More On Legal & Compliancefrom The Advisor's Professional Library
- RIAs and Customer Identification Just as RIAs owe a duty to diligently protect their clients privacy and guard against theft, firms also play a vital role in customer identification. Although RIAs are not subject to an anti-money laundering rule, securities regulators expect advisors to address these issues in their policies and procedures.
- Disaster Recovery Plans and Succession Planning RIAs owe a fiduciary duty to clients to prepare for disasters and other contingencies. If an RIA does not have a disaster recovery plan, clients financial well-being may be jeopardized. RIAs should also engage in succession planning, ensuring a smooth transaction if an owner or principal leaves.
Let's take a look at what some scholars are saying about President Bush's financial services agenda for his second term. Then let's move on to some thoughts and complaints that industry officials have about Securities & Exchange Commission rules--specifically the e-mail retention rule--that advisors will have to comply with this year.
The Shadow Financial Regulatory Committee, a group of politically influential business scholars from prestigious schools like the University of Pennsylvania and Emory and Columbia universities, meets regularly to discuss banking, insurance, and securities policy. The members got together in December to hash over what they believe will be the most pressing issues on the President's financial services agenda. They include Bush's proposed personal retirement accounts, the shabby state of the Pension Benefit Guaranty Corp. (PBGC), the insurance brokerage scandal, and the future of Fannie Mae and Freddie Mac.
While the committee's name suggests it works in the shadows, in truth this is a bunch of heavyweights who pull considerable weight with Congress. The panel's co-chairmen are both finance profs: George Kaufman of Loyola University in Chicago and Richard Herring of the University of Pennsylvania's Wharton School. They were joined a few months ago by John Hawke, a former comptroller of the currency who's now with the law firm of Arnold & Porter in Washington. He reminded me that among the panel's legislative successes were getting Congress in the 1990s to adopt its approach to bank supervision called "Prompt Corrective Action."
The Administration has floated the idea of using personal retirement accounts as part of a Social Security reform plan. If this occurs, the Shadow Committee says the Administration "should avoid a situation similar to what happened with the savings and loan associations, and is happening with the Pension Benefit Guaranty Corporation, namely a taxpayer bailout of investments that perform poorly." The committee also urged the Administration to be careful about the number and types of investment choices available to individuals in the accounts. For instance, "individuals might be allowed to choose from a limited number of different stock and bond indexes and broadly diversified funds. Competition among portfolio management firms to be chosen for the approved [investment] list, as well as the reopening of the approved list from time to time, would be desirable," the Committee says. Recordkeeping "could be centralized in the government in order to hold down costs and assure continuity. Portfolio management, however, should be carried out by private professional firms."
The PBGC's deficit, meanwhile, has hit an all-time high, and the Shadow Committee believes the situation is only going to worsen. In November, the PBGC said that its fiscal year-end deficit on single-employer plans jumped to $23.3 billion from $11.2 billion in 2003. The Committee predicts that more corporations will try to buy off employees asking for raises by "promising higher pensions, letting them know that their pensions are guaranteed by the PBGC." Other firms will "increasingly declare bankruptcy to shift their obligation" to the federal agency.
The Committee believes that as the PBGC deficit increases, it will be forced to increase premiums. This could cause more corporations with fully funded plans to convert them to defined contribution plans so they don't have to buy insurance from the PBGC. If this happens, the committee says, the PBGC will be "left with very weak corporations that have very weak plans," causing the PBGC to become insolvent and making a taxpayer bailout inevitable.
This disastrous outcome can be avoided, or so the panel believes. First, it recommends that the Administration and Congress should force corporations to fully fund their plans "with assets that can be and are revalued at least quarterly at market prices." It also says they should measure their pension liabilities by "discounting actuarially determined pension obligations by the relevant discount rate," e.g., the rate on long-term U.S. Treasuries, swaps, or their equivalent. The PGBC should also refuse to fund any new pension guarantees, but continue to back the pensions of plans it has already taken over. The PBGC should also increase premiums to help fund its current deficit. Finally, the committee argues, "since the Administration and Congress are unlikely to allow employees of bankrupt companies to lose their pensions when the PBGC legally becomes insolvent, the amount of taxpayers' funds that will be required to meet the PBGC's obligations should be estimated and budgeted for."
As for the bid rigging and unethical compensation practices by brokers and insurers that were uncovered by New York Attorney General Eliot Spitzer, the Committee says insurance producers should be forced to "disclose to prospective customers whether they represent the customer, one or more insurers, or both the customer and insurer, so that customers can consider the potential conflicts."
E-Mail Retention Rules
Meanwhile, the Investment Counsel Association of America (ICAA)--which represents SEC-registered advisors--is prodding the SEC to clarify its expectations of RIAs' retention, production, and surveillance of e-mail. "The SEC has changed this whole [e-mail retention] area without telling us what the rules are," David Tittsworth, ICAA's executive director, told me in a recent interview. After uncovering e-mail at mutual fund companies last year that exposed questionable trading activity, SEC examiners decided to review advisors' e-mails during examinations. The SEC has not only requested that all of an advisory firm's e-mail be made accessible to examiners, but has even asked that advisors monitor their employees' electronic missives.
The problem, says Tittsworth, is that advisors are now incurring huge costs to comply with the SEC's requests, as they're "contemplating major decisions regarding technologies and firm practices regarding electronic communications." But advisors have yet to see "any written guidance" from the SEC, Tittsworth says. He adds that ICAA's discussions with Chairman William Donaldson and senior SEC staffers about e-mail retention stretch back to last summer. It was then that ICAA began hearing complaints from its members about "the unprecedented e-mail requests" they were getting from the SEC.
It's standard practice now for SEC examiners to request all of a firm's e-mail or the e-mail of high-level management over a three-month period in an electronically searchable format. The SEC says that Section 204 of the Advisers Act--the books and records rule--entitles the regulator to review "any record or information maintained by an investment adviser, including records or information that do not fall under rule 204-2 (unless privileged)." But some advisors, Tittsworth told the SEC in a recent comment letter, haven't saved all of the e-mails that do not include required information under Rule 204-2. The SEC staff, Tittsworth says, has opined that firms are not required to retain e-mail that does not include required information. However, SEC staffers have cautioned that firms must have policies and procedures reasonably designed to ensure that required information is maintained. The ICAA has asked the SEC for "confirmation that this can be satisfied in a number of different ways and that firms need not employ a gatekeeper system to review all e-mail before deletion," Tittsworth says.
He points out further that some advisors maintain e-mail on backup disks that aren't easily searchable. "These firms have incurred considerable expense obtaining additional storage capacity and hiring specialists to restore contents and transfer requested material to a searchable format," Tittsworth says. He adds that some SEC staff members have said that advisors must maintain the functionality of an e-mail document. But it's standard practice for small firms in particular to print e-mail documents and delete the electronic version, he says. The SEC, however, may not look kindly on that. An SEC examination notice received recently by one RIA (at www.investmentadvisor.com/pub/1_1/breaking-news/4339-1.html) specifically demanded "all e-mails, including their corresponding attachments" and added that they "should be provided in an electronically searchable format." However, Tittsworth contends that "an existing rule has been understood to require that e-mail containing required records be maintained electronically rather than on paper."
Since sending its most recent comment letter to the SEC in November, the ICAA has resumed talks with SEC staff, Tittsworth says. The SEC is now trying to determine what its e-mail policy should actually be, Tittsworth says, and is taking into account the types of e-mail technology that are being used by smaller firms.
Advisors should also be aware of other issues that have cropped up during and after SEC exams. Nancy Lininger, president of The Consortium, a Camarillo, California, consulting firm that provides consulting services to advisors and broker/dealers on compliance issues, says a client recently received an e-mail from the SEC stating that the advisor failed to name a chief compliance officer on their Form ADV. It turned out that an examiner made an error and that the officer's name was on the form all along. But Lininger says that "this is a sign that the SEC is watching amendments [that advisors] make to their ADV."
The SEC has cut advisors a little slack in one area: They now have until February 1 to comply with the commission's code of ethics rule, Lininger says. The original compliance date was January 5. When the SEC comes knocking early this year, examiners will expect to see a code of ethics in writing, she says. Unlike other codes of ethics for professionals that are generally based on moral standards, the SEC's version asks for "very detailed personal trading procedures," Lininger says. She thinks the regulator's code of ethics overlaps the SEC's written supervisory procedures rule. Lininger says the SEC doesn't care if advisors maintain two documents--one for a code of ethics and another for supervisory procedures. She would normally recommend maintaining only one, "but I don't think you want to hand out your supervisory procedures when your clients ask for your code of ethics. That is an argument for keeping the two documents, even though the requirements overlap."
Washington Bureau Chief Melanie Waddell can be reached at firstname.lastname@example.org.