The Liability Needle in the RIA Haystack

I have always enjoyed working with registered investment advisers (RIAs) and their representatives (IARs). I first got into the investment industry in 1995, shortly after the NASD issued Notice to Members 94-44. NTM 94-44 clearly stated that BDs had a duty to monitor the trading activity of both independent RIAs owned by the BDs registered representatives and the BD’s own proprietary RIA.

I was one of the few attorneys in Atlanta who had an understanding of the Investment Advisers Act of 1940, so I responded to an  for a RIA Specialist with FSC Securities here in Atlanta. Met some incredible people like Jim Wisner, FSC’s President, Tom Wells, FSC’s general counsel. and Carolyn Maloney, who actually ran the RIA Compliance department for me.

One of the most frustrating aspects of my job as manager of RIA compliance department was that I knew I could offer more advice to the RIA firms than we were providing. At the same time, I understood FSC’s position with regard to the potential liability issues involved with providing such information.

BDs have no legal obligation to provide compliance advice to independently owned RIA firms. I do not think that most independent RIA firms believe that their BD will tell them anything they need to know with regard to RIA legal and compliance issues. Just as I tell my RIA compliance clients, if you do not have a legal obligation to provide a service, either by laws/regulations or based on your contract with a client, do not provide such service. If you do, a good attorney will argue that you voluntarily provided said service, so why did you not provide other additional services.

I believe that most RIAs and IARs are basically honest and want to provide their clients with valuable services.  That’s why I try to provide information on this blog that will educate RIAs and IARs and allow them to better protect themselves and their practices with regard to best practices and some little known legal nuances, or as I like to call them, liability needles in the RIA haystack.

Grab your master agreement with the custodian(s) that you use for your RIA practice. Somewhere in the agreement you will find language such as

You represent and warrant that you have necessary authority to enter into this agreement.

You represent and warrant that you have necessary documentation and authority to enter into this agreement.

You agree to indemnify and hold harmless XYZ and its affiliates, and its and their directors, officers, employees and agents from and against any and all claims, actions, costs, and liabilities, including attorneys’ fees, arising out of or relating to XYZ acting in accordance with any instructions that you may give.

Trust me, it’s somewhere in the master agreement, usually in a section entitled “Legal Authority” and/or Indemnification.” My experience is that too many RIA firms simply sign the master agreement without actually reading, considering and understanding the actual terms of the master agreement. In some cases, the failure to do so can have some serious adverse, and expensive, consequences.

The investment industry generally relies on a document known as a trading authorization in taking orders and trading. While the industry does business relying on such trading authorizations, no questions asked, the fact of the matter is that legally, a person needs to have a power of attorney in order to legally act on behalf of another person. Two of the most common power of attorney forms, also referred to as “directives” in some cases, are a durable power of attorney for health care and a financial durable power of attorney.

When a securities attorney is reviewing a potential case involving a discretionary account, they should always determine whether the RIA trading in the account had a power of attorney or just a trading authorization. If the attorney decides to proceed with the case and the RIA only had a trading authorization, the attorney is probably going to add an unauthorized trading claim.

RIA should always obtain a properly executed power of attorney from a client prior to trading in the client’s account. While in most cases a short and simple power of attorney will suffice to convey the necessary authority to the RIA, an RIA should always check the applicable state law for each jurisdiction in which they do business, as some state are well-known for having different rules and regulations. Do  not even get me started about Louisiana, where they still basically use the old Napoleonic Code. Yes, that Napoleon.

In an increasingly litigious society, an RIA can find itself and its officers facing not only their legal fees and costs, but having to potentially pick up the legal fees and associated costs of their custodian, since they may be named as a party as well for having executed the trades without the RIA having all the legally required documents.

I know that some BDs do have sample powers of attorneys that they provide to their registered representatives who manage discretionary accounts. As a registered representative of the BD, they should be more than willing to provide such form to IARs of independent RIAs owned by their registered representatives.

Truly independent may be able to find other RIAs that are willing to share the power of attorney form they use, but the prudent RIA will verify that any such form is legally acceptable in their jurisdiction. Some jurisdictions have very strict requirements as to certain required language and disclosures that must be included in certain types of powers of attorney.

Some attorneys and RIAs claim that a trading authorization is sufficient, as they will simply argues that a customer ratified any trades if they did not object to same. Ratification may in fact work, but courts and regulators have increasingly rejected such defenses, as both have adopted even stronger consumer-centric position.

If you own or are affiliated with a privately owned RIA, understand that it is your business and you have the responsibility for knowing and complying with any and all federal, state and local regulations. While RIA compliance has become increasingly more difficult and time-consuming, especially with the new emphasis on cybersecurity and client confidentiality, a RIA may not have to worry about such issues for long it if the required compliance is not done properly.


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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