When it comes to the preparation and submission of required annual documents to the U.S. Securities and Exchange Commission (SEC), few regulatory filings demand the level of meticulous care that investment advisory firms must use in completing Form ADV. It takes years to build a sterling reputation in the investment advisory business, but only an instant to have a reputation tarnished as the result of an undisclosed conflict of interest.
In 2019, the SEC introduced Regulation Best Interest (Reg BI) to establish a clear code of conduct when advisors make a recommendation of any securities transaction or investment strategy involving securities – including account recommendations – to a retail customer.
By adhering to Reg BI, advisors are acting in the best interest of retail customers by not placing any interest – financial or otherwise – ahead of their clients and are providing them with peace of mind. The challenge lies in identifying and mitigating all conflicts, many of which can lurk in areas in which advisors may not ordinarily look.
Follow the Money
The first step in achieving compliance with Reg BI is to establish, enforce, and frequently review a set of policies and procedures reasonably designed to detect, disclose, and deter existing and potential conflicts of interest. Once those standards are met, firms must keep all related records.
A useful way to uncover potential conflicts is to “follow the money,” a catchphrase popularized by the 1976 docudrama All the President’s Men like the way to cut through lies and deceptions and find the truth about the Watergate scandal. Put another way, it’s prudent for advisors to ask whether there are any ways they can manipulate and directly or indirectly benefit from a fiduciary relationship that could prove detrimental to their clients.
Based on our work with many clients in this area, our team of specialists at Core Compliance & Legal Services suggests firms prioritize a review of these specific following investment advisory business practices.
Potential Areas of Concern
- Brokerage and Trading
- Does your firm ever recommend or require the use of a specific broker-dealer or custodian?
- Do any of your employees recommend investments in which your firm has a proprietary interest?
- Do you or your firm provide preferential treatment of any kind to family members, employees, or selected clients?
- Compensation and Fees
- Does your firm charge 12(b)-1 fees and, if so, are they fully disclosed?
- Have you made full disclosure of your firm’s commissions?
- Do you disclose all wrap fees?
- Do any advisors recommend specific share classes of funds that may prove to be more expensive to the client?
- Does your firm engage in revenue-sharing compensation that encourages the use of proprietary products?
- Do any of your employees take on unnecessary risk in a client’s account to chase portfolio performance?
- Does your firm hold any internal sales linked to specific security?
- Solicitation Arrangements
- Does your firm receive or provide compensation to a third party for client referrals?
- Do you direct any client transactions to benefit from soft-dollar arrangements?
- Are you confident your firm has made sufficient disclosure when using client-directed brokerage arrangements?
- Employee Activities
- Does your firm make political and/or charitable contributions in exchange for potential advisory business?
- Does your firm have policies and procedures in place to prevent the favoritism of certain clients or service providers by providing excessive gifts and/or entertainment?
- Does your firm frequently monitor all outside employee business activities, including those that could affect the ability of associated persons to properly service advisory clients?
Although not an exhaustive list, your firm should be prepared to fully document answers to the above questions and perform a review of potential and existing conflicts at least annually in preparation for the filing of Form ADV and any time there is a change in business practices. Your firm should consider utilizing technology to assist with the monitoring of conflicts and internal controls for identifying and mitigating them. As a rule, communicating with employees is critical. Employees should be trained on how to identify conflicts and how to report them to the compliance department.
Reviewing the policies and procedures investment advisors have in place to identify and mitigate conflicts of interest is high on the list of the SEC’s examination priorities in 2021. Regardless of when your firm is scheduled to file its next updated Form ADV, it’s never a bad time to review your firm’s information on conflicts and prepare for the next steps. For more information, contact us today at (619) 278-0020 or visit us online at corecls.com.