More On Legal & Compliancefrom The Advisor's Professional Library
- Differences Between State and SEC Regulation of Investment Advisors States may impose licensing or registration requirements on IARs doing business in their jurisdiction, even if the IAR works for an SEC-registered firm. States may investigate and prosecute fraud by any IAR in their jurisdiction, even if the individual works for an SEC-registered firm.
- U.S. Securities and Exchange Commission Information This information sheet contains general information about certain provisions of the Investment Advisers Act of 1940 and selected rules under the Advisers Act. It also provides information about the resources available from the SEC to help advisors understand and comply with these laws and rules.
As industry officials digest the Financial Industry Regulatory Authority’s (FINRA) new suitability rule, Rule 2111, which took effect July 9, more onerous due diligence requirements for BDs are surfacing as well as reps having to take on what looks to be fiduciary responsibility.
Ron Rhoades (left), the 2012-2013 chairman of the National Association of Personal Financial Advisors (NAPFA) and associate professor of Alfred State College’s Financial Planning Program, points to the rule’s “investment strategy” language as providing the most challenge.
Rhoades says that under the rule, reps and BDs are now required to make sure their “investment strategy” meets suitability requirements.
“The ‘investment strategy’ language used by FINRA has already been interpreted by FINRA to apply to ‘hold’ recommendations,” Rhoades told AdvisorOne. “This will require registered representatives to document, in their client relationship management software, ‘hold’ recommendations to a client, such as: ‘Don’t do anything now.’ And, of course, some supervision of such recommendations must occur.”
Primarily, he continues, “this presents a documentation requirement for BDs and reps.” Plus, “liability for hold recommendations may result, especially in situations when due diligence on a product has not been updated.”
But a “larger issue,” he says, “is whether FINRA construes ‘investment strategy’ more broadly, as they have stated they will.”
For instance, if investment strategy is construed to apply to “portfolio investment policy” (i.e., overall portfolio investment strategies), then this may require BDs to perform two tasks, he says.
First, BDs would have to “undertake significant due diligence on the academic underpinnings (through academic research or back-testing) of various investment strategies, especially as to risks present.”
Second, BDs would have to ensure this information is communicated to customers. Until now, Rhoades says, “suitability related primarily to gathering information about the client, from the clients, and did not require communication of that information back to clients. It also required due diligence at the product level.”
Continues Rhoades: "Once you get into portfolio investment strategy that will evolve into communication of any adopted strategy back to the client, as a best practice—including the risks present in that strategy.”
Moreover, Rhoades says, “the imposition and maintenance of a strategic or tactical asset allocation plan by a registered rep for a client may well result in a fiduciary relationship being formed.”
In this respect, fiduciary status may be imposed under state common law—i.e., case law. Why? “Because the design and maintenance of an overall portfolio investment strategy for a client feels like much more than an ‘arms-length’ product sales relationship, and more like a relationship in which ongoing advice (of a comprehensive nature) is provided,” Rhoades explains.
As a result, if FINRA interprets the investment strategy language broadly, “registered reps cannot just rely on the fact that the account statements say: ‘This is a brokerage account, not an advisory account,’” Rhoades says, because “fiduciary status under state common law results from representations made and actions taken, evaluated on a case-by-case basis, and is generally not determined by the agreement of the parties.”
Rhoades says that he suspects dual registrants “may find that it is just easier to avoid all of the ambiguity created where they are providing ongoing advice to a client, and just establish investment advisory accounts.” Also, he says, “I suspect that greater use of written investment policy statements will occur, with disclosures of historical portfolio-level volatility contained within these statements.”