The Investment Adviser’s Achilles’ Heel v. 2.0

The Securities and Exchange Commission (SEC) recently released a notice regarding the use of testimonials and social media. Investment advisers are generally prohibited from using client testimonials. While the SEC has allowed the use of third-party ratings as long as certain requirements are met, as set out in the Dalbar decision, the whole area of testimonials is fraught with traps and, in my opinion, should be avoided, as it is an accident waiting to happen.

The testimonials and social media issue is just an example of a bigger issue for investment advisers. In my office, I have a framed copy of the famous “Pogo” cartoon where Pogo says “we have met the enemy and he is us.” As I have stated before, I think that the Achilles’ heel for most investment advisers is the lack of an effective risk management program for the firm. As I visit various investment adviser web sites and perform compliance audits for advisory firms, I am always surprised to see how advisory firms leave themselves exposed to unnecessary risk exposure.

I like to tell the story of a client who once called me from a national conference. The conference was being presented by one of the major custodians for advisory firms. The client had just attended a presentation on improved marketing for advisory firms. The client told me that the speaker had recommended giving customers magazine subscriptions and/or tickets to sporting events or plays in exchange for referrals. The client had run this idea by me before and I had explained to  him that such a promotion would require compliance with the ’40 Act’s solicitation rules.

Unfortunately, I see this type of situation all too frequently. Unless one if familiar with investment adviser laws and stays updated on same, it is easy to mislead investment advisers. Although such misinformation is usually unintentional, an investment adviser relying on same is still liable for any violation.

What the conference speaker failed to disclose is that providing anything in return for referrals and/or testimonials can be seen as an actual or potential conflict of interest since the gift could influence a client’s opinion. In fact, the SEC had dealt with this issue several years ago and raised the same non-disclosure of conflict of interest issue.

One of the biggest audit/liability issues for advisers is the use of “canned” or cookie cutter materials, including required manuals and other documents. Advisers need to understand that the first thing the SEC or a plaintiff’s attorney is going to ask for is a copy of the adviser’s manuals, disclosure document, contracts, etc. This is the proverbial “low hanging fruit” for liability and audit purposed, as it often points to violations.

Advisers need to understand that they need to be in compliance with their Form ADV, disclosure brochure, contract or other material. Technically, the advisory contract is the determining factor. However, it can, and usually is, argued that false representations in other advisory material constitute misrepresentations, if not fraud, in violation of Section 206(4) of the ’40 Act. Therefore “canned” or cookie cutter materials should always be amended to ensure that they accurately reflect an advisory firm’s actual practices.

Another issue with regard to advisory compliance is proof of enforcement of the firm’s policies and procedures, both in terms of timeliness and substantive enforcement. At the very least, an advisory firm should keep a separate files for P&P issues and the file should have quarterly reports indicating personal quarterly trades by the firm’s personnel, including any trades that required pre-approval under the firm’s P&P.

Perhaps the most important thing for advisory firms to realize is that their advisory firm is just that, theirs. The fact that the firm’s members may be affiliated with a broker-dealer does not require a broker-dealer to provide compliance and/or other legal services to the independent advisory firm. Under NASD 94-44, a broker-dealer is only responsible for reviewing the trades of the firm’s representatives who are affiliated with an independent advisory firm.

Advisory firms often indicate that they engaged in certain activity based upon their compliance consultants advice. There are some excellent RIA consultants. Unfortunately, there are some RIA consultants that are not excellent. Based upon my experience, while it is easy to go through the ‘4o Act and its related regulations as to an investment adviser’s required infrastructure, many consultants do not properly address the various liability issues that advisory firms need to address. Unfortunately, if an investment advisor is found to have engaged in improper conduct, the violation is going to be enforced, regardless of the quality of the consultant’s advice.

The key is for advisory firms to be proactive in creating and managing their firms. As the commission-based investment services platform is being replaced by the advisory-based platform, there are an increasing number of legal and regulatory decisions that are shaping the investment advisory business. Advisory firms that fail to monitor such development and adapt accordingly simply increase the likelihood of unnecessary liability and/or regulatory woes.


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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