Guess What? It's Examination Time

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

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

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 (www.sec.gov/rules/final/34-43985.htm). 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.