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Regulation and Compliance > State Regulation

Guess What? It's Examination Time

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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.

In addition to your business checkbook and bank statements, examiners will frequently request copies of bills relating to your firm, both paid and unpaid, for the last two years. Your habit of paying or not paying your own bills on time will give rise to an appropriate inference about the way that you are likely to be handling your client’s affairs.

Some RIAs may not be incorporated and may not have a separate business checkbook. In that case, a regulator will demand to review your private checkbook. To avoid this unnecessary intrusion, you should always keep business records separate from personal ones. Remember that your checkbook may reveal not only what you’ve paid for, but also what you are

Documents the

Examiners Will Peruse

Visiting examiners will want to check documents. In Alaska, for instance, state securities regulators review these books and records as part of their examinations:

o Journals, including cash/check receipts and disbursements, and any other records of original entry forming the basis of entries in any ledger

o General and auxiliary ledgers show- ing asset, liability, reserve, capital, income and expense accounts

o Checkbooks, bank statements, canceled checks and reconciliations o Bills and documents pertaining to the expenses of the firm

o Trial balances, financial statements, and internal working papers

o Correspondence and complaints

o Account information including contracts, disclosures and transaction activities

o Documents pertaining to discretion and custody of customer securities and cash

Source: Alaska Division of Banking,

Securities & Corporations

not paying for. For instance, a “soft dollar” issue may arise when the examiner notices a copy of The Wall Street Journal with a delivery label bearing your office and name and address, but is unable to see any entries in your private or firm checkbook for the subscription. If you aren’t paying for it, is the broker/dealer who executes your client’s trades paying for the paper? The same logic applies to other items in your office, including furniture and computers.

Perusal of your checkbook by an examiner may reveal other possibilities. If you indicate that you use solicitors, this will be confirmed by checks made out to these individuals and, of course, the identity of these solicitors will be revealed. These solicitors can of course be interviewed, if necessary, to confirm whatever representations are made by the RIA. If you indicated that you do not use solicitors, the examiner may question each checkbook entry that appears to be some kind of payment for some kind of service rendered: The examiner’s hunch is that one of these payments may be a solicitor’s compensation check or referral fee. And don’t forget deposit entries. Those that do not support your business will raise fiduciary-related questions.

In organizing your office, it pays to have a filing system that separates your practice into appropriate categories. At a minimum, you need to keep a separate complaint file and a separate audit file. Ortenzio advises that IA regulations require that even if you have never received a written complaint from a client or a deficiency letter from a regulator, you should have a separate complaint file. Your audit file system should also contain separate files for securities and insurance and other regulators according to states or in the case of a federally registered IA practice, a separate SEC folder.

No Dead Letters

An SEC or state securities regulator may ask you to provide copies of all correspondence sent to all clients within the past two or three years to verify, among other relevant things, that you have provided your client with an annual balance sheet of your firm in addition to your firm’s brochure and prospectuses of securities you sold to your clients. At a minimum, keep a client correspondence file in a separate cabinet that lists your clients according to alphabet, set apart from your individual client files. If an examiner asks to review all client correspondence, it is more convenient to produce one master file than to rummage through each individual client file to separate correspondence from other paperwork.

Each investment advisory client file, made by a financial planner for a client containing a plan involving advice about securities, should contain a copy of each buy or sel

Compliance Help

On the Web

Depending on your practice, you may be visited by examiners from the SEC or from your friendly state securities commission. For additional information on state securities examination procedures, consult these Web sites:

Alaska Division of Banking, Securities & Corporations

Washington State Department of Financial Institutions

Securities Division

l order for every security traded. If there are terms and conditions placed on the trade, a record of these should also appear in the file. Examiners want to know who is making the recommendation to the client to buy, sell, modify, or cancel a trade. Examiners also want to know who placed the order and who executed the order. Dates are critical for recommending, placing, and executing trades and should be included in the client’s file. If the client has given you discretion, the trade ticket must note your discretion and this should be reflected in your file on that client. Rule 204-2(a)(3) of the Investment Adviser Act of 1940 requires an RIA to maintain, among other things, a memorandum of each order given by the advisor for the purchase or sale of a security, showing the terms and conditions of the order.

Remember also that on April 2, SEC Rule 11Ac1-6 went into effect ( This requires broker/dealers who route customer orders in equity and option securities to publish quarterly reports that identify where customer orders are sent for execution. An RIA may want this in his or her client’s file for due diligence reasons. Remember that as a fiduciary, you owe your client the duty of best execution. To meet this obligation, an advisor must execute transactions so that the total cost or total proceeds of the trade are the most favorable, under the circumstances. Courts have concluded that RIAs must consider the full range and quality of a broker’s services when placing a trade, including such items as execution capability, commission rates, financial responsibility, and the value of research services provided to the RIA.

Suitability Concerns

The examiner will also want to know the types of securities that you have your client invested in. Suitability issues are always a red flag, especially since approximately half of all errors and omissions claims are tied to suitability issues. You will want to make sure that your file documents the fact that, at a minimum, you conducted an interview in accordance with NASD Conduct Rule 2310. And if you do sell your client on a mutual fund, you will want to make sure that your client file has a receipt showing delivery of a prospectus for every fund that you recommended to the client before you opened an account with that fund. Your file should likewise contain similar receipts showing annual delivery of the balance sheet to the client, as well as delivery of Part II of form ADV or of the advertising brochure, and also delivery of the solicitor’s brochure, if applicable.

Next in line in importance in the client file are compensation documents. Examiners will want to review your fee agreement. Some examiners have actually come across fee agreements not signed by a client. Examiners will look closely into whether you are charging full brokerage fees or whether you are using a discount brokerage schedule when charging your client RIA fees. In conjunction with your fee agreement, you will want to make sure that all client-billing invoices are maintained in the client file. Just as important, these invoices should show how your fees are calculated and clearly state the billing period covered by the invoice.

If You Have Custody, Be Prepared for a Visit

Bear in mind that at least 50% of all enforcement actions involve theft of client funds. For this reason, if you have or can be deemed to have custody, your chances for compliance examination increase dramatically. If you have discretion to trade your client’s account, the examiner will also want to see the power of attorney your client has given you. Make sure these forms are signed and have not expired. An examiner will want to see where, following the trade, the proceeds of the sale went. That will lead the examiner to a review of your supervisory procedures.

The duties at the firm for many day-to-day operations, such as review of incoming and outgoing correspondence, customer financial plans, new account documentation, and disclosure of all conflicts of interest, and personal securities transactions by firm members should be kept current and well documented by your compliance officer. Even one-person operations require compliance supervision and documentation that supports this supervision.

Indeed, investment advisors are required to have a formal compliance manual, even if you are a sole practitioner. The manual is one of the first things an examiner will want to see. Make sure it isn’t dusty. If your firm is larger than a one-person operation, at least once a year divide the manual into sections and assign them to colleagues and staff for a review of essential procedures. Delegate to a specific staff member the responsibility of taking notes during annual compliance meetings.

Whatever you do, something will invariably escape even the best-prepared advisor. If you do receive a deficiency letter after your examination, make sure you correct any deficiencies immediately. In Pennsylvania, for example, you are required to respond in writing within 30 days, stating that you have corrected deficiencies cited by the regulator. Be sure to make a record of when and in what manner any deficiencies are corrected, and who corrected them. Place this in your central audit file–there may be a follow-up examination. After all, the examiner who shows up at your doorstep shares your mission: preservation of the integrity of the financial services industry. In this business, credibility is everything.


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