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Regulation and Compliance > Federal Regulation > SEC

3 Critical Areas Regulators Are Watching

By Thomas D. Giachetti

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As the popular song from “Love Story” starts, “Where do I begin?” So many things to share, so little space in this column. Over the past few months, I have seen so many issues that advisors ignore at their regulatory or financial peril.

First, a query to regulators: How did Wells Fargo happen? All the regulation and oversight of financial institutions, and still it occurs? As I have said countless times over the last 30 years, you can’t regulate bad guys! When is the last time the Securities and Exchange Commission and other regulators, with all of their gross over-regulation, have ever caught the bad guys before they committed the wrongdoing? Never — the system is never proactive, only reactive, and the Wells incident will most likely lead to even more unnecessary regulation. Regulators, perhaps you were spending too much time and resources overexamining and punishing law-abiding good professionals for nonsensical issues. Oh, to be SEC commissioner for just six months! But I digress.

Here are three examples of issues regulators are examining in advisory firms.

1) Mutual Fund Share Class Issues 
“All things being equal,” according to regulators, an advisor must opt for I shares versus R shares when available. You can’t justify R shares because you don’t want your clients to incur transaction fees when the client, given the dispersion in expense ratios, would have been much better off with the I shares. God forbid you opt for R shares in a wrap program when I shares were available! In a wrap program, that raises a gross conflict of interest given that the advisor has an economic disincentive to purchase transaction fee shares.

Of course, there may be reasons to buy the R shares (e.g., I shares are unavailable, the investable amount does not qualify, anticipated short-term holding period, transaction fees assessed on dividend reinvestment). However, you must be able to demonstrate to the SEC, if raised, that you have a written policy regarding share class protocol, and have considered all such corresponding factors if you opt for an R share when an I share is available. To disregard this requirement could result in you writing a check back to affected clients.

2) Holding Brokerage Class Shares

Have any of your clients transferred previously purchased brokerage class shares (C or A shares) to a portfolio you manage? If yes, and if raised during an exam, you must be able to demonstrate to the SEC that absent mitigating circumstances you reviewed the transition of those shares to an available lower-expense share class, and where practical you made (or recommended, if non-discretionary) the transition to the lower-expense share class. Here also, to disregard could result in you writing a check back to affected clients.

3)Vendor Due Diligence
You are a steward of your clients’ information. Can you demonstrate that you have a process to vet (initially and continually) the vendors that have access to your premises or client information? Have they executed confidentiality agreements? Due diligence is not only for your primary office, but equally applies to any branch or remote offices. Too often firms forget that from a regulatory perspective, staffed branch offices are no different from your principal office.

During on-site exams, the SEC will now regularly do a walk-through. Have a written policy requiring employees to lock their office doors at night if sensitive information is on their desk, especially information that can lead to identity theft (if there are no locks, consider buying them; they’re not expensive). The same goes for file cabinets. And don’t tell me that the cleaning staff or security guards are not smart enough to know what they’re looking at — never judge a book by its cover. There are many very smart people cleaning offices and serving as night guards, some of whom could be predisposed to engage in inappropriate activity if you invite it. Make sure you ascertain what building management does initially and on an ongoing basis to vet individuals who have access to the premises, and document that for your compliance files.

— Read SEC Announces Reporting Changes for Advisors on SMAs, Performance on ThinkAdvisor.

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