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Due Diligence: An Advisor’s Obligation

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Due diligence—how much is enough? Is the SEC really asking due diligence-related questions during regulatory examinations? Investment advisors should address these issues as they relate to their decisions and recommendations, especially regarding separate account managers that an advisor may use or recommend to his clients.

The paramount issue: Do you know the identity of the custodian at which the assets will be held? If yes, do you have electronic transparency to confirm that the assets continue to remain at the custodian? Can you monitor the accounts to confirm that the assets continue to be managed consistent with the designated objective or mandate? If the manager is engaged as part of a recognized custodian platform, you will generally be able to achieve these two requirements.

 If not, you may have a lot of explaining to do during a regulatory examination. For example, how would you know if anything has occurred to adversely impact the underlying client assets? How are you able to provide ongoing monitoring services of the assets? If you cannot do so, and unless you are being paid solely as a solicitor for the manager, what is the basis for your ongoing advisory fee? Advisors who do not have this ability (or who have an underlying manager who will not permit it) should either think twice about allocating assets to such managers.

Secondly, assuming you can satisfactorily address the above, what type of initial and ongoing due diligence have you done on the managers to which you allocate client assets? If you obtain access to the manager via a custodian or third-party platform sponsor, is it enough to say the platform sponsor does it? Maybe before, but no longer. If you want to rely on the custodian or platform sponsor, it is the advisor’s obligation to ascertain, in writing, what due diligence the custodian or sponsor conducts on an initial and ongoing basis (e.g., site visits, ADV review, financial review, regulatory/disciplinary proceedings, material litigation/arbitration, style drift, loss of key personnel, best execution determination, confirmation of a business continuity plan, proof of E&O insurance). The advisor should maintain a file of the sponsor’s due diligence process, together with documentation of any additional due diligence or reviews conducted by the advisor.

What if you retain managers directly and not in conjunction with a platform? If you do, then your due diligence burden is magnified. Unless you engage a third-party due diligence provider, the advisor will be exclusively responsible for initial and ongoing due diligence. Even if you utilize the service of a third-party due diligence provider, just as with the custodian or platform sponsor, you will have an obligation to ascertain, in writing, what is the provider’s initial and ongoing due diligence process. Are you provided with any initial or ongoing written reports on each manager?

Is there any less of a burden if the advisor does not directly engage the manager, but recommends the manager to his clients, who then contract directly with the manager? From a client liability standpoint, depending upon the scope of the recommending advisor’s role and contractual obligations to the client and manager, perhaps. However, unless you can demonstrate that your role was exclusively that of a solicitor (your role was merely to introduce the client to the manager, and it is the manager who has the fiduciary obligation), and you have correspondingly clearly indicated the limitations of your role to the client in writing (in your Part 2A, the solicitor disclosure document or some other written document), regulators will still want to understand both your initial and ongoing due diligence and review processes.

Gone are the days when you could merely explain your due diligence and review processes. Today, the SEC wants an advisor to not only explain, but be able to submit evidence thereof. Many advisors are woefully underprepared for such inquiries. If you are one of them, get to work.


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