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- How to Avoid Sabotaging Your Compliance Exam There is much more to compliance examination survival than knowing all of the rules. It helps to understand why the rules were put in placeand to recognize that examiners are not the enemy.
Compliance consigliere Tom Giachetti continued his war last week on consultants selling prepackaged forms and services.
“Compliance is what?” he rhetorically asked, before continuing in typical Giachetti style. “Not forms; Not consultants; it’s BS.”
The chairman of the securities practice group at the law firm Stark & Stark and ThinkAdvisor contributor argued that advisors wouldn’t even do half of the compliance work if the “SEC wasn’t coming after you. Why? Because it takes you away from time spent with clients. You have to justify your existence and prove that you are not a criminal. So it becomes all about getting through an examination.”
Speaking to a morning crowd at a compliance workshop sponsored by Laserfiche and TD Ameritrade that also featured Greg Friedman of software maker Junxure, Giachetti warned the assembled advisors of five red flags the SEC is looking for in exams.
1) Assets Under Management
There is no such thing as “assets under advisement,” he said, so don’t use the term. It’s all about discretionary versus nondiscretionary control that advisors have over their clients’ accounts.
“If you can’t trade it, you can’t count it,” he argued. “The SEC is bringing enforcement actions against firms for grossly exaggerating their AUM to make them seem larger than they are.
“If you say you manage something, you’d better manage it,” he continued. “If the SEC asks how you earn a fee you can’t say, “because my consultant told me so.”
If you serve as a trustee for the client in any capacity, then you custody for them, with all the attendant responsibly that brings. If you pay a client’s taxes, college bills for their children or anything like that, you are a financial intermediary. It is better to have standard letters of authorization. Send them once a year, have the client sign them and then send them back. It’s “a very simple process,” Giachetti says.
“Are you bragging to clients about you performance? If so it will put you on the highest echelon of scrutiny when it comes to SEC enforcement actions. If for any reason your marketing people say, ‘I need numbers,’ you’ve got the wrong marketing people.”
Forget publishing performance net-of-fees versus gross-of-fees, “you have to quote the performance with the highest fee you would have charged on your schedule,” he said.
Finally, if advisors use model portfolios, be aware of dispersion analysis.
“If your model is up 150 basis points for the quarter, you better be able to prove all of your clients in that model are up 150 basis points as well, or you have a dispersion problem.”
4) Due Diligence
If the advisor uses separately managed accounts, private investment funds and similar products, be prepared to answer two questions on the exam.
“The first is how you found the products; the second is how you monitor them,” he said. “If you use them off of a custodian’s platform, it makes it easier because you can see the money move due to transparency. However, the question then becomes, ‘What does the custodian do to vet them?”
5) Client Confidentiality
What are you doing to ensure the confidentiality of the client is protected? According to Giachetti, an agreement should be signed with your building management, building staff and unrelated third parties who are sharing office space.
“Anyone with ingress and egress to your office, building janitors, for instance, should have a confidentiality agreement with you. It won’t stop someone from stealing, but at least then you are covered.”
Third-party IT vendors are especially problematic, he warned, because they know everything about the advisors business.
“You should use a vendor checklist to demonstrate how you found the vendor and why you use them.”
“You train your staff in excellent service. Well, sometimes there is a reason not to give service. Add a paragraph to the client agreement that you will not transact any wire transfer without verbal verification. This is important; I just saw a case of fraud that totaled $389,000.”
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