More On Legal & Compliancefrom The Advisor's Professional Library
- Do’s and Don’ts of Advisory Contracts In preparation for a compliance exam, securities regulators typically will ask to see copies of an RIAs advisory agreements. An RIA must be able to produce requested contracts and the contracts must comply with applicable SEC or state rules.
- Agency and Principal Transactions In passing Section 206(3) of the Investment Advisers Act, Congress recognized that principal and agency transactions can be harmful to clients. Such transactions create the opportunity for RIAs to engage in self-dealing.
FINRA’s new rule 2111 seems to be triggering serious discussion, perhaps for the first time in the U.S., about advice suitability with regard to risk, which is a good thing. By international standards FINRA is playing catch up, as are advisory services generally in the U.S., when it comes to suitability and risk. A requirement to assess an investor’s risk tolerance and to consider that assessment when giving advice is commonplace elsewhere, and in some cases has been a given for many years.
The benchmark on risk suitability is being set by the U.K.’s counterpart to the SEC, the Financial Services Authority. In March 2011, the FSA released a guidance paper, “Assessing Suitability: Establishing the Risk a Customer Is Willing and Able to Take and Making a Suitable Investment Selection.” In the U.S. and elsewhere, the willingness and ability to take risk are more commonly referred to as risk tolerance and risk capacity. The guidance paper was the outcome of a study by the British regulator of what advisors were actually doing with regard to risk tolerance and risk capacity. The study found widespread inadequacies which were identified and addressed in the guidance paper. Standards in the U.K. then were no lower than current standards in the U.S. A similar study carried out in the U.S. today would find similar inadequacies. Since the guidance paper was released, the FSA has followed up on its recommendations and a review of its findings is expected soon.
Whether FINRA’s new rule will have any immediate impact remains to be seen. At a recent National Society of Compliance Professionals conference, a FINRA representative said that he was not aware of the U.K. regulator’s activities and said that FINRA had no current plans to issue guidance on what advisors needed to do to discharge their obligation. Rather, he said FINRA was leaving that to the brokerage firms.
One unfortunate aspect of the new rule is FINRA’s definition of risk tolerance, namely, “a customer’s ability and willingness to lose some or all of the original investment in exchange for greater potential returns.” Regulatory Notice 11-25 cites the SEC’s Beginner’s Guide to Asset Allocation, Diversification, and Rebalancing as the source for the definition.
As noted earlier, willingness to take risk is usually interpreted as being synonymous with risk tolerance. Under FINRA’s definition, high risk tolerance would mean that both the willingness and ability to take risk were high, whereas low risk tolerance would mean that either willingness or ability to take risk were low.
Additionally, the investors section of the FINRA website currently includes this statement:
Both your age and your time frame for meeting specific financial goals play a role in determining your risk tolerance. If you're young and have a long time to meet your goals, you may have a higher risk tolerance than someone who is nearing retirement and is counting on investment income to live on for two or three decades.
That description of risk tolerance is a statement of the accepted ‘wisdom’ that younger investors are more capable of recovering from a setback because they have more time to do so. But this is about financial circumstances, including human capital, and not psychological predisposition. Using it in this manner further muddles the meaning of risk tolerance and this lack of clarity makes compliance with the suitability rule more difficult.
Admittedly, this may simply represent a lack of communication between FINRA’s education and compliance arms. Nonetheless, it is indicative of the terminology difficulties that abound in discussions about risk tolerance specifically and risk suitability generally.
In suitability discussions in other jurisdictions, the early stages became quite confusing for advisors because, among other things, terminology was used with different, and sometimes unusual, meanings by different participants. In this context FINRA’s unusual definition of risk tolerance and the inconsistency between that definition and the views expressed on its website are not helpful.
The U.K. regulator's standards do constitute good practice. However, it is not unknown for regulators elsewhere to have set compliance standards that mitigate against good practice. Hopefully that is not going to happen in the U.S.