More On Legal & Compliancefrom The Advisor's Professional Library
- The Few and the Proud: Chief Compliance Officers CCOs make significant contributions to success of an RIA, designing and implementing compliance programs that prevent, detect and correct securities law violations. When major compliance problems occur at firms, CCOs will likely receive regulatory consequences.
- Code of Ethics Rule The Code of Ethics Rule, found in Rule 204A-1, uses severe consequences for violation to help ensure investment advisors will do the right thing.
Ask any advisor what their biggest bugaboo is these days and they're sure to utter one word: compliance. Over the past few years, the SEC and NASD have kept advisors and their broker/dealers and custodians on their toes by issuing one rule after another. This year alone, three SEC rules go into effect--hedge fund advisor registration; the so-called Merrill Lynch rule, which exempts certain brokers from registering as advisors under the Investment Advisers Act of 1940; and the annual compliance review.
The Merrill Lynch rule and hedge fund manager registration are two of the most contentious rules to come out of the SEC. Let's look at the Merrill rule first. The securities regulator has received scads of comment letters from advisors and industry officials arguing that the Merrill rule, aka the broker/dealer exemption rule or SEC rule 202(a)(11)-1--which became effective January 31--is fraught with problems and ambiguities, and that it fails to clearly distinguish when a broker is acting in a fiduciary capacity. As Lou Stanasolovich, president and CEO of the RIA Legend Financial Advisors in Pittsburgh, puts it: "the rule doesn't go far enough to create a level playing field" between brokers and advisors. Stanasolovich, like others in the industry, argue that legislation that governs fee-based advice is the only way to create a level playing field. Melanie Lubin, Maryland's securities commissioner, told a group of lawyers in Washington recently that legislation is the only way to "recognize that there's a new reality." Unlike years ago when investors' only option was to execute trades through a broker, today investors can choose to go it alone and execute a $5 trade through the Internet. However, by choosing to use a full-service broker today to decide which investment is appropriate, the investor automatically presumes the broker is a fiduciary, she maintains. "Investors expect an ongoing relationship no matter who they see [an advisor or broker]; they get this idea through advertising," Lubin said.
Lubin and Tom Giachetti, a securities lawyer with Stark & Stark in Princeton, New Jersey, both believe the Merrill rule will spark a slew of litigation and arbitration cases. Giachetti, who has many advisors as clients, says that realistically there's no clear and concise way to delineate for clients "in what role or capacity" an advisor or broker is acting. Under the law, he says, an investment advisor is a fiduciary. When a broker recommends a product, however, NASD rules require that he or she must only determine whether the product is suitable for the client's needs, so the broker is not acting as a fiduciary, he adds. "A fiduciary would have to determine not only whether the product is suitable, but if there are other products out there that are more suitable and/or less expensive because as a fiduciary, the advisor would have to have an undivided duty of loyalty to the client," Giachetti says. "The broker is not held to that duty or standard."
David Tittsworth, executive director of the Investment Adviser Association (IAA) in Washington, which represents SEC-registered advisors, says that while "there is a massive amount of confusion" among investors "about who are brokers and who are advisors and the differences between the two," what's equally troubling is the fact that advisors, brokers, and other officials in the industry "are mixed up, too." Results of an SEC focus group that was conducted less than a year ago confirmed the broadly held belief that "there is massive confusion among investors about what a broker is and an advisor is and their respective obligations," Tittsworth says. After giving a speech to an audience of mainly brokers in which he addressed the Merrill rule, Tittsworth said he was bombarded with requests from brokers asking him to explain, "What's going on." Tittsworth says his "rallying cry" to the SEC now is to "enforce the rule and educate investors about whatever the rule is." Giachetti adds that he doesn't have "a clue as to how [the rule is to be] communicated properly, supervised, and/or enforced if there's any violation." The rule is "asking way too much from the B/D and also putting too much of an onus on the end client."
The independent broker/dealer community is of two minds on the issue of compliance. Many B/D executives--particularly at the larger independent B/Ds--say compliance is merely a cost of doing business, and that they're handling it without much fuss--at least in conversations with the media. But smaller B/Ds express more frustration with the amount of time, energy, and money that they must spend to stay compliant (see "The Price of Being Small" sidebar).
Not Always Black and White
One of the SEC's primary missions is to protect investors, but Tittsworth says he's yet to find any information on the SEC's Web site, "except for a few things that are misleading, that explain the difference between brokers and investment advisors, and that talks about this issue in an intelligent fashion."
Under the SEC's rule, broker/dealers who provide non-discretionary advice that's solely incidental to their brokerage services regardless of the form of compensation are exempt from registering as investment advisors. Industry officials and advisors are still scratching their heads as to what "solely incidental" actually means. The SEC has made attempts to clarify "solely incidental," but, for the most part, the definition is still "messy," says Lubin, the Maryland Securities Commissioner. The SEC now says that if a broker has discretionary authority, which means she has the ability to make investments for clients without first getting their permission, that is not solely incidental, Tittsworth says. "That's an improvement," he adds. The SEC has "put some meat on 'solely incidental,"' but "is it as far as I would like it to go? No." For instance, say a broker does not have discretionary authority and he's talking to his client about general asset allocation--60% in stocks, 40% in bonds. "Where does that run on the continuum of either providing investment advice or financial planning activities?" Tittsworth asks. While it's probably, in and of itself, not a scenario that would trigger the Investment Advisers Act of 1940, it depends on the other variables that are involved, he says. "It's not always black and white."
If a broker is merely talking to a client about a particular product, then it seems that's when the exclusion would apply, adds Giachetti. However, when a broker is talking about a "client's entire portfolio--the planning or investment management--that's where the problems occur."
The Securities Industry Association (SIA) asked the SEC last December to clarify the differences between a "financial plan" that falls under compliance with the Investment Advisers Act, as opposed to "financial planning services" provided as part of a brokerage relationship subject to the Securities Exchange Act of 1934. Robert Plaze, associate director of the SEC's Division of Investment Management, responded in a no-action letter that same month. He said whether a particular document or financial tool is a "financial plan" depends on whether the document or tool is used in the context of delivering advice that bears the characteristics of a financial plan. "A financial plan generally seeks to address a wide spectrum of a client's long-term needs," he said, "and can include recommendations about insurance, savings, tax and estate planning, and investments." Plaze said that this comprehensive type of financial planning is "distinct from a financial tool that is used to provide guidance to a customer with respect to a particular transaction or an allocation of customer funds and securities based on the long-term needs of the client."
But Darla Main, a dually registered advisor with Main Advisory Inc. in Pittsburgh, says a problem she's running into is that there are "vast differences" in the way broker/dealers are interpreting the Merrill rule. She's now trying to figure out how her firm's RIA "plays into the guidelines being established by the broker/dealer" she uses, Multi Financial Services in Denver. She says her B/D has been issuing weekly guidance on complying with the rule, but "some of it is open to interpretation, or it's never been tried or tested." (See Playing Field column.)
The Dually Registered Advisor
To ensure they're complying with the rule, some industry officials have suggested that dually registered advisors--who are registered with the NASD as part of their broker/dealer affiliation and with the SEC as a registered investment advisor--explain to the client upfront that they can work with them in one of two capacities--as an advisor or a broker. But it's not that simple, Main argues, because rarely does a client come to an advisor looking for help with only one need. Clients "want to be guided through their journey--their financial planning journey or their savings journey or their [retirement] withdrawal issues," she says.
Mark Tibergien, chairman of Moss Adams's Securities & Insurance niche (and an Investment Advisor columnist), believes it's hard to discern how a dually registered advisor can "wear two hats" and act as a fiduciary. "How is the client going to know when they [the advisors] are acting as a broker and as an advisor?" he says. Moreover, points out Tibergien, since "many advisors that have been with a B/D have been moving into the financial advisor/planner role, many of their recommendations have been done in a financial planning context." Maryland's Lubin also wonders how the 190,000 state-registered investment advisors who also hold a B/D license can switch hats effectively.
In its letter to the SEC, the Securities Industry Association asked the regulator if a dually registered advisor could, under the Merrill rule, provide both financial planning services and brokerage services to the same client. The SEC's Plaze told the SIA that dually registered advisors could, indeed, step out of their role as a fiduciary to a financial plan, and then return to their role as a broker. Nancy Lininger, a consultant with The Consortium in Camarillo, California, says she expected the regulator to opine that the dually registered advisor "is always a fiduciary." When moving from one role to another, Plaze said advisors must make it very clear--and not just verbally--that they are "stepping out of the trust and confidence role" of the advisor and into the registered rep role, and must then disclose any conflicts of interest. The dually registered advisor should inform the client in writing of the transition, counsels Giachetti, "because the standard [a broker] would use to sell you a product may not be the same standard that [an advisor] would use to" manage your assets. "I'm not saying that the broker wouldn't adhere to [the fiduciary] standard," says Giachetti, "but from a legal perspective, they're not held to that standard."
Lininger says that while she's all for disclosure, requiring the registered rep who's doing a fee-based account to tell a client they're not an advisor--and that they may have conflicts of interest--glorifies fee-only advisors. By disclosing this, "the rep has to give an 'I am slime speech.' How do you sell effectively against that?"
Lawsuits and Hedge Funds
The Financial Planning Association (FPA) filed suit against the SEC over the Merrill rule nine days after the SEC issued the rule last April. Fee-only planners have trouble grasping, for one thing, how a suitability analysis or segmented financial component of a financial plan does not qualify as a financial plan. Lininger says that when reps are doing a segmented investment plan, they're not going to be performing more comprehensive planning services covering areas like taxes or estates. The FPA also argues that when registered reps are giving advice on 529 or 401(k) plans, they are acting in a fiduciary capacity. "Obviously, a registered rep has to be able to fill out a 529 plan and do suitability on that," Lininger says. Reps have to use common sense, she says. "Reps shouldn't say, 'I'm just giving you a suitability analysis,' when it's really a financial plan. They should just focus on suitability and the investment portfolio."
(The FPA was required to submit a written brief to the U.S. Court of Appeals for the D.C. Circuit by March 27. The SEC must respond to the FPA's brief by May 11, to which the FPA must respond by May 25.)
The SEC is also being challenged in court (by a hedge fund manager) over its hedge fund advisor registration rule, which took effect February 1, and which reflects a growing unease over the lack of regulation for this growing industry (see "Accident Ahead?"). The SEC's Plaze told a group of lawyers at a recent conference in Washington that the SEC expected 700 to 800 new hedge fund advisors to be registered by the effective date. That number is a little short of what the SEC anticipated, Plaze said, because some hedge funds are using what's called a two-year lock-up period to avoid registration. With a two-year lockup "contributions or investments [to the hedge fund] made after February 1, 2006, have to be subject to a lock-up--that is, you can't redeem that money or earnings thereon, for at least two years and a day," explains Michael Tannenbaum, a partner with the law firm Tannenbaum Helpern Syracuse & Hirschtritt in New York.
If a hedge fund does lock up that new money, he continues, "then the fund is not considered to be a private fund, and the significance of not being a private fund means that when the hedge fund advisor determines the number of its clients in order to register (you can have up to 15 investors without registering), it counts the fund as one." If the fund was a private fund, on the other hand, "when you make that count, you have to look through the fund to the number of investors to determine the count." Some advisors to hedge funds say they are choosing the two-year lockup because investors worry that registration will distract them.
Some hedge fund advisors are holding off on registering because they're awaiting the outcome of the lawsuit, and still others aren't registering because they fear the cost of registration will be too great. Tannenbaum believes one of the benefits to registration is that hedge funds become eligible to receive allocations from pension funds and other institutional investors. The downside to that, however, is that "an increase in pension fund capital brings hedge funds under the auspices of ERISA rules and thus makes the Department of Labor (DOL) the 'new kid on the block,'" he says. "There is a legitimate fear that the DOL may flex its muscles and become an additional entity policing hedge funds."
The Annual Review
By April 3, investment advisors must also be prepared to comply with the SEC's annual compliance review rule. In 2004, the SEC issued a rule mandating advisors develop a manual of their policies and procedures, and comply with the rule by April 2006. Now the SEC wants to see that firms have developed these policies and procedures and have been updating them accordingly. Advisors are still unsure as to what types of updates and policies the SEC wants to see, but an SEC spokesman says the regulator doesn't plan to issue any further guidance. Rolayne Swenson, a planner with Balasa Dinverno & Foltz LLC, a wealth management firm in Itasca, Illinois, says that while her firm has some questions about compliance with the rule, she's confident her firm will pass SEC scrutiny with flying colors. Her firm worked with National Regulatory Services (NRS) to develop a customized policies and procedures manual, and the firm just completed reviewing it to "see what issues we've had over the year, what needed to be changed, and were there any areas we missed the first time around" in developing the manual. Giachetti adds that it's extremely important for advisors not to use canned policies and procedures. "This [SEC] rule presumes that the policies and procedures that advisors have implemented are appropriate in the first place," he says. But "too many investment advisors' procedures are either woefully inaccurate or woefully incomplete." The SEC wants to see that firms have been updating their policies and procedures throughout the year as events change--for instance, if they add new services, or if the SEC implements a new rule, or if new legislation is passed. While the rule doesn't specify who should be at the helm of a firm's policies and procedures, and preparing for the annual compliance review, Giachetti says it's the chief compliance officer's duty.
Keeping up with compliance chores will continue to occupy a substantial portion of advisors' time, as industry officials and observers are steadfast in their belief that regulatory scrutiny by the SEC and NASD isn't going away. Lininger, for one, believes that the NASD, even more so than the SEC, "is coming down too strong" on the firms it oversees. Just last year, advisor Darla Main contemplated exiting the profession because the compliance burden became overwhelming, but she decided to stick it out, because, in her words, "I love working with clients." That's dedication.