That Dog Won’t Hunt

First, my apologies for the delay between posts.  It has been incredibly busy between helping advisers prepare for the conversion to state supervision, helping new RIAs set-up their practices and performing fiduciary audits. 

I think RIA firms are finally getting the message that the regulators are serious about stepping up regulatory audits.  The SEC recently announced that they are going to conduct reviews of the representations that RIA firms are making regarding such matters as their experience and their AUM.  These are areas that plaintiffs’ attorney have focused on for some time in connection with fraud claims.

As many of you know, InvestSense provides both compliance consulting and fiduciary oversight services.  Like most compliance consulting firms, we provide mock compliance audits. 

Unlike most compliance consulting firms, the fact that I am an attorney allows InvestSense to go one step further and provide fiduciary audits where review an RIA firm’s policies,  procedures and risk management programs and alert the RIA firm to potential legal liability exposure resulting from such policies and procedures.

Many RIA firms mistakenly confuse their compliance issues with their need to effective risk management programs for their firm.  An RIA firm can have all the required compliance files and compliance manuals and still be totally unprotected against legal liability.  It’s a major loophole that plaintiffs’ attorneys take advantage of all the time.

I recently read Harold Evensky’s new book, “The New Wealth Adviser.”  Once again Mr. Evensky has put out an outstanding resource for investment advisers.  I highly recommend the book to all investment advisers.

In the book, Mr. Evensky emphasizes that advisers need to be well versed in both the professional and legal obligations of the industry.  The lack of a legal handbook for investment advisers is exactly why I published “The Prudent Investment Adviser Rules” (“Rules”) several years ago. 

The Rules is an ongoing compilation of court and regulatory decisions that establish the legal requirements and parameters for  investment advisers.  With the growing push for a universal fiduciary standard, the Rules take on a whole new importance for the financial services profession.  Most recently, we saw a decision here in Georgia addressing greater fiduciary responsibilities for financial advisers involved with non-discretionary investment accounts.  While it remains to be seen if other jurisdictions issue similar rulings, there is a general feeling that the courts and the regulators are going to extend the reach of fiduciary responsibilities of financial advisers to provide better protection to investors.

I am currently updating the Rules to reflect the changes that have occurred since I published the original rules.  While I provide my clients with regular updates through my newsletter, I decided that it would be appropriate to consolidate the updates into a new edition of the rules.

Those who are clients or have heard me speak know that I like to focus on the three decisions that I feel every investment adviser needs to know.  These three decisions cover three areas that regulators and plaintiffs’ focus on: suitability, risk management and portfolio construction/management.

Suitability is one of the primary grounds for actions against financial advisers.  Many advisers claim that they do not understand the concept of suitability.  For many regulators and attorneys, while it may be difficult to provide one all-encompassing definition of unsuitability, Supreme Court Justice Potter Stewart’s explanation regarding pornography, that he knew it when he saw it, is the applicable standard.

Many investment advisers and stockbrokers get ensnared in the suitability trap because they are not aware of the relevant legal decisions.  The James B. Chase decision is one of three decisions that I believe every adviser should know and understand.  In Chase, the NASD clearly stated that suitability required the financial professional to determine both the customer’s willingness and  ability to bear the contemplated investment risk.  Interestingly enough, Harry Markowitz introduced the two-prong concept back in 1952 when he introduced his Modern Portfolio Theory.  

Far too often advisers ignore the “ability to bear” portion of the suitability equation and find themselves in an indefensible situation.  Back in my compliance days, I would routinely reject proposed transaction due to a customer’s apparent inability to bear the investment risk involved in the proposed trade.  Time and time again the broker would wave the new account form in my face telling me the trade was within the marked objectives for the account.  Time and time again they would march out of my office in search of someone else to approve the trade.

While Chase and its progeny have firmly established to two-prong test for suitability, I would suggest that there is a growing support for a third prong, that being the need to assume greater risk.  Even if the customer is willing and able to assume the risk of the proposed investment(s), was there a need to do so.  Here, we reintroduce the concept of fiduciary responsibility, the obligation to always act in the client’s best interests.  As courts and regulators have continued to expanded the concept of the fiduciary duties of financial advisers, the “need” prong has taken on increased importance.

There are numerous other legal decisions that helped define the suitability standards for investment advisers and the rest of the financial services industry.  As Mr. Evensky points out, it is the responsibility of the adviser to be aware of applicable legal standards.  The courts and the regulators have consistently ruled that ignorance of the law and/or good intentions (the pure heart, empty head defense) is no defense to a legal action alleging unsuitable trades or breach of one’s fiduciary standards.  That dog simply won’t hunt.

Happy holidays and best wishes for a prosperous new year to all!

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, RIA, RIA Compliance, securities, securities compliance and tagged , , , , , , , . Bookmark the permalink.

1 Response to That Dog Won’t Hunt

  1. harvey friedentag says:

    You are right on with all of your comments.

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