Recent actions by federal and state regulators have underscored their increased emphasis on sales practices in wealth management.
In part one of this series, we discussed the evolving regulation of sales practices and how they are impacted by innovations in technology. Here, we delve into these risks in more detail and offer suggestions on how to mitigate them.
Investment Appropriateness and Suitability
Most investment advisors conduct some type of suitability test when opening investment accounts — for example, using a standard form or online questionnaire. However, investors often fail to fully understand the potential risks associated with each investment decision. For their part, brokers might be biased toward advising customers to make riskier investments with higher commissions or fees.
As the CFA Institute states, “The current practice of using questionnaires to identify investor risk profiles is inadequate and unreliable, typically explaining less than 15% of the variation in risky assets between investors.” Instead, it is important to consider a number of factors when assessing an investor’s risk profile. If the level of suitability analysis is too high, advisors may be missing clients’ needs or misidentifying them. Advisors themselves must fully understand the characteristics and risks of the securities, and discern whether clients truly understand the risk of their investments and strategy, since failure to properly identify investor risk profile and investment needs increases legal, regulatory and reputational risks.
Particularly for discretionary accounts, a written statement of investment objectives should be kept on file and updated as a client’s investment strategy changes. The rationale for any transactions falling outside of the agreed scope of investment objectives should be thoroughly vetted and documented by the compliance function. It is particularly important to ensure that brokers are recommending suitable products and strategies for the elderly, as high-risk or long-term investments that provide high commissions for the broker can be construed as elder financial abuse. In addition, suitability questionnaires used by robo-advisors deserve particular scrutiny, as there is greater risk that a potential investor answering questions without assistance may not understand the questions or terminology.
If advisors are working with accredited investors under Regulation D, they should consider whether to limit their investor assessment to the Accredited Investor Rule. Relatively naïve investors may meet the accredited investor standard, based on income and assets, but may need additional advice and disclosures based on their actual levels of sophistication.
Lastly, it is equally important to review procedures when funds are “swept,” to ensure compliance with guidance on self-dealing and conflicts of interest in the investment of fiduciary funds. As the Federal Deposit Insurance Corp. (FDIC) states, “the use of own-bank deposits as a trust investment is by definition a conflict of interest and self-dealing, since the bank is investing funds held as a fiduciary with itself.” Therefore, it is necessary to ensure that sweeps and other movements of money with discretionary accounts are clearly disclosed, documented, and in the client’s best interests.
Most of the risks related to investment appropriateness and suitability detailed in the section above will also apply to fiduciaries in meeting a similar, but even higher, fiduciary standard. Fiduciaries must take additional steps to ensure that they are always serving in the best interest of the client. This includes addressing any potential conflicts of interest in arrangements such as revenue-sharing agreements or the offering of proprietary investment products.
Automated Solutions and Tools
Robo-advisors, which provide automated financial guidance and services, have had a significant impact on the industry, with nearly every major bank and brokerage adopting or launching their own version of a robo-advice platform. Like human advisors, robo-advisors are required to register with the Securities and Exchange Commission, and they are held to the same laws and regulations as broker-dealers, namely suitability. Moreover, SEC guidance has emphasized that since registered as investment advisors, robo-advisors will be held to the same fiduciary standard as 1940 Act RIAs. Further, FINRA guidance suggests that automated offerings be onboarded with increased training for employees, as well as frequent assessments of how well the tools are performing, including fees, costs and conflicts.