When a regulator shows its hand, take it seriously—a poignant lesson that one is wise to heed. At the end of January, the Securities and Exchange Commission (“SEC”) released a Risk Alert entitled ‘Observations from Broker-Dealer Examinations Related to Regulation Best Interest (“RBI”)’.
It would be easy for an investment adviser firm to dismiss this as being relevant only to B/Ds. While this appears, on its face, to be true, the ideas undergirding RBI are easily adapted to the Fiduciary Duty standard to which investment advisers are already held. With such ease of crossover, investment advisers should expect the SEC to adapt topics from these RBI examinations to its investment adviser examinations program.
So, how to prepare for this eventuality?
The SEC’s RBI exam focused on the following obligations the Rule places on B/D firms:
- Disclosure Obligation
- Care Obligation
- Conflict of Interest Obligation
- Compliance Obligation
Notable in the risk alert is a lack of reference to failures surrounding the Compliance Obligation. Since failures in fulfilling the Compliance Obligation would involve taking no action whatsoever in reference to the Rule, we know that the risk alert’s findings came from firms that made a good faith effort to comply with the Rule but were still found to be deficient.
Typically understood to mean the use of Form CRS, this can be seen as applicable to adviser firms that work with retail clients. Check your firm’s Compliance Policies and Procedures Manual. Does your Manual:
- Specify the circumstances under which Form CRS should be updated?
- What this looks like: Your Manual could say that Form CRS will be reviewed annually and updated if needed or when a material change to the business occurs. Of course, if your firm feels that more frequent review is necessary, incorporate that into the Manual.
- Assign responsibility for distribution of Form CRS updates to client?
- What this looks like: Your Manual specifically should indicate who sends updated Form CRS to retail clients. It does not need to reference someone by name, but naming a certain department at your firm, for example, would assign actionable tasks for the department to complete.
- Provide a means of tracking the delivery of Form CRS updates to clients that would prove to a regulator that updates were indeed distributed?
- What this looks like: Your Manual could reference keeping a list of retail clients and a method for indicating that the updates were sent and/or received.
This deals with an Investment Adviser Representative’s (“IAR”) business conduct with respect to a retail client in the investment advisory relationship. In the investment advisory space, there are specific implications when recommending a qualified plan-to-IRA rollover or IRA-to-IRA transfer transactions. Your firm’s Compliance Policies and Procedures Manual must govern this conduct. Does your Manual:
- Require the IAR to consider alternatives when recommending these transactions? Does it establish a process or step-by-step roadmap for the IAR to follow when considering alternatives?
- What this looks like: Do not set about trying to compare every single possible alternative that exists. Rather, find a way to narrow down alternatives to what your firm offers in-house AND could reasonably be offered to the client as a legitimate substitute for the transaction being contemplated. Establish the scope of alternatives and/or how the IAR should arrive at those alternatives: does your firm instruct IARs to consider and document a comparison with two or three alternatives? Does your firm utilize an analysis tool to evaluate different investments and intends for IARs to use it? If so, put it in the Manual. And don’t forget that with these transactions, leaving the account where it is or liquidating the existing investments are viable alternatives to be considered, too.
- Instruct the IAR to consider cost but not go into detail as to which costs should be considered or how to determine these costs?
- What this looks like: Discussions of cost have been perhaps one of the most confounding features of the Rule. Because while there is an almost inborn inclination toward low cost, the measure of a recommendation should be total value to the client. When instructing IARs to consider the costs of a recommendation, your Manual should emphasize highlighting all expenses a client will incur or should expect to pay if he or she pursues a particular alternative as well as the benefits and risks attached to each alternative.
- Create a framework for comparing alternatives or considering costs, but not require its use?
- The best systems in the world do no good if they are not used as designed. If your firm has designed a tool or form or some other means by which to comply with your obligations related to these transactions, include a requirement to use it in your Manual. Then support usage requirements by conducting periodic tests with your IARs to verify proper use.
- Instruct the IAR to document the basis for a recommendation but does not instruct the IAR what to document or how?
- What this looks like: Documenting the basis for recommending these transactions is merely a summary of the above items. A discussion of the recommended transaction’s features, costs, benefits and risks to the client as well as how these dimensions compare to the alternatives described previously should be completed. Your firm also should designate a location for these discussions to live for ease of reproduction both for firm information purposes and for document production when asked by a regulator.
Conflict of Interest Obligation
This obligation requires firms to create policies and procedures to mitigate or eliminate conflicts of interest. Does your Manual:
- Address conflicts but not describe how the firm deals with them?
- What this looks like: Adviser firms have always been held to this expectation as part of the Fiduciary Duty. Recent emphasis on this duty and conflicts of interest have created a sense of urgency around this topic. Analyze your firm’s business, take note of your firm’s unique conflicts of interest—those situations where what your firm wants and what your clients want are different or divergent—and include in your Manual specific actions your firm takes to mitigate or eliminate the conflict. If you need help finding a starting point, consult your firm’s Form ADV Part 2A and Form CRS (if your firm files). These documents will already have conflicts of interest listed and may serve as a source of inspiration to help you recognize other conflicts of interest.
- Stay too generic in addressing conflicts and not highlight examples unique to your firm?
- What this looks like: Specificity is key when disclosing conflicts; this is a basis for a potential client deciding whether to engage your firm. Being honest and specific about conflicts up front starts the relationship off on the right foot. So, review your firm’s materials that discuss conflicts. Do any of them contain language where a first-time reader would not be able to articulate the nature of the conflict or describe its effect on the advisory relationship? If so, revise to make more specific.
- Rely too heavily on disclosure to mitigate a conflict and not change the firm’s practice with regard to said conflict?
- What this looks like: While it is true that conflicts are allowed to be disclosed for advisers, it is also well-advised to review your firm’s business and ask if mere disclosure of a conflict would satisfy a regulator. Some conflicts are unavoidable. For example, your firm charging advisory fees against a client account is, indeed, a conflict of interest, but unavoidable and without which, the advisory relationship and business would not exist.
- Conversely, avoidable conflicts are those that, if eliminated, would not profoundly affect the function of the business as to drive it into non-existence and as such should be considered for elimination. For example: there is a certain advisory firm that also is an insurance agency that writes life, health, and Long-Term Care insurance (“LTCi”). They disclose the insurance business on Form ADV and describe the incentive to recommend insurance policies based on the amount of commissions paid, commissions that enable the insurance business to exist. However, the president of the firm feels very strongly about the importance of LTCi to clients’ long-term financial well-being. And so, to encourage the writing of more LTCi policies, the president of the firm announces that triple points toward the firm’s biannual incentive trip contest will be awarded for LTCi policies written.
- From this example, we find a practice that is an avoidable conflict. Though the president of that firm may feel strongly about a certain product, those feelings must not be emphasized to such a point that it would undermine the judgment of IARs when they contemplate recommendations to clients.
Training, Reviews, Testing
The SEC also offered takeaways related to training and recordkeeping for review and testing purposes.
While there is no rule against an individual branch office having records related to their business on-site, all records absolutely must exist in your firm’s designated centralized location, such as the main office. Further verification should be carried out during on-site audit visits and include documentation in the audit affirming that the books and records observed on-site also exist at your firm’s main office or other designated centralized records depository.
Finally, training and other efforts to continually inform your IARs of proper procedure and process related to the Care, Conflict of Interest, and Disclosure Obligations must be maintained. Your IARs must be reminded of:
- any roles they have in updating and/or delivering Form CRS;
- the necessity of analyzing costs, investment alternatives, and documenting rationales for recommendations for qualified plan rollovers and IRA-to-IRA transfers; and
- how to recognize and address conflicts of interest.
Recent deficiencies cited by the SEC during Broker/Dealer examinations demand advisers’ attention. Given the adaptability of these exam topics to the investment advisory space, performing these exercises will help you to prepare now for the SEC should they ask you about the same topics in an exam. Core Compliance & Legal Services, Inc. “Core Compliance” and its staff of knowledgeable compliance consultants have years of experience in adapting to the often uncertain regulatory environment, and anticipating and preparing for regulators’ next moves. For more information or for assistance with enhancing your compliance program, please contact us at firstname.lastname@example.org or visit us at www.corecls.com for more information.
Author: Matthew Rothchild, Sr. Compliance Consultant, Core Compliance works extensively with investment advisers, broker-dealers, investment companies, hedge funds, private equity firms and banks on regulatory compliance issues.
This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon in regard to any particular facts or circumstances without first consulting with a lawyer and/or tax professional.