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