That Dog Won’t Hunt

Posted on December 18, 2011 by jwatkins

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!

Posted in compliance, RIA, RIA Compliance, securities, securities compliance | Tagged , , , , , , , | 1 Comment

3 FAQs on RIA Ks

Posted on October 26, 2011 by jwatkins

I recently received a call from an RIA firm that had been cited during an audit for having an improper RIA client contract.  The CEO explained that they had tried to save some money by copying an advisory contract from one of the form books at a law school.  Being familiar with the form book in question, I questioned whether the CEO was being honest with me.

I asked the CEO to e-mail me a copy of his contract.  I then drove over to one of the law schools in Atlanta to check the form book for myself.  Much to my surprise, the form book’s advisory contract did not provide some of the mandatory and recommended disclosure language for investment advisory contracts.  Unfortunately, the CEO and his firm paid a high price for the lesson learned.

I know, everyone hates attorneys.  Everyone is quick to remind me that Shakespeare said “first, let’s kill all the attorneys.”  Everyone knows the quote, but few know the rationale behind the quote.

During my time as RIA Compliance Manager for FSC Securities, I drafted several model advisory contracts for both FSC’s proprietary RIA and the independent RIAs affiliated with FSC.  I’m proud to say that FSC is apparently still using those contracts, as I still run across them.  Sixteen years later, I still use a slightly modified version of those model contracts today for my consulting clients.

Based on my experience, many RIA firms have advisory contracts which do not meet the required legal standards.  What RIA firms need to understand is that the use of a non-compliant advisory contract can have severe consequences.  A non-compliant advisory contract generally entitles a client to rescind the contract and recover all fees paid to the investment adviser, with interest thereon, from the original date of the ineffective contract. Clients can also attempt to recover any losses or other financial costs sustained as a result of the adviser’s actions pursuant to the non-compliant contract.

From a regulatory perspective, use of a non-compliant advisory contract can subject an RIA to an enforcement proceeding by the SEC for fraud pursuant to the Investment Advisers Act of 1940 (“Act”).   Advisers may also face regulatory actions from their state, as most states also have rules and regulations that require certain disclosure language in investment advisory contracts.  Many RIAs are surprised that they can face both state and federal prosecution.  The key is that under the National Securities Market Improvement Act of 1996 (NSMIA), the states retained the right to prosecute for fraud.

Fortunately, most of the state requirements track the federal requirements, making compliance relatively easy.  Some of the key requirements under the Act, the rules and regulations promulgated under the Act, and similar state provisions are that every advisory contract must contain language that provides

  • that the advisory contract cannot be assigned without the clients consent;
  • that the client must be given the right to rescind the advisory contract unless the client is provided with a copy of the RIA’s advisory contract and disclosure document a certain amount of time prior to entering into an advisory relationship (generally no less than 48 hours prior to signing the advisory contract); and
  • details regarding the adviser’s termination/refund policy as well as the manner that refunds will be calculated.

State laws should always be reviewed to ensure that an adviser’s contracts do not raise regulatory issues, including potential fraud issues.  Some states have special disclosure requirements for investment advisory contracts (e.g., Texas and Minnesota).  Anyone engaging in advisory business in a state with such special requirements could arguably be prosecuted by the state for fraud for failing to comply with the state’s contract requirements, regardless of whether the RIA is SEC or a state registered.  An RIA simply cannot overlook the broad power of the states to prosecute for fraud.

Exculpatory, or “hedge” clauses, while not prohibited,  are frowned upon by regulators due to their potential for confusing or misleading clients.  I generally advise my clients not to include such clauses, as I believe it sends a negative message to a potential client and such clauses are generally not going to protect an adviser from any wrongdoing, as RIAs are fiduciaries under the law and are held to a very high standard of conduct.

A common mistake that I see with advisory contracts is a lack of consistency between the disclosures contained in the RIA’s Form ADV and the RIA’s advisory contract.  I have been told that this is an area that is going to receive greater attention during audits.  The advisory contract is the actual legal document that controls the adviser/client relationship.  However, discrepancies between an adviser’s Form ADV and an adviser’s advisory contract can be the grounds for an action against the adviser for fraud and misrepresentation.

My experience has been that most non-compliant investment advisory contracts were either self-written by RIA firm or by a non-attorney compliance consultant.  I know a number of securities/RIA compliance consultants that are excellent at advising on the applicable compliance standards.  However, when it comes to legal drafting, they consult with an experienced compliance attorney to ensure that their clients are protected.  As I mentioned earlier, hate on attorneys all you want, but remember, you get what you pay for.  On more than one occasion I have heard regulatory personnel ask the RIA who drafted the non-compliant advisory contract, followed by a suggestion that they consult with an experienced securities compliance attorney.

In the situation I discussed at the beginning of this post, the RIA firm is looking at having to reimburse the client for all fees and commissions received, with interest thereon.  They are looking at having to deal with negative publicity.  Furthermore, since the contract pre-dated the 2008 bear market, they are facing the possibility of having to reimburse the client for losses suffered during that time, with interest thereon, since technically there was no contract which gave them the authority to manage the account.  And then there are the regulators waiting in the wings.

An ounce of prevention….

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Investment Advisers and the Internet

Posted on September 24, 2011 by jwatkins

First, the necessary disclaimer – there is no way to cover all the applicable rules and regulations regarding investment advisers and the internet in a single blog.  While it is hoped that the analysis provided herein is helpful, it is neither intended to serve, nor does serve, as a substitute as for an actual review of the actual materials referenced.  The purpose of this post is to alert advisers to some of the issues I am seeing on a regular basis, issues that can have both regulatory and legal liability issues.  OK, now that that’s out-of-the-way, on to the good stuff. 

For most investment advisers, their web site is an integral part of their marketing plan.  Dually registered investment advisers must comply with their broker-dealer’s rules, the rules and the regulations of FINRA, and the entity through which their RIA firm is registered, either the SEC or a state regulatory body.  RIAs whose advisory representatives are not FINRA licensed do not technically have to follow FINRA’s rules and regulations.  However, they should still monitor FINRA’s releases, as they are often the guidelines used by other regulators and the courts in assessing the conduct of anyone in the financial services industry. 

FINRA Regulatory Notice 10-06 offers the primary guidelines for blogs and social networking web sites.  In short, FINRA’s rules separate sites with “static” content from sites with “real-time, interactive” content, so-called “interactive electronic forums.”  Static content is basically just that, information posted to your web site which is not expected to change.  On this blog, it would consist of both my posts and my articles.  If you are a dually registered investment adviser, FINRA requires that you get such material approved by your broker-dealer’s compliance department before posting it on your site, as such materials are considered advertising.

Unscripted “real-time, interactive” content, on the other hand, is not considered to be advertising and is therefore not required to be pre-approved prior to posting.  However, a dually registered investment adviser’s broker-dealer is expected to review and supervise such activity to ensure that such activity is conducted in compliance with FINRA’s rules and regulations.  FINRA generally describes such interactive forums as chat rooms and online seminars.

Whether an investment adviser is dually registered or not, they are subject to the prohibition against false or misleading claims and representations.  In a recent enforcement action, an adviser was sanctioned based upon the adviser’s pattern of  positive investment recommendations. 

FINRA’s rules and regulations require that advisor’s conduct their business in a manner consistent with the principles of fair dealing and good faith.  Most states require similar conduct under some form of unfair business practices legislation, as well as common law principles such as fraud and breach of fiduciary duty.

While there is no general prohibition against putting links on an adviser’s web to third-party sites or to allowing third-parties to post on an adviser’s web site. I caution my clients not to do so.  Linking to such third-party sites can be construed to approving all of the information on such site, including all links on such site to other third-party sites, what I call the “Seven Degrees of Kevin Bacon” dilemma.  An adviser is also deemed liable for any third-party posts on their web site which violate any regulatory or legal standards, including offensive or abusive posts. 

Recommendations are a touchy subject.  Most broker-dealers prohibit their registered representatives from making any sort of investment recommendations online.  I make the same recommendation to my clients to reduce any potential liability exposure. 

While many advisers like to post investment recommendations on their web sites and/or make investment recommendations online in chat rooms or other social media sites, making such recommendations increases the risk of potential liability exposure unless the recommendation is suitable for every investor to whom it is made.  Since advisors rarely have the required personal information to evaluate every online participant in a social media site, if any investment recommendations are made online, they should be generic in nature.  Again, my advice would be to avoid online investment recommendation altogether.

Personal endorsement are another commoon problem.  I regularly see personal recommendations/endorsements on LinkedIn pages for investment advisory representatives.  While registered representatives can market their services by using personal endorsements, investment advisory representatives cannot.   Even if an endorsement is based on services provided as a registered representative, the court and the regulators have consistently held that if someone is dually registered, personal endorsements may not be used in any marketing by the representative.

The last topic I want to touch on is online investment analysis tools.  Once again, as an attorney I feel I should disclose that I am currently working on a number of cases involving the suitability of the advice provided by such programs.

The NASD released Notice to Members (NTM) 04-86 in 2004. The release provided that broker-dealers, and by implication their representatives, could use computer programs and their output in providing simulations and analyses on potential outcomes in connection with investment advice being provided to their customers.  The financial services industry quickly jumped on board to use such investment analysis programs in connection with financial planning and asset allocation planning.

What many advisers have failed to realize is that the NTM is not a safe harbor for the use of such investment analysis tools.  A closer analysis of the NTM indicates that the NTM basically deals with the disclosures which must accompany any use of such programs.  The NTM clearly states that anyone using such programs must do so in compliance with al applicable federal securities laws and regulatory rules, including suitability and fair dealing rules.

And there’s the rub.  Most investment analysis tools contain some sort of risk tolerance analysis.  The validity of such programs is a source of legitimate debate, as, at best, such programs can only analyze an investor’s willingness to accept investment risk. 

What many advisers are unaware of is that a suitability analysis requires an analysis of both an investor’s willingness and ability to bear a certain level of investment risk.  Interestingly, this two-prong approach to assessing suitability is not only the applicable legal standard for both regulatory and legal decision, but was the standard Harry Markowitz cautioned advisers to use when he introduced Modern Portfolio Theory in 1952.   Advisers who blindly accept the output from investment analysis tools without recognizing the limitations of such program, including the suitability analysis limitations, may find themselves on the wrong side of a regulatory or court decision. 

The investment analysis tools/suitability issue highlights another issue that advisers need to address.  While there are numerous companies offering RIA compliance services,  and these companies can usually analyze regulatory notices, proper analysis of such notices requires that existing legal decisions be integrated into the analysis process. 

Based on my experience, very few compliance personnel, either in-house or independent, are even aware that the suitability assessment is a two-prong process.  As a result, the determination of an investor’s ability to bear investment risk is often overlooked and it is easy to make a succesful suitability claim.  As noted investment adviser Harold Evensky noted in his new book, like it or not, the law is inextricably intertwined with the investment  advisory business and advisors have a duty to understand both their professional and legal obligations.

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RIA Compliance in 3-D

Posted on September 8, 2011 by jwatkins

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.

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Don’t Go There!

Posted on July 27, 2011 by jwatkins

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.

Posted in 401k compliance, 404c compliance, compliance, investments, RIA, RIA Compliance | Tagged , , , , , , , , , | Leave a comment

The RIA’s Achilles’ Heel

Posted on June 23, 2011 by jwatkins

As an attorney and a compliance consultant, I realize the difference between RIA compliance and RIA risk management.  I also realize the importance of both.  Unfortunately, I see far too many cases where RIA firms have unnecessary liability risk exposure due to the failure to implement appropriate risk management strategies.

Whenever I do a mock audit for an RIA firm, I always include a risk management assessment as well.  An RIA firm may have all of the files and manuals required under the ’40 Act and still find itself on the losing end of an investor’s claim of breach of fiduciary duty.  Even thought RIA firms and their members are not expected to be attorneys, there are a number of key decisions, such as In re James B. Chase, Levy v. Bessemer Trust and LaRue v. DeWolff to name just a few, that investment advisers should be aware of given their potential impact on their practices.  Compliance errors usually end in fines and suspensions, while risk management errors may threaten your RIA firm’s very survival, both from the resulting monetary damage and the regulatory investigation that is sure to follow.

This distinction between compliance and risk management is something broker-dealers rarely mention with registered representatives who own their own RIA firms since there is no requirement that broker-dealers do so.  Broker-dealers are only required to monitor trading activity of RIA firms independently owned by their registered representatives.

As a former director of RIA compliance for one of the nation’s largest independent broker-dealers, I was not allowed to warn the registered representatives with their own RIA firms about these issues due to the concern about providing legal advice.  When I open my legal/ compliance practice, I was finally able to prepare a fiduciary investing manual for my clients, covering approximately thirty key decisions, with ongoing updates.  There are plenty of excellent firms providing compliance services to RIA firms, but unless they are also attorneys, they cannot legally provide RIA firms with the legal services necessary to properly address the issue of RIA liability risk management.

If you own an RIA firm, it is your responsibility to educate yourself about potential legal issues and establish the necessary risk management strategies and procedures to protect both the firm and the firm’s individual advisory representatives.  Two of the most common RIA risk management mistakes that I see involve the use of IPS statements and “black box” financial planning.

Far too many RIA firms fail to use IPS statements.  A properly drafted IPS statement allows a client to see a commitment by both parties as to the services to be provided and the expectations of both parties.  A properly drafted IPS statement can also be an important tool for an RIA firm in case a dispute or claim does arise.  In many cases, an IPS statement can help summarily resolve a dispute or claim, saving the RIA firm both money, mental distress and unwanted negative publicity.

“Black box” financial claims can be relatively easy to win if the client’s attorney knows what he or she is doing.  Many such claims eventually settle prior to arbitration since few advisors ever take the time to actually research the theories and other writings of Dr. Harry Markowitz and Dr. William Sharpe to see what they actually said and what they warned about in using their theories.  It is very easy to make a case against an adviser who claims that they were acting in accordance with the Prudent Investor Act when the adviser has never actually taken the time to read the Act, including all of the relevant notes.  The use of Modern Portfolio Theory and the Prudent Investor Act without studying  and truly understanding the theories and writings of those behind such theories and laws is not only ill-advised and negligent, but arguably grounds for malpractice.

If you are ever involved in a claim, a good securities attorney is going to ask you how you arrived at your recommendations and whether you relied on MPT and/or MPT-based software.  Since most commercial asset allocation/portfolio optimization software programs are based on MPT or CAPM, Dr. Sharpe’s variation of MPT, an adviser should be prepared to answer detailed questions about both theories, followed by detailed questions regarding the adviser’s understanding of the Prudent Investor Act.

The plaintiff’s securities bar is well aware of these issues and the questions to ask to make their case.   I realize that most investment advisers will continue to ignore their Achilles’ heel, their lack of effective liability risk management policies and procedures.  The proactive Prudent Investment Adviser, on the other hand, will take steps to protect their firm from unnecessary liability risk exposure and provide better service to their clients.

Posted in compliance, investments, RIA, RIA Compliance | Tagged , , , , , , , , | 1 Comment

Due Diligence Doldrums

Posted on June 3, 2011 by jwatkins

Whether you are a registered representative, an investment advisory representative, or both, you have a legal obligation to do your due diligence regarding the suitability of any investments you intend to recommend to your clients.  What many brokers and advisory reps do not understand is that the duty to do due diligence is a personal one.  Simply relying on third party reports and ads, wholesaler representations or even compliance officer decisions does not guarantee that a broker or reps will not be held liable if a recommended investment is later determined to be unsuitable.

Back in my compliance days, brokers would constantly get upset with me when I would not approve a trade because I had questions regarding a piece of sales literature provided by a wholesaler or inconsistencies between a fund prospectus and a wholesaler’s representations.  What I knew, and the brokers did not, was that reasonable reliance on third parties is generally not an effective defense against a finding of unsuitability, against a claim of failure to perform the required due diligence.

Two personal cases will always stand out for me.  In one case, a wholesaler for a prominent mutual fund company had been promoting one of the company’s newer funds as a “growth” fund.  The brokers were submitting a stream of purchases for the fund for growth oriented investors.  The branch manager and I had decided to see if the reps were even bothering to actually review the fund’s prospectus, which clearly stated that the fund was for investors looking for aggressive growth.   Every rep stated that they had read the prospectus, but I rejected every trade submitted for the fund as they exceeded the “growth” investment objective of the investor.  

I used the case to warn the brokers of the need to review advertising and other materials provided by third parties.  Most of the brokers realized I was watching out for them and eventually thanked me.

The second incident involved a piece of sales literature that a wholesaler had been secretly distributing to the brokers.  Fortunately, some of the brokers alerted me to the ad and I contacted the fund company to request a copy of the NASD letter approving the piece.  When I recieved the NASD letter, I immediately noticed several issues that the NASD had raised that had not been corrected.  Had the brokers used the uncorrected sales piece, they could have been held liable along with the mutual fund company.

Good compliance officers should perform a lot of this preventive due diligence for brokers.  I always recommend that brokers follow up with compliance and document their files with a copy of the supporting documentation.  If nothing else, it shows that the broker made a  good faith effort at due diligence and did not just blindly accept a thrid party’s representations.

Unfortunately, RIAs are often not as experienced in compliance and fail to properly guard against potential due diligence claims.  The required compliance files are often incomplete or missing and there is rarely any supporting documentation to show that due diligence was performed prior to using any sales literature provided by a wholesaler or other third party.

Bottom line, always perform your own due dilgence regarding potential investment recommendations and document what you did and when you did it.  Before distributing any third party materials, request a copy of the Finra approval letter to ensure that the material was approved as submitted.  If the approval letter was conditioned on changes being made to the submitted material, check to see that the changes were actually made.  Based on my experience, many third parties do not make any changes and just distribute the material since they know few even ever ask to see the approval letter.  If the wholesaler or third party refuses to produce the actual NASD letter, do not use the piece and note this refusal to copperate going forward.

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Investment Advisers and Outsourcing

Posted on April 20, 2011 by jwatkins

Outsourcing is definitely one of the hot topics with investment advisers.  Most investment advisers I talk to about outsourcing feel that outsourcing asset management and/or compliance responsibilities will allow them to concentrate more on building up their assets under management and, consequently, their fees.

While outsourcing may allow an  investment adviser to concentrate more on asset gathering, advisers need to realize that outsourcing certain responsibilities does not relieve them of their ongoing fiduciary duties in connection with such duties.  Since fiduciary duties are personal in nature, an investment adviser cannot simply delegate fiduciary responsibilities to another and walk away. 

First of all, a fiduciary has a legal duty to monitor third parties to whom the adviser has delegated responsibilities to protect the client against unauthorized or unsuitable activity.  Furthermore, an investment adviser has a duty to redress any harm caused to a client as a result of such improper activity, including an obligation to sue the offending third-party if necessary. 

What many investment advisers do not understand is that third-party assets managers often include language in their master advisory contracts with investment advisers that states that the investment adviser, not the third-party asset manager, remains liable for the suitability of the third-party asset manager’s programs.  On more than one occasion I’ve had the unfortunate duty to tell investment advisers that such language was hidden in the master contract and that they faced liability for not continuing to monitor the client’s account.  Proactive investment advisers who take the time to review such contracts or have such contracts reviewed by an attorney can often negotiate to have such language removed, as asset managers will rarely walk away from potential accounts.

As a former RIA compliance director at one of the largest  nation’s largest independent broker-dealers, I am often asked about outsourcing compliance responsibilities.  First, I’m not sure that such would be acceptable by the SEC, FINRA or state regulators in light of the Royal Alliance decision several years ago.  The decision basically raised issues regarding the ability of a broker-dealer to provide effective compliance oversight to a large network of branch offices spread out over the entire country.  Two of the issues raised by the regulators were the ability to supervise daily activity without having an actual physical presence in the respective branch offices and the sheer number of representatives being supervised.

Assuming that a compliance outsourcing system can be created that would be acceptable to the regulators, investment advisers need to understand that in the event that the third-party compliance provider makes an error, the investment adviser would most likely still have ultimate responsibility for such a mistake, as the courts and the regulators have consistently held that advisers who choose to outsource advisory responsibilities do so at their own risk, regardless of the terms of their contract with the third-party provider.

The bottom line is that outsourcing is yet another example of caveat adviser, another area of investment adviser law where being proactive is the sound course of action.  Taking the time to consult with someone experienced and knowledgeable in investment adviser law can help an adviser protect both their practice and their clients.

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The Little Known Win-Win Fiduciary “Gotcha”

Posted on January 25, 2011 by jwatkins

It is well-established that investment advisers are fiduciaries.  Fiduciary law is based primarily on principles developed under agency law and trust law.  When you mention fiduciary law, most people immediately think of the duty of loyalty, the requirement that a fiduciary always put a client’s interests first.  What many investment advisers do not understand is the extent of that obligation.

I am often asked by investment advisers and attorneys to perform a fiduciary audit on incoming and/or existing accounts.   The prudent investment adviser realizes that even if the actual management of a client’s investment account is outsourced to a third party, the investment adviser still has a responsibility to monitor the account and take actions to redress any wrongs comiitted by a third party asset manager.  What many investment advisers do not realize is that they have a similar duty when they accept a client’s account.

As part of the duty to always act in the best interests of a client, both agency law and trust law require a fiduciary to disclose information that would be beneficial to a client’s interests and to take action, if necessary, to protect and preserve a client’s property.  With regard to the duty to review new fiduciary accounts, Section 76, comment d, of the Restatement, Third, Trusts states that “the trustee ordinarily has the associated responsibility of taking reasonable steps to uncover and redress any breach of duty committed by a predecessor fiduciary.”

Advisers often counter with the objection that they are not attorneys and do not feel comfortable reviewing and/or commenting on another fiduciary’s action for fear of legal consequences.  Both Sections 76 and 77 of the Restatement advise a fiduciary to seek advice of counsel or the court, if appropriate, in order to meet their fiduciary obligations.  Seeking the advice of a compliance officer or a compliance professional may not protect an investment adviser unless the compliance officer/professional understands fiduciary, trust and agency law ands is aware of the relevant legal and regulatory decisions in these areas.

The fiduciary duty to review new accounts and advise clients of potential fiduciary breaches by previous fiduciaries can actually prove beneficial to investment advisers.  In addition to complying with the legal standards for fiduciaries, performing the required review and advising a client helps demonstrate to a new client that the investment adviser is truly watching out for the client’s best interests, which in turn promotes greater trust between the client and the investment adviser.

Furthermore, in the event that any fiduciary breaches resulted in losses, taking action to recover such losses could result in additional assets under management for the adviser and additional management compensation.  Because of the legal and financial issues involved in redressing potential fiduciary breaches, we always recommend that investment advisers fulfill their duty to disclose such concerns to a client and then let the client make the ultimate decision on whether to pursue such matters.  An investent adviser should always document both the disclosure of such information to a client and the client’s decision regarding the matter.

Posted in 401k compliance, 404c compliance, compliance, investments, retirement plans, RIA, RIA Compliance, securities | Tagged , , , , , , , , | Leave a comment

The Times They Are A Changin’

Posted on December 21, 2010 by jwatkins

With the pending release by the SEC of the new fiduciary rules, I have received a lot of e-mails and calls regarding the potential implications for currently registered  investment advisers.  Since investment advisers have been held to be fiduciaries under both the Investment Advisers Act of 1940 and various court decisions interpreting the Act, the new fiduciary rules should not have any procedural impact on currently registered investment advisers. 

If, as expected and hoped for, the SEC takes the common sense approach and simply adopts a universal “best interest of the client” fiduciary for anyone providing  investment advice to the public, the business model for broker-dealers, registered representatives and insurance companies offering investment products must make significant changes.  According to various reports, broker-dealers have accepted the inevitability of  a “best interests” fiduciary standard.  

However, not surprisingly, the insurance industry apparently continues to fight a “best interests” fiduciary standard.  Such a standard would have serious implications for some current insurance industry practices and products, most notably alleged overselling of coverages and variable annuities.  Based upon my own experience with the insurance industry, insurance sales based on actual needs sometimes becomes buy as much as possible.  Variable annuities raise a number of fiduciary issues given their typically high fees, inverse pricing structure and potentially disastrous impact on one’s estate plans.

A universal “best interests” fiduciary standard would continue to provide an edge to currently registered investment advisers as broker-dealers, insurance companies and their representatives adjust to the new standards.  It can be expected that some will simply ignore the new fiduciary requirements, continuing to do business the old way unless and until they get caught.   Some have predicted a significant increase in the number of independent investment advisory firms, the rationale being that if they have to meet a fiduciary standard anyway, why not increase their profit potential. 

Existing investment advisory firms will be able to tell both existing and potential clients that it’s business as usual, as their firm has always been required to put  a client’s “best interests” first.  Advisory firms may want to consider gaining an additional competitive advantage by pointing to a 2007 Schwab Institutional study that concluded that 75% of brokerage accounts did not match the client’s goals, following that up with an offer for a free portfolio review.

With the release of the new fiduciary standards, the financial services industry will definitely undergo a change.  Prudent investment advisors will recognize and seize upon the opportunity to gain or maintain an edge on their competitors.

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