More On Legal & Compliancefrom The Advisor's Professional Library
- The Few and the Proud: Chief Compliance Officers CCOs make significant contributions to success of an RIA, designing and implementing compliance programs that prevent, detect and correct securities law violations. When major compliance problems occur at firms, CCOs will likely receive regulatory consequences.
- Code of Ethics Rule The Code of Ethics Rule, found in Rule 204A-1, uses severe consequences for violation to help ensure investment advisors will do the right thing.
To get more clarity about the issues I raised in my last blog (The 2% Solution) about the recent change in NAPFA’s membership standards, I had a conversation with Geoffrey Brown, the fee-only financial planning organization’s CEO.
I have to admit I may be more confused now.
On its face, the new standard seems simple enough. The old standard allowed NAPFA members to own up to 2% of a commission-charging “financial services industry firm.” I was able to determine what that means in NAPFA’s view: On its website, under “Membership Standards,” Section 2. Prohibition of Certain Ownership Interests and Employment Relationships explains:
“Financial services industry firm includes any entity or individual that offers any type of financial service, e.g., securities broker or dealer, investment adviser, asset manager, investment company, banking institution, savings institution, trust company, mortgage bank, credit union, savings and loan association, insurance broker or dealer or agent, real estate broker or agent, commodities broker or dealer or agent.”
Not a bad list, with the curious exception of “real estate broker or agent.” For example, the definition of “financial services” on qfinance.com reads: “the business activity of the financial institutions that offer money management services such as banking, investment, brokerage, and insurance.”
Note the emphasis on “money management services.” As the saying goes, some of my best friends are real estate brokers, and I’ve never known any of them to have anything to do with “money management,” except perhaps of their own IRAs.
This is admittedly a small point, which in all likelihood applies to only one of the 125 members or so that Geoff Brown says will be affected by the rule change. That member is Rick Kahler, of Rapid City, N.D., who, in addition to his fee-only advisory firm, owns 50% of his family’s real estate agency. According to Kahler, he’s been a NAPFA member since 2009, when his application was initially turned down, but was then approved for membership under the condition that he “added a line on my ADV which stated that I’m not active in the real estate firm nor do I received any commissions from it.”
Hence my confusion: To start, Kahler’s admission as a NAPFA member came at a time when ownership in “a financial services industry firm” was limited to 2%. Moreover, I still don’t understand why ownership in a real estate agency is even on the list. Apparently, I’m not alone.
In a comment to Ann Marsh’s June 27 story on financialplanning.com (NAPFA Faces Member Loss After Fee-Only Rule Change), “Tom B” wrote:
”For the record, I'm on NAPFA's Compensation Task Force which is charged with interpreting the Fee Only rule in the context of new member and existing member renewal applications. I do not believe Mr. Kahler's ownership of a 50% stake in a real estate sales firm violates the definition of ‘fee only’ unless he is charging clients a fee for financial advice in connection with their acquisition, disposition or retention of real estate.”
According to Geoff Brown, “NAPFA’s membership committee is working with Kahler and other members to help them understand what the new membership standards require, and to meet those standards so we don’t lose any members. It’s an ongoing process; we will look at each situation on a case-by-case basis. If it’s a little more intricate, we’ll help the member develop a plan that meets their needs and our regulations.”
When I asked Brown what latitude the compensation committee has, and what options are available to members, he replied: “There are lot of moving parts. We don’t have any specifics, because we don’t want to tie our hands, or get locked into any time frame. But we do have some latitude.” If the committee’s former dispensation on Kahler’s 50% ownership is any indication, one can only infer it has quite a bit of latitude.
Then I raised the question of retirement plan holdings: what about the mutual funds in members’ 401(k)s or IRAs? Undoubtedly some of those funds hold stock of what are clearly financial services industry firms. “We’re not concerned with private holdings in public companies,” Brown said. “I’d think this would be kind of obvious. I don’t know how we could get that information, or even enforce a requirement like that. This is a membership standard; it’s not a law or a regulation. For us to sit down and think about every possibility would be just mind bending.”
I have to admit, just trying to figure it out is bending my mind. For instance, to find out which possibilities the NAPFA did think about, I took a look at the rest of NAPFA’s membership guidelines. (I know, big mistake.) Section 2 clearly states that: “Neither a member nor an affiliate may be employed by a financial services industry firm (see definition below) that receives transaction based compensation...”
But when it comes to ownership restrictions, things appear a bit more murky:
“A related party to a member or an affiliate may not own any interest in a financial services industry firm that receives transaction based compensation as prohibited by NAPFA; and to whom the member or affiliate makes referrals or otherwise directs business.”
Note that this seems only to restrict ownership by related parties or affiliates, while saying nothing about ownership by members themselves. Also, the “and” in the last clause suggests that ownership in transaction compensated firms is only restricted if the member directs business its way.
I may be missing something in the legalese here, but I don’t see anything in NAPFA’s membership standards that restricts members from having an ownership interest in such firms.
I’m sure it makes some sense for NAPFA to give the membership committee some latitude to work with existing members who currently have ownership of up to 2% of financial services industry firms. But if the Kahler case is any indication, the committee has huge latitude to make unlimited exceptions at its own discretion with all memberships.
Combined with Geoff Brown’s dismissal of addressing the “mind-bending” issues such as ownership of mutual funds (which I’ve heard was the reason for the 2% rule in the first place), this lack of clarity and consistency can only create confusion among existing members—and prospective members.
Rick Kahler put it best: “They should put a moratorium on doing anything until they think through this stuff.”