When a taxpayer is audited, the IRS expects to see receipts and other documentation to substantiate all of the deductions taken. The audit will go far more smoothly if the taxpayer’s records are organized and thorough. Showing up at the audit with a shopping bag filled with receipts will be counter-productive. Similarly, RIAs will fare much better during a regulatory exam if their records are well-organized and meticulous.
Rule 204-2 under the Investment Advisers Act identifies the books and records an RIA is required to create and retain. Paragraph (e) of this rule states that specified books and records must be “maintained and preserved in an easily accessible place for a period of not less than five years from the end of the fiscal year during which the last entry was made on such record.” The most recent two years of records must be held “in an appropriate office” of the investment advisor, which typically means the principal office of the RIA.
Partnership articles, as well as any amendments to them, must be maintained in the principal office of the RIA and be preserved until at least three years after the termination of the enterprise. This longer retention period also applies to articles of incorporation, charters, minute books, and stock certificate books of the RIA and any predecessor.
As rules change, an RIA’s books and records obligations are revised as well. As we will see in Pay-to-Play Rule, an RIA providing service to a government entity must keep additional records satisfying the pay-to-play rule. Those record-keeping obligations became effective on March 14, 2011.
A Books and Records Example not to Follow
While taxpayers sometimes try to make their income look smaller, one RIA attempted to make its assets under management appear larger. On March 9, 2009, an enforcement complaint was filed against Leila Jenkins and her firm, Locke Capital Management Inc. The RIA fabricated a Swiss client whose accounts supposedly contained over $1 billion. The RIA then used this fictitious client to enhance the firm’s credibility in order to attract real investors. After a routine examination, the SEC discovered that the Swiss client did not exist. In fact, the RIA had no real clients in 2003, 2004 and 2005. In 2006 through 2008, the RIA did have actual clients but the firm’s assets under management were materially overstated. The RIA also lied to the SEC and clients about the firm’s performance.
The complaint alleged that the firm violated Rule 204-2 under the Investment Advisers Act and committed the following books and records violations:
- Failed to make and keep accurate trial balances and financial statements
- Failed to keep a list or other account records documenting the RIAs discretionary authority with respect to any funds or transactions
- Failed to retain originals or copies of all written agreements between clients and the RIA
- Failed to maintain copies of client acknowledgments and solicitor disclosure documents as required by Rule 206(4)-3 and Rule 204-2
- Failed to retain all accounts, books, internal working papers, and other records needed to calculate performance or rate of return
Jenkins produced documents, in conjunction with an examination that she claimed were copies of custodial statements for the Swiss client’s accounts. In actuality, the custodial statements were not genuine.
In the complaint mentioned in Proxy Voting, which was filed against an employee of Bernard Madoff’s advisory firm, Eric Lipkin allegedly helped to prepare fake books and records in the event that a regulator or investor requested them. Because Madoff never engaged in any trading and never held any real securities positions for his firm’s advisory clients, Lipkin created fake reports and false statements.
Situations such as these are very unusual. Typically, RIAs neglect to create or retain the appropriate books and records, and rarely falsify records in an effort to perpetuate a fraudulent scheme.
Without books and records, examiners cannot do their jobs effectively. This chapter serves as a review of key documentation that examiners expect to find at an RIA’s office. Many of these books and records must be sent to examiners prior to the examination. Others will be provided at the time of the examination or after the fact to resolve a particular question that has arisen. When examiners review an RIA’s books and records, they will be looking for prohibited practices, breaches of fiduciary duty, conflicts of interest, and other types of misconduct.
Overview of the Books and Records Rule
The SEC’s statutory authority to conduct examinations is derived from Section 204 of the Investment Advisers Act. The language in that section of the statute authorizes the SEC to conduct examinations of an RIA’s records as necessary to protect the public. Most states have also authorized their securities regulators to examine the books and records of RIAs within their jurisdiction. As a prelude to a state or SEC compliance exam, an RIA will be asked to produce extensive books and records. An RIA’s inability to produce requested books and records is likely to cause examiners to form an unfavorable impression of the firm’s business practices.
Every RIA must make and keep true, accurate, and current books and records relating to its investment advisory business. These records are described in Rule 204-2 under the Investment Advisers Act, commonly known as the Books and Records Rule.
Books and records are not just printed materials. For example, an RIA that used radio advertisements was cited for violating Rule 204(a)(11), because he did not retain a script of each commercial. He also paid several radio show hosts and stations for live airtime, but could not supply examiners with transcripts of those interviews.
Firms must keep all versions of their websites for the period required by the books and records rule. As we saw in Use and Misuse of Social Media, the ability to create and preserve books and records is one of the major obstacles RIAs must overcome if they hope to use social media.
State Books and Records Rules
States will often incorporate Rule 204-2 into their statute regulating RIAs. For example, Title 61 of the Utah Uniform Securities Act requires RIAs in that state to comply with Rule 204-2 of the Investment Advisers Act.
Pursuant to Title 61 of the Utah Uniform Securities Act, the Division of Securities issued R164-5-1, detailing the recordkeeping requirements of broker-dealers and RIAs. The rule states:
“(1) Except as provided in subparagraph (D)(3), unless otherwise provided by order of the SEC, each investment adviser licensed or required to be licensed under the Act shall make, maintain, and preserve books and records in compliance with SEC Rule 204-2 (17 CFR 275.204-2(1996)), which is adopted and incorporated by reference, notwithstanding the fact that such investment adviser is not registered or required to be registered under section 203 of the Investment Advisers Act of 1940.
(2) To the extent that the SEC promulgates changes to the above-referenced rules, investment advisers in compliance with such rules as amended shall not be subject to enforcement action by the Division for violation of this rule to the extent that the violation results solely from the investment adviser’s compliance with the amended rule.
(3) Every investment adviser that has its principal place of business in a state other than this state shall be exempt from the requirements of subparagraph (D), provided the investment adviser is licensed or registered in such state, and complies with such state’s record keeping requirements.”
States may have slightly different rules. For example, Virginia’s statute requires RIAs to keep a file containing a copy of each notice, circular, advertisement, newspaper article, investment letter, bulletin, or other communication device including electronic media that is circulated or distributed, either directly or indirectly, to two or more persons. Rule 204-2 under the Investment Advisers Act requires RIAs to retain advertising materials sent to ten or more persons. In New York, RIAs must retain advertising materials sent to five or more persons.
An investment advisor registered in more than one state will not face different books and records requirements. Section 222 of the Investment Advisers Act states:
“Dual compliance purpose: No State may enforce any law or regulation that would require an investment adviser to maintain any books or records in addition to those required under the laws of the State in which it maintains its principal place of business, if the investment adviser:
is registered or licensed as such in the State in which it maintains its principal place of business; and is in compliance with the applicable books and records requirements of the State in which it maintains its principal place of business.”
Otherwise, an RIA’s books and records obligations would be even more difficult.
NASAA’s Overview of Books and Records Requirements
It is helpful to look at the books and records requirements recommended by the North American Securities Administrators Association (NASAA). According to NASAA’s Investment Adviser Guide, an RIA will generally be required to keep the following records:
- Receipts and disbursements journals
- General ledger
- Order memoranda
- Bank records
- Bills and statements
- Financial statements
- Written communications and agreements (including electronic transmissions)
- List of discretionary accounts
- Personal transactions of representatives and principals
- Client records:
- Powers granted by clients
- Disclosure statements
- Solicitors’ disclosure statements
- Performance claims
- Customer information forms and suitability information
- Written supervisory procedures
RIAs that have custody of clients’ assets must retain:
- Journals of securities transactions and movements
- Separate client ledgers
- Copies of confirmations
- Record by security showing each client’s interest and location thereof
RIAs that manage assets must retain client purchases and sales history, as well as client securities position.
The previous list is by no means all-encompassing. More information can be found at:
According to NASAA, records are required to be maintained in an easily accessible place for a period of five years from the end of the fiscal year during which the last entry was made. For the first two years, the records must be maintained in the RIA’s principal office.
Although Rule 204-2 does not address email specifically, the requirements of the Books and Records Rule still apply. To comply with Rule 204-2, certain emails should be retained for at least five years following the fiscal year during which they were sent. The SEC treats instant messages in the same manner. Typically, document request lists from regulators will ask for emails between certain dates.
States are likely to ask for specific documents in preparation for an onsite exam or desk audit. For example, the South Carolina Securities Division Investment Adviser Examination Program Overview warns RIAs that it reviews all incoming and outgoing correspondence, including written and electronic mail messages. Depending upon a state’s regulatory priorities, examiners will request different records.
Generally, RIAs must retain email communications received or sent by the firm relating to the following:
- Recommendations made or proposed to be made
- Advice given or proposed to be given
- Receipt, disbursement, or delivery of funds or securities
- Placing or execution of any order to purchase or sell any security
Attorney Michele L. Gibbons and Angela M. Mitchell of Capital Research and Management Company listed common types of emails, that must be retained, in their presentation to the National Society of Compliance Professionals in October 2006.
- Emails between employees and members of the public relating to the RIA’s business
- Internal email from an RIA’s portfolio manager to a trader dealing with execution of an order
- Emails relating to the placement or execution of a client’s securities
- Emails to clients regarding proposed trades
- Email from an RIA’s CCO to a portfolio manager regarding a complaint about a specific holding or trade
- Client complaints
- Emails from an RIA to a client’s custodian regarding an advisor’s management fee
- Updates from an IAR to a client
- Research report sent from an analyst to a trading colleague
- Advertisements and promotional materials sent via email
Even though an advertisement is sent using email or text, an RIA must still comply with the firm’s advertising policies and procedures discussed in Advertising Advisor Services and Credentials. Most RIAs implement policies and procedures requiring that all advertisements must be pre-approved by the firm’s CCO. Furthermore, in certain jurisdictions, a state-registered investment advisor may be required to send a copy of an advertisement sent via email or text message to securities regulators at the same time it is transmitted to prospective clients.
Examiners will certainly look at advertisements transmitted electronically during a compliance exam. A recent Michigan desk audit asked for printed copies of email solicitations, electronic bulletin board solicitations, and chat room solicitations.
Because of books and records retention requirements, some advisory firms do not permit their IARs to use smart phones when communicating with clients, while others put restrictions on their usage. Some RIAs do not permit IARs to text clients unless the messages are captured on the firm’s server, since this is the only way the RIA can supervise this communication.
For compliance purposes, text messages should be handled in the same manner as emails, and must be retained for the five-year period required by the Books and Records Rule. Examiners will be very critical of a firm if the CCO is unable to locate and produce emails or text messages requested. The SEC or state securities regulator may have received a copy of the email or text message from a current, former, or prospective client who filed a complaint. They might even suspect that the RIA was trying to hide the fact that a complaint was filed.
The Big Picture
Thorough and complete books and records enable RIAs to demonstrate that they have fulfilled their fiduciary obligations to clients and complied with applicable rules and regulations. Though compliance with the Books and Records Rule is burdensome, it shows that the RIA is committed to compliance. Without books and records, it is impossible for advisors to prove they satisfied their fiduciary duties.
Records retention is also very important for disaster recovery plans, which securities regulators require RIAs to implement. At a minimum, an RIA should establish disaster recovery plans for storing, maintaining, and restoring the firm’s books and records. RIAs should also implement a policy for disposing of sensitive information.
According to Gibbons and Mitchell’s presentation to the National Society of Compliance Professionals, the SEC takes the position that any retained records may be examined, even if they are not required to be preserved by the Books and Records Rule. Records that are not required to be preserved may be destroyed unless they are incidental to a legal proceeding, complaint, or a regulatory action.
The SEC and state securities examiners often review books and records in a vacuum. IARs may not have the opportunity to explain what a particular document means or its intended meaning. As an example, desk audits rely on information sent from an RIA to the examination team. Although examiners may contact the RIA for more information, the team will be reviewing these materials in their offices, not the advisors offices.
Documentation should be self-explanatory. This is not always the case if an examiner is reviewing a cryptic email or text message. Because electronic communications tend to be brief and informal, there is a higher probability that they will be viewed as misleading. Examiners will not know the story behind a message, and will not know if the advisor discussed the topic in much greater detail during a previous discussion with the client.
Securities regulators have shown an increasing willingness to fine RIAs for books and records violations. One RIA was recently fined $20,000 for numerous books and records deficiencies, although the firm’s attorney was able to negotiate a lower penalty.
Books and records violations are often intertwined with other compliance deficiencies. For example, the Code of Ethics Rule requires RIAs to provide copies of their codes to supervised persons and keep documentation acknowledging that they were provided. Failure to produce those acknowledgements for inspection by examiners is a Books and Records Rule violation.