If you are an investment advisor, it’s a good bet that you will face a compliance examination by a securities regulator during the life of your practice. Examinations, especially ones by state regulators, may come with no warning. But when the examiner shows up at your door and flashes his or her badge, you can expect to undergo a thorough grilling. That’s why it is essential to keep your practice in a constant state of readiness for the state or federal examiner who just might come calling.
In a recent audioconference presentation to the Society of Financial Services Professionals, Zachary G. Ortenzio, a senior compliance examiner with the Pennsylvania Securities Commission, explained the examination process. The first thing you need to know, of course, is who your examiner will be. If you are registered with the U.S. Securities & Exchange Commission, you will face an SEC compliance examiner. If you aren’t, you will be examined by a compliance examiner from the securities commission of each state where you have registered. Since most states’ investment advisor statutes closely track the federal Investment Adviser Act of 1940, state and federal examiners tend to look for the same things during examinations. But be aware that you can be examined by a compliance examiner from a state in which you are not registered. If you are registered only in New Jersey, for instance, your practice can nonetheless be examined by a Pennsylvania compliance examiner even if just one of your clients is a Keystone State resident.
Why You May Be Visited
An examiner can show up for one of two reasons: You were picked for routine scrutiny, or you were selected for cause. A complaint by an investor or colleague in the financial services industry can make you vulnerable to an examination for cause. But a routine examination of a broker/dealer can also lead to a “cause” examination. For example, during the course of an NASD compliance examination of a broker/dealer, facts may come out or issues may arise relating to registered investment advisors of the B/D. Since NASD Regulation does not have jurisdiction over investment advisors, NASDR will contact either the SEC or the appropriate state securities commission to look into these RIA issues. Depending on the type of questions raised by NASDR, your chances for a cause examination may increase. Such an examination may be conducted by a federal or state regulator.
If associated persons in your investment advisory practice have disciplinary problems on their U-4s and U-5s or have possibly questionable dealing with investors, expect an increased probability for a cause examination. A prior deficiency letter that you ignored or responded to in an inadequate manner can also trigger a cause examination. So can your failure to provide a regulator with requested materials, or if your answers to questions on your form ADV deliberately seem to lack clarity.
If you have not yet been examined or if it has been a while since your last examination, the chances increase that your turn is around the corner. If you have custody of or discretion over client’s assets, the likelihood of an examination increases again. Remember that there is no formula for determining when your time for an examination has come. Indeed, regulators are deliberately uncertain about this. But when a compliance examiner shows up, it pays to be polite. Being obsequious, on the other hand, can be counterproductive. Don’t offer to take the examiner to lunch–that is prohibited in some states. “Offer me a $5 lunch?,” asks Ortenzio. “You’re not getting much for your money. Don’t bother. Just give me water.”
Your Legal Options
If your books are not in order when the doorbell rings, you won’t buy time for yourself by demanding that the regulator produce a search warrant. Regulators don’t need one to examine your books. Pleading the Fifth Amendment to avoid producing possibly incriminating records is also not an option. Since NASD Regulation is a private organization, pleading the Fifth is, according to the courts and SEC, not a recognized constitutional right during NASDR exams. If the SEC is doing the examination, pleading the Fifth is a recognized right; but since SEC proceedings are civil in nature, administrative law judges in SEC cases are permitted to draw a negative inference of wrongdoing from pleading the Fifth. If the judge rules against the investment advisor, the case can be referred to NASD Regulation for a disciplinary hearing if the IA has securities licenses registered with NASD. If NASDR rules against the IA, licenses can be suspended or terminated and the IA barred from the industry. State exams generally follow a similar pattern.
Certainly, there is no legal obstacle to legal counsel being present at an examination. But in civil proceedings, Miranda rights do not apply. This means that the examiner is not required to halt the exam until counsel arrives. Money for legal fees can be better spent by retaining a law firm that specializes in RIA practices and conducts unannounced examinations of clients. Of course, you should also have in place an excellent filing system, compliance program, and trained staff that can continue to function in spite of a compliance examination. Indeed, some investment advisory firms go the extra mile of having a designated staff person trained for examinations. However, even if you have a liaison, regulators are permitted to ask appropriate questions of any individual associated with your firm.
If you have a business that is different from your financial services business that is not shown on your ADV, you may have a problem. A real estate practice, a law practice that encompasses non-financial services such as personal injury, and probably even an estate administration practice, would need to be reported on the ADV. If you are a CPA who is also an RIA, the examiner is going to want to know to what extent your traditional accounting practice varies from your investment advisory practice. If the difference is significant or confusing to the public, the examiner is going to want to know why you failed to discl
|Questions Compliance Examiners May Ask|
| Visiting examiners will query advisors about many
aspects of their practices. Here are some examples.
o Why did you decide to become an investment advisor?
o What is your investment philosophy?
o How many clients do you have now?
o How many clients left over the past year?
o Why did this or that client leave you to go to another IA?
o How do you attract clients to your practice?
o Do you advertise?
o Do you use solicitors?
o Are you the only individual in your office that gives investment advice?
o If there are others, what NASD licenses do they have?
o Do you have a complaint file?
o Do you have custody of client assets?
o Do you have discretion over asset management?
o If you have discretion, who picks the broker? You or the client?
o If you pick the broker, why?
o How often do you offer investment advice? On a need basis, calendar basis, or on another schedule?
o Do you place any restrictions on investment advisor accounts?
o If so, what are these?
o If you have custody over client assets, do you have a six- month audit report by an independent CPA?
o Have any inadequacies in this report been sent to the SEC or appropriate state securities commission?
o Does the RIA have his or her own Web site?
ose this other business on your form ADV. “We will look at your description and then see if you are following what you say,” Ortenzio notes.
How the Process Works
After you admit the regulator to your office, the examination process usually begins with an interview. Keep in mind that prior to coming to your office the regulator has scoured your ADV, usually focusing on whether you have custody of or discretion over management of clients’ assets. You will be asked to provide the compensation or fee agreement that you have for each client.
In addition to the contract that you have with your client, the examiner will want to see a copy of the brochure you give to your clients to inform them about the nature of your practice and services offered. If you use Part II of the ADV for this purpose, you’ll be asked to produce a copy of the offering that is actually given to the client. If you choose to have a brochure to give to your client instead of Part II of the ADV, the examiner will want to review it. Remember that investment advisors cannot make use of testimonials. Also, investment advisors cannot make reference to a specific profitable recommendation from the past 12 months without also listing all recommendations–including the losers–made within those same 12 months.
An examiner will also want to see how you are using the words “registered investment advisor.” The examiner will scrutinize your use of “RIA” on your business marquee, business cards, and letterhead. Expect to be asked whether your use of RIA suggests that being one implies certain educational accomplishments and enforcement of your market conduct by a professional organization and its ethical standards.
If you use someone who is not an employee to solicit business for your firm, the examiner will want to see whether you have a separate brochure for this purpose. More importantly, the examiner will ask whether the brochure discloses to the client whether the solicitor will receive compensation for that referral and, if so, whether the brochure helps the client appreciate that such an arrangement will increase the cost to the client.
Your Fiduciary Responsibilities
Because an investment advisor is a fiduciary, you will be asked to produce documents that verify that you act in a trustworthy manner. These will likely include records of your and your family’s private investments. Here the examiner is looking for evidence of personal trades made in conflict with investment recommendations given to clients. That, in turn, may open the door to an investigation into whether your advice is impartial and disinterested.