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Regulation and Compliance > State Regulation

Reasoned and Reasonable

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For those many of you who called or e-mailed me about my last column regarding the confusion that is too often caused by both self described experts and/or regulators as to rule “misinterpretation” and the differences between “best practices” and regulatory requirements, thank you. But I wasn’t finished, I just ran out of room to write. So now that I have more space, I continue with the rantings of a simple country lawyer who at times gets extremely frustrated by the inconsistencies and misinformation that continues to plague the advisory community.

First, as I postured in my last column: “Aren’t advisors already subject to too many rules and requirements that have little to no relevance to their practices or the needs of their clients?” Please don’t misconstrue my point. I have tremendous respect for the need for necessary regulation and for those whose job it is to ensure compliance therewith, but at some point, something went terribly wrong.

Where were the regulators during the past four to six years when the Street was slowly igniting the fuse of a ticking time bomb that could (and potentially still can) wreak more havoc upon the entire country and its financial system than ten thousand “rogue” investment advisors? To which point, I hasten to add, there exists no such number! The vast majority of investment advisors are law-abiding, conscientious professionals who do their best every day for their clients. Regulations never seem to stop the bad guys, rather they just seem to frustrate the good guys. Regulations never seem to prevent a catastrophe, they just ensure that those who are law abiding are compliant. Regardless of the breadth and scope of regulations, there will always be those scant few who will choose to ignore them.

Unfortunately, too often the acts of a very few result in regulations that burden the vast many. Regulators are rarely proactive, just reactive. Is it their fault? Many times, no. However, what usually results is “one-size-fits-all” regulation attempting, in good faith, to make sure that the catastrophe never occurs again. Unfortunately, the broad brush of the regulation paints too many who have no relationship to the underlying unscrupulous acts, and now are faced with the burden of compliance. Does that mean that there should be no regulation? Of course not! Just “reasoned” and “reasonable” regulation.

A broad Brush Was Hardly Necessary

For an example of a regulation run wild, take privacy notices. I always thought that advisors were fiduciaries under the law and were required to maintain client information in confidence. But as a result of some practices by large financial institutions, all registered investment advisors (the vast majority of which are small, closely-held businesses) were painted with the same broad stroke by the regulators and required to adopt privacy policies. Was it really necessary? How many advisors do you know that were offering their clients’ information to third-party marketers or others? Now everyone provides privacy notices. However, nobody reads them, and they crowd the mailrooms and mailboxes throughout the country. I believe I even received one from my local newsboy. Was there a need to stop the practice? Of course. Was there a need for the broad brush? I submit that the answer is a resounding no. Again, does that mean that there should be no regulation? Of course not! Just “reasoned” and “reasonable” regulation.

For those of you who may correctly point out that sending a privacy notice is just a simple process, you are correct. But where does it end? I respectfully submit that you have missed the point.

The Usual Culprits

This brings me to the issues of misinformation, inconsistency, and best practices versus regulatory requirements. Specifically, these issues become no more apparent than during regulatory examinations. For example:

o Anti-Money Laundering (AML)/Patriot Act compliance. The Patriot Act is not currently applicable to investment advisors. Why? Because it would most likely result in duplicative efforts that serve no purpose (aren’t investment advisors subject to enough regulations that have little to no relevance to their practices or their clients?). Custodian firms are subject to the Patriot Act. Moreover, as indicated above, Rule 206(4)-7 indicates that advisors must establish and maintain policies and procedures that are germane to their advisory operations. Thus, if an advisor does not have any clients in any of the OFAC countries, or accepts no cash from clients, why would it need to establish a formal AML program? Should your firm have a discussion of AML/Patriot Act in its policies and procedures so that employees or representatives can have an understanding thereof? Yes. A formal program? No.

o Risk assessment. I know of no rule that requires such an exercise. Is it prudent to conduct such an assessment? Yes, as part of the annual compliance review that is required under Rule 206(4)-7. However, that is not the issue–the issue is whether it is required. I read too many SEC deficiency letters that state it is required and that the advisor is deficient for not having conducted/prepared such an assessment. Why is that the case? Why not just recommend that the firm should consider it as part of its annual review? Why not, in the deficiency letter, delineate between regulatory violations and practice recommendations, and make it clear that the advisory firm will not suffer any penalty if it determines not to implement practice recommendations, particularly when such “recommendations” tend be very uneven and inconsistently applied throughout the various SEC branches around the country.

o The annual compliance review. When it comes to the annual review to be conducted by the Chief Compliance Officer of an RIA firm, how can the regulators cite an advisor as to the sufficiency/deficiency thereof when there has been little to no guidance from the regulators to advisors as to the form or content of the review?

o Appropriateness. Why do the Commission examiners sometimes spend one week or more examining a small fee-only mutual fund asset allocator advisory firm? Should it really take that long?

o Best execution. Although advisors are required to ensure that the clients receive best execution, the regulators have never specified how an advisor determines whether its clients are receiving it. I have heard too many different stories from too many advisors regarding the various ways examiners explained how an advisor can determine that it has discharged its best execution obligation (I will explain how an advisor can easily determine the same in one of my upcoming columns).

Thus, based upon the above, why not have uniform examinations for different types of advisors (i.e. institutions, smaller advisors vs. larger advisors, private investment fund [hedge fund] advisors, etc.) rather than using a one-size-fits-all examination? This pre-examination profiling can be easily accomplished based upon the information in Part 1 of Form ADV (i.e., type of entity, type of services, amount of assets, number of employees, etc.) and asking the advisor prior to commencing the exam to verify, in writing, that there have been no material changes thereto since the last filing.

Moreover, why are there inconsistencies between the content of examinations depending upon the region of the country–either slightly modified or sometimes significantly different? Are advisory practices different based upon geography? The vast majority of advisors operate very simple practices, and are too often intimidated by the examination process when they need not be. Why? Because the majority of the examination questions have little to no relevance to their practices (e.g., “step-out transactions,” order flow, revenue sharing, soft dollars, directed brokerage, private investment funds, etc.) Correspondingly, the risk assessment for such advisors should be a much simpler process, as should the examination process.

Compliance is the Goal

I commend the SEC for undertaking initial mini-reviews of newly registered advisors so it can rate an advisory firm on its “risk” level. I am hopeful that such efforts will be a starting point to better coordinate and streamline the process so as to make it more effective for advisors, regulators, and the public.

I continue to spend a great deal of my time traveling throughout the country preparing advisors for regulatory examinations. During the process, in conjunction with the advisor we identify areas that are in need of improvement, from both a regulatory and liability protection standpoint. The advisor will learn what does and does not apply to them from a day-to-day operational and from a regulatory examination perspective, as a result of which the advisor is able to substantially reduce its compliance efforts. Of course, the objective is not to become less compliant. Rather, the goal is to just become compliant! Too many advisors waste time, money, and energy by engaging in too many efforts that are either not required or have no relevance to their practices. Again, there arises misinformation, misinterpretation, and the failure to seek the right answer from someone who knows.

I submit that reasoned and reasonable regulations and examination formats would serve everyone’s best interests: the regulators, advisors, and clients alike. Advisors should know what their obligations are and effectively discharge them, but regulators should do a better job in identifying and explaining them. By so doing, it would permit regulators and advisors to be more efficient with their time and efforts. After all, they are all serving the same client, the investing public.

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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