Fundamental changes in financial market oversight appear imminent amid a prevailing sense of regulatory impotence, says Barry P. Schwartz, a partner at ACA Compliance Group, a regulatory consulting firm in Boca Raton, Fla. "The tendency," he says, "is to look to reduce costs across an organization, and certainly compliance costs fall into that category. Now more than ever, it's important for advisory firms to remain focused on compliance."
Such a reminder emanated from Washington, D.C. late last year in the form of an open letter from Lori A. Richards, director of the SEC's Office of Compliance Inspections and Examinations, to CEOs at SEC-registered firms. "While many firms are considering reductions and cost-cutting measures," she wrote, "we remind you of your firm's legal obligation to maintain an adequate compliance program reasonably designed to achieve compliance with the law."
Observers like Schwartz say they expect 2009 to be a year for major overhaul at regulatory bodies such as the SEC and FINRA in light of the recent succession of havoc-wreaking bank failures, Ponzi schemes and investor losses. As a result, they say, advisors should brace for not only closer regulatory scrutiny but also significant changes in how -- and by whom -- they are regulated.
"Everything is essentially on the table," says Schwartz, himself a former SEC compliance examiner. "Something seems likely to happen in a broad sense in how investment advisors are regulated," including such possibilities as the merging of the SEC and the Commodity Futures Trading Commission.
But amid the big-picture uncertainty created by such potential scenarios, there are narrower but still pressing compliance issues that advisors must tackle on a day-to-day basis. Here are some of the regulatory responsibilities and initiatives that advisors and compliance experts say deserve extra attention:
Documentation, disclosure and communications regarding client suitability and investment objectives. The market nosedive has profoundly affected not only account values but client mindset. For advisors, that means redefining what kinds of investment and insurance tools are suitable for each individual client, and revisiting and potentially recalibrating their investment strategies accordingly.
"We have been auditing all the contracts we have with our existing clients on the wealth management side, especially the annuity contracts," explains Jim O'Shaughnessy, managing partner at Sheridan Road Financial Services, an advisory firm in Northbrook, Ill., "to make sure they fully understand where their contracts currently sit. We're doing absolutely all we can to be proactive in reaching out to clients with face-to-face meetings and phone calls, making sure we're consistently delivering information to them and documenting exactly what we deliver."
Due to the combination of widespread asset repositioning and investor unease, advisors need to protect themselves with a paper trail. "I'm a firm believer in documentation," says Laura Crosby Brown, director of compliance at Regulatory Compliance LLC, a consulting firm in Londonderry, N.H. "Have clients read about something, then have them sign that they read it all and understand it. Be sure whatever you ask them to read is written in plain English, so people can easily identify the things that will impact them."
This is no time to be lax on the disclosure, documentation and suitability front, cautions Schwartz. "In an environment like this, there's a tendency for clients to question why they are in a certain investment with which they lost money, and to want to discuss that with an attorney."
Advisors also should expect more regulatory scrutiny of their pre-sale disclosure practices, whether the product is an insurance or financial instrument. From fees to contractual terms, it all needs to be on the table. "We are giving a lot more information to the client before a sale occurs," notes O'Shaughnessy.
The heat is also on firms that deal in annuities. The SEC adopted a final rule late last year designed to provide investors in fixed (equity) indexed annuities greater protection by regulating certain contracts as securities. That rule came on the heels of FINRA's Rule 2821, which includes new suitability, training and supervisory guidelines for variable annuity transactions and advisory firms that sell VAs.
Regulators "are particularly concerned about people nearing or in retirement who are in the 'protection-of-assets' phase and how they are communicated to" about annuities, says Crosby Brown. Her recommended antidote: "Make sure you discuss all the attributes and risks of a product and make sure the investor understands surrender penalties, lock-up penalties, things like that."
The perceived shakiness of once rock-solid majors in the financial services, banking and insurance sectors requires advisors to be more vigilant with due diligence, especially in evaluating the provider of a financial instrument or insurance product. "There is an increased level of concern (among regulators), especially at the state level, about the viability of individual insurers," observes O'Shaughnessy. Their concern focuses on variable annuities with lifetime income guarantees and other forms of living benefits, he says. "They want to know, are an insurer's guarantees safe? That puts pressure on us as a firm to educate ourselves about the companies we are entrusting our clients assets to before we make recommendations."
The Madoff case underscores the importance of advisor due diligence with other, more complex investment vehicles as well -- "alternative" instruments such as structured products, managed accounts, principle-protected notes and other derivatives. That due diligence must extend beyond the instrument itself, to the party who's ultimately responsible for managing the assets inside it. "Clients will certainly be asking more questions about where their money is going and who is handling it," says Crosby Brown. "So advisors really need to understand what they are selling, who's behind it and where the client's money is really going."
Another crucial area of due diligence is understanding -- and communicating to clients -- any potential liquidity constraints associated with certain alternative investments, such as structured products. Liquidity is a hot-button regulatory issue, says Schwartz, because during last year's financial meltdown, investors in some cases weren't able to make redemptions with certain structured vehicles, even though they met all contractual criteria for doing so. Regulators will be watching "to see that advisors in fact are marketing these products accurately and not misleading customers about their ability to get their investment back if and when they want it back."
Preserving the privacy and sanctity of client information is another top priority for state and federal regulators alike. "Are you equipped to identify potential threats and to protect against them? It's a huge (regulatory) issue and something consumers are very tuned into," says Crosby Brown. "The big thing is to make sure all your networks are secure -- that you change passwords frequently, that you use encryption and have secure firewalls."
Advisory firms small and large are "getting pressure from all directions" to implement stronger systems for safeguarding electronically stored client information, says Schwartz. "States have really jumped on this issue." Meeting the stricter information-protection standards can be especially taxing for small practices, particularly during lean times, Crosby Brown points out. "A lot of the smaller firms are sort of struggling to put the IT infrastructure in place because the technology is expensive."
As committed as advisory firms are to playing by the rules as they're currently written, they are also keeping an eye on developments in Washington, D.C., mindful that the entire regulatory playing field could be in for a seismic shift sometime in 2009. "We're kind of sitting tight," says O'Shaughnessy, "and watching what might come out in the next 100 days."
Congress appears destined to make "major changes" in the financial regulatory scheme, according to Crosby Brown. Whatever happens, she says, "It's going to be interesting."