In the aftermath of the bull market of the 1990s, federal and state regulators are scrutinizing even the smallest registered investment advisors more closely today than at any time in the past six decades. In fact, retail investment advisors are now finding themselves subject to the same intensive books and records and sales practices oversight as broker/dealers. This is why you must know not only how to survive a regulatory audit, but also how to make sure you’re fully prepared. And while it may be simplistic to say that you have nothing to fear but fear itself when the auditor rings your doorbell, you should welcome the visit, for it will serve as a sanity check of whether or not you have sound business practices. Furthermore, the driver for such sound business practices should be less to stay clear of the regulators–much less your broker/dealer’s compliance department–and more to minimize your own malpractice exposure.
When your time comes and you get “The Call,” keep your composure and notify your broker/dealer’s compliance department, if applicable. It is not to your advantage to be antagonistic. That will not help matters. Creating friction between yourself and a regulator may trigger an “I’ll get you” mentality on the part of the examiner. It is in your interest to be as helpful and courteous as possible. And remember that in the area of professional preparation, there is no “okay, now let’s get ready” approach. You should start to prepare for an audit the day you open your doors for business. If you keep good, commonsense business records, and exercise care and diligence in conducting your business, you will be prepared.
If you are a National Association of Securities Dealers (NASD) registered representative as well as an RIA, you could be the subject of any number of audits. The Securities & Exchange Commission (SEC) or NASD may, on a random basis, audit select branch offices of B/Ds to review their securities activities as registered representatives. The SEC or state regulators–and, at some future point, the NASD or an independent self-regulatory organization, or SRO–may also audit your investment advisor practice.
In sum, there are three basic types of audits:
oAn SEC/NASD securities compliance audit
oAn SEC/state investment advisor audit
oA broker/dealer compliance department general audit
The scope of each audit is basically the same, in that all will focus on certain aspects of financial, operational, and sales practices. Within these areas, the review process will be fine-tuned to address the particular subject of the audit.
Remember, You Are Running a Regulated Entity
When I joined the independent financial services community fresh out of the ranks of the regulators in 1986, I witnessed what was then a slow but gradual evolution to the fee-based business, primarily for the purpose of providing hourly or fixed-fee financial planning services. The regulatory platform, then and now, was the Investment Advisers Act of 1940 and its provisions. Critical to understanding your place in such provisions is an appreciation of both the time frame and reference point of the act.
The act was written primarily to address the business practices of large, institutional investment advisors who managed the assets collected by large distribution companies. As a result, it contains more high-level, broad directions, rather than tactical proscriptions, thus creating the perception of few regulatory books-and-records hurdles to entry.
This, together with the growing fee-based asset management business, which quickly outpaced the fee-based financial planning business, has helped drive an influx of thousands of SEC and state RIA registrations that have outdistanced regulators’ examination oversight capabilities.
However, some 10 years after the influx began, regulators have devised a two-tiered oversight system–the federal SEC and a state regulatory body. This model hands to the SEC responsibility for the regulation of large advisors, those who have at least $25 million under regular and continuous management, while the states get responsibility for advisors with $25 million or less and/or no provision of continuous management or supervisory services.
The creation of this two-tiered regulatory framework, paired with the erection of its ever-increasing regulatory infrastructure, has made audit inspections a more common occurrence for all. In this new climate, in fact, you may be forced to ask yourself, “What is my value-added proposition? Am I in the business of running a regulated entity, or in gathering and servicing client assets?”
Know What You Mean, and Mean What You Say
Can you clearly define your role as providing “financial planning,” “brokerage,” or “investment management” services to clients? Have you been maintaining clear records to back up these chosen roles? If so, then you should not have to worry about surviving an audit.
However, you will need to clearly distinguish between your brokerage-only, financial planning-only, and investment advisory-only clients–or any combination of these–by fact of operation as well as by books and records. Each of these functions has separate, distinguishing characteristics. But they also have certain blurred similarities. Therefore, some time should be given to a brief review and description of certain basic functional definitions. When I use the term functional, I mean an examination of widely accepted marketplace protocols. Here are the most important definitions:
Brokers. A broker is a salesperson who will receive transaction compensation only if the products he or she represents are purchased. A broker’s services involve qualifying clients for investment in products by determining their suitability (risk tolerance, goals, and objectives) up to and including the point of sale. Obviously, from a business perspective, the broker would be expected to maintain an ongoing relationship with the client. However, the broker is not contractually obligated to provide ongoing brokerage advice and counsel to the client, especially if there is no expectation of additional investable assets.
As such, a broker is held to a “point-of-sale” suitability liability standard, which requires the conduct of a suitability analysis at the time the product is sold. However, based on the broker’s relationship with the client as well as the amount of potential ongoing business that the client might offer, the broker may decide to fire and forget the client. Absent a basic desire to maintain client goodwill, the broker may not be contractually obligated to revisit a non-discretionary client’s portfolio allocation any time after the initial purchase. Therefore, the primary audit document for a brokerage client is the standard new account form. The new books and records requirement sets forth the responsibility to have such forms updated every three years.
Financial Planners. Although there is no single industry-accepted definition of financial planning, regulatory or otherwise, I offer the following understanding as set forth in 1987 by the SEC in its Release IA-1092:
“Financial planning typically involves providing a variety of services, principally advisory in nature, to individuals or families regarding the management of their financial resources based upon an analysis of client needs. Generally, financial planning services involve preparing a financial program for a client based on his or her financial circumstances and objectives. This information normally would cover present and anticipated assets and liabilities, including insurance, savings, investments, and anticipated retirement or other employee benefits. A financial planner may develop tax or estate plans for clients or refer clients to an accountant or attorney for these services.”
A simple illustration of the financial planning process might entail a planner helping a client to meet goals and objectives by creating a cash-flow analysis, or working with and advising the client on the rearrangement of income and expenses to create discretionary cash flow to fund certain long-term objectives such as buying a house or planning for college or retirement. The functional definition of the financial planner is someone who offers clients his or her intellectual capital, rather than someone deemed to be pushing product. As you can see, this is a more multi-dimensional relationship calling for file maintenance of financial planning contracts and plans.
Investment Advisors. The functional definition of an investment advisor, as set forth by Section 202(a)(11) of the Investment Advisers Act of 1940, is “any person who, for compensation, engages in the business of advising others, either directly or through publications or writing, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who for compensation and as part of a regular business, issues or promulgates analysis or reports concerning securities.”
The investment advisor would traditionally set forth his objectivity by also charging a “fee-only” percentage of assets under management for providing investment advice. He would not be deemed to be pushing products. An RIA may not be providing financial planning services, much less brokerage. Therefore, such services would also need to be set forth in clear and distinct contracts and disclosure documents.
Separating From the Herd
Whether or not you separate your financial planning and investment management advisory clients from your brokerage-only clients–and that is highly recommended–you must be able to do so by fact of operation and documentation. In other words, financial planning and asset management files must contain, in addition to brokerage documents, copies of their respective advisory documentation, such as contracts, offers to deliver the most current disclosure documents, and so forth. You would not expect to find such documents in brokerage-only files.
Disclosure and Engagement Documents
Setting forth a clear audit trail of who you serve, where you do business, and what services you deliver begins and ends with the quality of your disclosure documents. Although Rule 204-2 of the Advisers Act provides for the creation and dissemination of disclosure documents (such as the Part II ADV form), such institutional-style documents contain little–at least by way of format, much less substance–of the user-friendliness expected by today’s retail advisory clients.
It is my experience that advisors do not put enough time and effort into their disclosure documents. Relying on a thinly drafted Schedule F at the end of the Part II ADV document is not as effective as creating a well-thought-out and choreographed brochure containing all the fleshed-up disclosure elements of the Part II ADV. As a complement to such a brochure, clear, plain-English contracts go a long way in delineating what services are being offered and to whom. These services may include full or segmented planning, continuous management or portfolio monitoring, and performance appraisal services.
Books and Records
Having confirmed your ability to set forth a clear definition and separation of your services and applicable clients, we can now address the more sundry aspects of audit oversight requirements.
Financial Records. Although requirements vary by regulator, there is a general expectation that you must be able to provide a general balance sheet, which can demonstrate your basic financial solvency with respect to your regulated RIA entity. Therefore, you should not consolidate financial records such as bank accounts of your advisory, brokerage-only, and personal business activities.
Trading Authority. Beginning with brokerage, mutual fund, or third-party custodial account-opening documents, and ending with your respective contractual agreements, all such documents that set forth the limits of your discretionary trading authority must be readily available, executed, and current.
Order Memoranda. Accepting that we are all moving from the paper-based order ticket environment to electronic platforms, changing the medium does not change the matter of what traditional information must be maintained. This information includes time of order receipt (for non-discretionary accounts), order entry and execution, as well as whether discretion was exercised or not exercised and by whom.
Customer Advertising and Communications. Investment advisors cannot make use of testimonials and are subject to very specific performance advertising guidelines. Also, separate correspondence and customer compliant files must be maintained.
Custody. Although most investment advisors have their clients’ funds and securities held at a third-party custodian such as Charles Schwab or at their broker/dealer, you must ensure that your billing practices for advisory fees do not trigger custody requirements and a surprise independent annual audit. Therefore, make sure that such billing is effected pursuant to the SEC’s exemptive provisions as contained in the “Kennedy Letter.” This means that, concurrent with your billing, you send a statement to your clients that clearly sets forth your calculation methodology and the resultant amount charged.
Moreover, your authority to withdraw funds or liquidate securities positions from the account must be limited to the amount of fees charged.
Solicitation Agreements. All such arrangements, contracts, and disclosure documents must be maintained in conformance with SEC Rule 206(4)-3 (The Solicitor’s Rule). Therefore, you must maintain a separate solicitor’s disclosure statement, which must be attached to your Part II, Form ADV, and given by the solicitor to the potential client. This statement must set forth the terms and amount of the solicitation compensation to be received from a client by the solicitor. Further, you should maintain a separate contract between yourself and each solicitor that clearly sets forth your mutual roles and responsibilities. Finally, you should be observant of state laws that may require solicitors to register as advisory representatives.
Best Execution. Most retail-oriented investment advisors may not have the ability or systems to freely direct trades to the most cost-effective markets, because they contracted through either their broker/dealers or a third-party clearing entity. But such operational and business restrictions must be considered and disclosed to your clients. Still, these constraints do not totally absolve the advisor from exercising reasonable due diligence over the quality of such third-party’s executions.
An RIA must have written policies and procedures outlining how it is complying with Regulation S-P. These policies must address the collection of non-public personal information, how such non-public personal information is shared, and how the advisor maintains documentation to identify customers and their status as to whether their non-public information can be shared. Also, advisors should document steps taken to safeguard the protection of customer records and information.
Insider Trading. On October 22, 1988, Congress enacted the Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA). ITSFEA amended the Insider Trading Sanctions Act of 1984 in several respects, including establishing a requirement that every broker/dealer (and RIA affiliated with, or who custodies with, a broker/dealer) establish, maintain, and enforce written policies reasonably designed to prevent the misuse of material, non-public information by the broker/dealer or investment advisor or any person associated with the broker/dealer or investment advisor.
Money Laundering. On October 26, 2001, President Bush signed the Patriot Act. Title III of the Act, referred to as the International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001, imposes obligations on broker/dealers under new anti-money laundering (AML) provisions and amendments to the existing Bank Secrecy Act (BSA) requirements.
Among other things, the Money Laundering Abatement Act required all financial institutions, including broker/dealers, to establish and implement, by April 24, 2002, AML programs designed to achieve compliance with the BSA and the regulations promulgated under the act. Violations of the AML laws could lead to criminal prosecution. Similar provisions have been proposed for RIAs and are pending approval.
A doctor is responsible for the medical condition of his or her patients, so in a real sense he is a “Health Manager.” You are responsible for the financial condition of your clients: you are a “Wealth Manager.” Unfortunately, in our society, people tend to care more about their health than their wealth.
In that regard, you should consider the following:
Profile Other Professionals
o Learn from other profes-sionals, such as doctors and lawyers. Get a second opinion. Have a witness present in cases where the client’s judgment could later have been deemed to be impaired, such as might often occur with elderly clients or clients in distress.
o Maintain a defensive, professional attitude.
o Carefully store files and telephone logs, and maintain ex-employees’ addresses and phone numbers for possible future reference.
Standardize Your Policies and Procedures
o Set up a manual of all routinely followed procedures. Keep a manual on every employee’s desk.
o Document, in writing, each employee’s scope of authority.
o Develop checklists to insure the timely completion of tasks.
o Set up and maintain a diary system.
o Set up a forms manual with instructions outlining when to use standard letters, memos, and meeting reports.
o Set up a procedure for handling checks.
o Devise a system to learn about complaints and comments, so that you are aware of problems immediately.
o Use two-part telephone memos and note forms, with notes confirming your discussion.
Train Your Staff
o Hold staff meetings every one to two weeks.
o Have a written meeting agenda, keep minutes of the meeting, and record attendees’ names.
o Keep this information, and any handouts, in your meeting file.
o Train employees on policies and procedures listed in your company manual, and provide them with training on company products and underwriting guidelines.
Put It In Writing
o Review your notes from meetings or telephone conversations with your clients.
o Summarize main points and responsibilities. Answer the questions: Who is responsible to do what and by when?
o Always date and initial your notes.
o Maintain a telephone log of all calls.
o Make sure that members of your staff know how to take messages in a professional and accurate manner.
Stay Within Your Area of Expertise
o Know your products thoroughly.
o Have all proper licenses.
o Consult with experts on law, accounting, real estate, or other areas.
o If you choose to broker business, do it with companies whose products you know.
o Designate one person to maintain files on changes in federal and state laws that affect your business.
o Keep track of all staff license renewal dates.
o Subscribe to trade journals and maintain a library.
o Attend professional meetings regularly and participate at professional conventions.
Remember, an audit should serve to confirm the existence and quality of the well-thought-out and choreographed practice management protocols that you began to put in effect on the day you opened your practice and started accumulating client accounts. Although the audit may point out regulatory deficiencies in your practice or the industry at large, it will also serve as a sanity check. It will tell you how well you have battened down the hatches for that occasional day when a client may want you to take responsibility for his discontent.
John McGovern is chief compliance officer for the AIG Advisor Group and served as supervisor of examiners for the National Association of Securities Dealers from 1984 to 1986. He can be reached at firstname.lastname@example.org.