In my last two Expert’s Corner columns (“Confusion and Misinformation, November 2007 and “Use Them, But Carefully,” December 2007), we addressed some of the misinformation and confusion regarding the use of hedge clauses and arbitration provisions in advisory contracts. In this month’s column I will address a topic of sometimes even greater misinformation and confusion–the requirement that an advisor use an Investment Policy Statement.

With the advent of SEC Rule 206(4)-7 which requires SEC registered investment advisors to implement and maintain policies and procedures appropriate for their investment advisory business, registered investment advisors must continue to recognize that compliance is an ongoing process that requires the review/ updating/amendment of regulatory filings, disclosures, and procedures. Agreements and disclosure statements may require review and updating due to regulatory or state law changes and/or changes in your business operations. Never let yourself become complacent with respect to compliance matters. The scope of regulatory examination issues continues to grow and becomes more complex, and advisors must continue to review, amend and/or enhance current policies and procedures to avoid adverse regulatory findings.

For SEC registered investment advisors, the frequency and scope of compliance inspections is, for the most part, determined by the Commission’s perception of the advisor’s compliance risk profile. In order to be prepared, the firm should be familiar with both the examination process and the issues that will be raised during the examination. By conducting a mock examination advisors are better able to address and correct current deficiencies, enhance current procedures, and, most importantly, recognize and avoid those issues that could result in potentially adverse regulatory determinations and/or enforcement matters. (I always strongly urge advisors to make sure their mock examination is conducted by an attorney, which makes the examination privileged attorney-client information–one whose results are not subject to turnover to regulators and plaintiff’s attorneys.)

The SEC’s latest examination document request list requires the production of many items that are unfamiliar or inapplicable to most investment advisors. While some of these documents are not required under the Investment Advisers Act, an advisory firm should be appropriately prepared to respond to all items that are applicable to its practice. Otherwise, the firm could face the possibility of substantially longer and/or more frequent SEC inspections.

However, in addition to ongoing changes to the laws, rules and/or procedures applicable to a firm’s practice and representatives, so too are the financial situations and corresponding investment objectives of your clients subject to change. Therefore, as part of its ongoing compliance processes, an advisory firm should be equally as diligent in implementing internal policies and procedures designed to avoid adverse client-initiated litigation/arbitration proceedings resulting from the failure to identify and confirm both initial and ongoing client investment suitability parameters.

But how does the advisory firm protect itself from an adverse client litigation/ arbitration proceeding resulting from such failure? In addition, how does an advisor demonstrate that it has devised internal procedures reasonably designed to identify and confirm both initial and ongoing client investment suitability parameters? Is the answer an Investment Policy Statement?

No! At least not in the manner that most advisors think of an Investment Policy Statement–a too-often much too long, complicated, and clumsy dissertation of various investment-related information and historical data that serves more to confuse than to enlighten the client. Such a comprehensive formal process is also most likely very time consuming, and most likely a major reason why so many advisors do not properly document client investment suitability parameters, either initially and/or on an ongoing basis. Moreover, such documents are too-often forgotten relative to acknowledging amendments resulting from changes in financial situation and/or investment objectives subsequent to the commencement of the investment management process.

A Statement That Suits Your Practice

Some type of investment policy statement should be obtained and maintained by an investment advisor. However, longer does not necessarily mean better! Examples of the type of corresponding documents that investment advisors may determine to implement include client questionnaires, fact sheets, investment objective(s) confirmation letters, and/or more formal investment policy statements. It’s a pretty simple process that advisors too often neglect in favor of “canned,” extremely complex or ambiguous procedures that lead to confusion, conflict and liability.

Too many times, especially when defending advisory firms in litigation and/or arbitration proceedings, we see advisors falling victim to their own sloppy documents (a “canned” questionnaire or ambiguous form that is a minefield of conflicting responses). If the client indicates on the second that his/her objective is a 10% annual return, but on the fifth page (clearly, in my opinion, too long a document) that he/she can only tolerate a principal loss of 5%, we have a conflict, such that the advisor, as a “fiduciary,” should not begin the investment management process until such time as the client’s objectives and risk parameters are consistent, and written confirmation of them has been obtained.

Also, be very careful not to label investment suitability or strategies in terms of “conservative,” “moderate,” “aggressive,” “balanced,” growth,” or some other nondescript terms, without defining what you mean by those terms. Ambiguity will most likely be construed by a court or arbitration panel against the advisor. Most importantly, be clear to define the risks associated with such strategies (i.e., principal risk and fluctuation), portfolio composition (i.e., equities, fixed income, combination, etc.) and the minimum anticipated time horizon associated with such a strategy.

Although the Investment Advisers Act does not currently impose an express suitability requirement on investment advisors, the SEC maintains that investment advisors have a fiduciary duty to reasonably determine that the investment advice and/or services that it provides to its clients are suitable, taking into consideration the client’s financial situation, investment experience, investment objectives, and investment time horizon. Accordingly, each firm should be prepared to demonstrate to the Commission that it has a policy to obtain (and maintain) sufficient information regarding the client’s circumstances so as to enable the firm to determine whether particular advice and/or services are suitable, initially and thereafter. In fact, an advisor’s investment suitably process is one of the initial questions on the SEC examination.

Keep It Simple

Our general recommendation is to keep the client “in-take” process simple. Have a new client information document that requires the client to indicate, in his/her own handwriting, his/her risk parameters and investment objectives, and, most importantly, any reasonable restrictions that the client desires to impose on your investment management services. Have the client complete and execute the document, including a written indication if he/she wants to impose any reasonable restrictions. If there are none have the client, in his/her own handwriting, indicate “None.” Thereafter, prior to commencing the investment management process, confirm the information obtained in a written investment objectives or policy statement, either to be executed by the client, or, in the alternative, advising the client to notify you immediately, in writing, if his her understanding is contrary to that stated. In addition, the confirming document should advise the client to immediately notify you if there has been a change in his/her financial situation or investment objectives, or if he/she desires to impose, add, or modify any reasonable restrictions to the management of his/her accounts. Thereafter, the advisor should annually send a letter to the client confirming that you continue to manage the accounts in accordance with their previously designated investment objectives, and that it remains his/her responsibility to advise you if there has been a change in his/her financial situation or investment objectives, or if he/she desires to impose, add, or modify any reasonable restrictions to the management of his/her accounts.

Although the above recommendations and observations provide no guarantee that an advisor will not face adverse client initiated litigation or arbitration proceedings in the event of investment losses, it does provide the advisor with a first-line defense as to the procedures it implemented to clearly identify investment parameters, both initially and on an ongoing basis.


Thomas D. Giachetti is chairman of the Securities Practice Group of Stark & Stark, a law firm with offices in Princeton, New York, and Philadelphia that represents investment advisors, financial planners, broker/dealers, CPA firms, registered reps, and investment companies. He can be reached at tgiachetti@stark-stark.com.