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.

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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.

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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.

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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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A Pure Heart and an Empty Head Is No Defense

Posted on November 18, 2010 by jwatkins

Unbeknownst to many investment advisers, it is their responsibility to educate themselves as to applicable legal standards for their advisory practices.  Investment advisers affiliated with a broker-dealer often assume that the broker-dealer will keep them updated as to any compliance and/or legal information they need to know.  However, under NASD Notice to Members 94-44, broker-dealers are only required to review the trading activity of their registered representatives that are members of independent investment advisory firms.  Broker-dealers have absolutely no legal obligation to provide compliance or legal support services to independent advisory firms.

Investment advisory firms that discover that they have violated one of the Prudent Investment Adviser Rules or another applicable legal standard often argue that they meant well and they simply were unaware of the applicable legal standards.  This “pure heart, empty head” defense has been consistently rejected by the courts and the regulatory bodies, based primarily on the fiduciary relationship that exists between an investment adviser and their clients.  Investment advisers must be proactive and assume responsibility for learning the applicable legal standards and continuing to monitor future rulings and decisions that may impact their practices.

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Hello world!

Posted on November 11, 2010 by jwatkins

IA Insight is a blog for investment advisers and those who advise investment advisers, such as attorneys and compliance personnel.  The goal is to provide practical and meaningful information to help investment advisers and their advisers develop and maintain acceptable “best practice” standards to better serve their clients and protect their advisory practices.

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