party with superior position, knowledge and experience to use such leverage against a disadvantaged party, holding that a party cannot be said to affirm an action unless the party has both sufficient information and sufficient capability to analyze and understand the transaction.

An emerging due diligence issue is the issue of “pseudo” diversification, or the the recommendation of portfolios containing a large percentage of highly correlated investments.  The premise behind the “pseudo” diversification claim is that the highly correlated investments fail to provide an investor with an acceptable level of protection against downside risk.  The fact that an analysis of correlation of returns can be done relatively quickly using Microsoft Excel or at one of several online sites also strengthens a due diligence/breach of fiduciary duty claim based on “pseudo” diversification.

The recent bear markets and the continued exposure of wrongful acts in the financial services industry ensure that investment advisers will continue to face increased regulations in the future.  By focusing on the three D’s – disclosure, documentation and due diligence – and setting up and maintaining proper compliance programs for these threes areas, RIA firms will have addressed a major portion of their compliance concerns.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ 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 and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
This entry was posted in compliance, investments, RIA Compliance and tagged , , . Bookmark the permalink.

1 Response to RIA Compliance in 3-D

  1. Scott says:

    I am a fee only advisor and still find fee products or managed portfolio’s not giving full disclosure but mostly disclosing. Transaction costs for mutual funds under the 1940 Act does not require the disclosure of those costs. Sometimes these can be significant. Sites like Personal Fund will tell you that 100% turnover in a mutual fund portfolio may be about 1% extra costs not disclosed and 200% would be 2% extra costs not disclosed. I have some managed accounts I like because of the risk management and past track record of reducing risk or flucuations and yet nearly impossible to figure out all the costs associated.

Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.