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Regulation and Compliance > Federal Regulation

The Three Troubling Themes

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As I travel the country lecturing at investment industry conferences, conducting compliance reviews, attending enforcement proceedings, playing too little golf, and realizing that outliving one’s frequent flyer miles is not necessarily a good thing, I am often amazed at the disparity of questions I am asked about the investment industry, its rules and regulations by a diverse cross-section of industry professionals at different stages of their individual careers. There are three common themes I divine from these disparate questions. First, that there exists far too much misinformation and misunderstanding about what is required to maintain regulatory compliance. Second, simply knowing the rules is far different from knowing how those rules may or may not apply to your business. Third, there is no such thing as a stupid question, unless you count those questions that are never asked and thus go unanswered.

Theme No. 1: Getting Informed

Where does the all-too-common amount of misinformation and misunderstanding come from? There are various sources, including: (1) “compliance consultants” whose practical knowledge of the industry is much more limited than you may appreciate; (2) study groups that serve to share or reinforce bad habits or perpetuate misinformation (i.e., seeking validation or comfort from others who may have no better understanding of the issues or rules than do you); (3) relying upon the content of “canned” documents rather than taking the time required to cull through such “one-size-fits-all” compliance approach to dissect what does and does not pertain to your firm’s advisory operations, thereby creating an unintended liability minefield during a regulatory exam or in the event of a client litigation or arbitration matter; (4) conference sponsors who may invite speakers based upon business relationships rather than expertise that is vital to its attendees; and (5) firm principals who fail to appreciate their ongoing role with respect to compliance, and the supervisory role they have with respect to the compliance officers that they may employ.

Misinformation Takeaway: It is incumbent upon a firm’s chief compliance officer to cull through information and misinformation. However in order to be able to do so, she must first have a solid understanding of the industry and how its rules apply to her firm’s operations.

Theme No. 2: Knowing the Rules

It is simply not enough to know the rules. Rather, knowing how the rules apply and do not apply to your advisory operations is the key to establishing an maintaining a cogent compliance program. Remember that rule 206(4)-7 requires that your firm’s compliance policies and procedures reflect your firm’s operations. That means your specific firm, not some generic outfit!

Do your policies and procedures indicate the applicable rule or procedure that you want your employees or representatives to be aware of so that they can understand the issues presented? Furthermore, do your policies and procedures indicate whether the rule or issue is currently applicable to the firm’s advisory operations? Here are some examples. Broker/dealer rules are not investment advisor rules; there are substantial differences between a fiduciary standard and a non-fiduciary standard. (This is, by the way, one of the major reasons I do not believe that FINRA should have regulatory responsibility for investment advisors.)

Too many purveyors of compliance materials are still stuck in the broker/dealer world. Moreover, too many compliance officers have a broker/dealer background and do not appreciate the differences between the rules and regulations applying to B/Ds and their firm’s “advisory” operations. Here’s a warning applicable in particular to firm principals: You do not discharge your responsibility by appointing compliance officers who do not have the requisite industry experience or understanding -You are ultimately responsible. You should be able to duplicate and understand whatever your CCO does in the event that the CCO is not present when regulators arrive. Finger pointing is not a winning strategy during a regulatory exam or client litigation/arbitration proceeding. The buck does stop with you!

For this reason, when I conduct compliance reviews, I ask that the chief compliance officer, his assistant, and his supervisor (the firm owners or principals) be present to understand the issues that will be presented during a regulatory examination. How can senior management evaluate or supervise its CCO if at least one member of said firm’s senior management does not have a good understanding of what the CCO’s functions and responsibilities are?

Finally, how much time is your firm spending addressing compliance issues that are not relevant to your firm’s operations? Are you really saving money by engaging that “compliance consultant”? Or do you have a false sense of security? Do you really need an anti-money-laundering program? Is it required? Do you need a best execution policy? If yes, does it involve more than just comparing transaction costs? If yes, how are you determining that you have obtained good “price” execution. Note to CCOs: Cost of execution is not the prevailing issue any longer–that was five years ago. There no longer exists the disparity of execution costs between the major custodians. Rather, the issue is “quality” of execution.

Note to regulators! I do not know of any legitimate reason for a best execution policy for mutual fund asset allocators. When one transacts in securities that trade at net asset value at the market close, then “quality” or “price” of execution should not be an issue, unless the advisor is purchasing transaction-fee funds with costs that skew the industry norm, without conspicuously disclosing such higher costs to its clients so that the client can make an informed decision as to whether she should continue the relationship. I believe that such practices are extremely limited in the advisory industry, especially among advisors who have the freedom to recommend the custodian(s) of their choosing, rather than those advisors whose principals may have a registered representative relationship with a broker/dealer and whose custodian choice/pricing has been limited by the broker dealer. In these instances, conspicuous disclosure is absolutely necessary for the advisor to discharge its fiduciary duty to its clients.

Theme No. 3: Asking Unstupid Questions

Yes, your teachers and parents were right, there is no such thing as a stupid question. That’s because there may be no specific rule or regulation one can point to that provides a definitive answer, Rather, the answer may depend upon determining what the prudent business practice is given the circumstances. Here’s an example. How often should I update my Form ADV’s written disclosure statements–Part II and Schedule F? Answer: The rules are pretty clear as to the timeframe thereof depending upon the nature of the issues/amendments presented.

Here’s a better question. When is the last time I provided my clients with an updated ADV? “Well,” says the advisor, “I offer it every year, in accordance with the rules.” Yes, but in your offer, did you advise the client that you have made substantive changes thereto that may be germane to his ongoing relationship? Further, if such changes were made, isn’t a better practice to provide the written disclosure statement rather than just offer it? It is disconcerting, I must say, that many advisors are reticent to do so. An advisory firm is a fiduciary and should provide its clients with full disclosure.

Note to CCO and/or firm principals: When is the last time a client asked for your most current disclosure statement? Is an offer to provide a current disclosure statement without indicating that there have been substantive revisions to said statement really an “offer”? If you really want to protect the firm from client allegations that “I never knew, nobody ever told me,” then it is my recommendation (and how we at Stark & Stark advise our clients) that the firm, once every two to three years, in lieu of offering its written disclosure statement, actually provide it to clients with a corresponding cover letter indicating that this year, in, lieu of the offer we are providing the disclosure statement, and that if the client has any questions, the firm will remain available at his/her/its convenience to address them.

The Parting Glass

So, to all chief compliance officers and their supervisors, please appreciate the difference between good information and misinformation, make sure you know how regulatory rules and practices appropriately apply or do not apply to your firm, and, finally, if you are ever unsure as to either of the above, ask a not-so-stupid question from someone you “know” is able to provide the correct answer.

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, and a regular contributor to Investment Advisor. He can be reached at [email protected].


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