A new report from a group that represents state securities commissioners takes investment advisers to task for compliance deficiencies in “a number of significant problem areas.”
As state securities regulators prepare to assume increased oversight over a larger group of investment advisers, the report finds industry-wide compliance deficiencies in the United States and Canada that still need attention. Investment advisers who want to minimize their risk of regulatory violations are taking notice, as they work to incorporate an updated list of recommended best practices.
A series of coordinated examinations by 45 state and provincial securities examiners reviewed compliance deficiencies recorded in the first half of 2011 at 825 investment advisers. Those reviews found 3,543 deficiencies in 13 compliance areas. By comparison, a similar examination in 2009 found 1,887 deficiencies in 13 compliance areas at 458 investment advisers.
The 2011 state examinations were conducted under the guidance of the Investment Adviser Operations Project Group of the North American Securities Administrators Association, an organization that represents state securities commissioners. Mike Huggs, chair of NASAA's IA Operations Project Group and director of the Mississippi Securities Division, says the report was issued for the benefit of the advisory community to know where to look for deficiencies so that they may be addressed.
“Our goal in identifying deficiencies and recommending best practices is to help investment advisers strengthen their internal compliance programs and improve the services they provide to clients,” says Jack Herstein, NASAA president and assistant director of the Nebraska Banking and Finance Department, Bureau of Securities.
Top Deficiencies
Tightening the regulatory oversight of investment advisers—after all, Bernard Madoff was one, and look what he did—is one of the many reforms required by the Dodd-Frank Act. Small advisers have long been on the outer fringes of that oversight; as they fall under greater scrutiny in the future, they'll need to improve their compliance efforts considerably.
The state examinations report comes at a time when state securities regulators are poised to take over regulatory oversight from the SEC of investment advisers that manage assets under $100 million, a significant increase from the current $25 million threshold. That means in June 2012 roughly 3,200 advisers will have to deregister with the SEC and make the switch to state registration. “Those are significant changes any way you cut it,” says David Tittsworth, executive director of the Investment Adviser Association.
“A word of caution to advisers would be if something has changed in your business practice, make sure you not only change it in Part I, but also make the corresponding change in Part II.”
—Mike Huggs,
Chair,
NASAA's IA Operations Project Group
The March 30, 2012, deadline to register with either the SEC or switch to state securities registration is just around the corner. This is likely going to result in a backlog of registrations, as many wait until the last minute. “Think about starting early so that you can meet the deadline without being in the whole rush,” says Bart Mallon, co-founder of law firm Cole-Frieman & Mallon.
The NASAA report identified 13 broad weaknesses, with registration, books and records, and unethical business practices topping the list. Nearly 60 percent of the investment advisers examined had deficiencies in registration, 45 percent in books and records, and 37 percent demonstrated unethical business practices. Other problem areas include supervision, advertising, and privacy.
Part of the problem with the registration area, says Huggs is confusion over the forms that must be filed with regulators. For example, Part I and II of Form ADV, which is the form investment advisers use to register with both the Securities and Exchange Commission and state securities authorities, can be particularly puzzling. “Most of the problems with the registration come from Part I and Part II of ADV not matching up,” says Huggs.
Specifically, Part I requires precise information about the investment adviser's business that's important to regulators: ownership information, clients, number of employees, nature of the business, any disciplinary occurrences, and such. Part II, which was revised last year, requires investment advisers to prepare narrative brochures written in plain English that clearly disclose information to their clients about the adviser's business practices, conflicts of interest, disciplinary information, and more.
Part II, which no longer is a series of check-the-box options, “probably is going to be an area where deficiencies occur, mainly because it is new,” Huggs says. “A word of caution to advisers would be if something has changed in your business practice, make sure you not only change it in Part I, but also make the corresponding change in Part II.”
NASAA IDENTIFIES DEFICIENCIES
Below are the top 10 deficiencies identified in the North American Securities Administrators Association state examinations report.
Source: North American Securities Administrators Association.
Investment advisers also continue to struggle with recordkeeping. Maintaining client suitability information “continues to be one of the top areas in books and records where we find deficiencies,” Huggs says. “It somewhat confounds us that advisers are deficient in this area.”
Such information is similar to a risk profile. What are the needs, goals, and financial status of the firm's clients? What risks do they want to take? “An adviser is required to document that and keep it updated every couple of years or when clients' goals change,” adds Huggs. Other deficiencies in books and records include not properly safeguarding client records and data, and not backing up data.
The report identifies several unethical business practices that it observed at many investment advisers. For example, examiners found contracts were missing or nonexistent, altered documentation, and signed blank documents. In some instances advisers made the mistake of including a “hedge clause” in contracts, which is any provision that would lead a customer to believe that some kind of right is being waived, which is against the rules.
BEST PRACTICES FOR INVESTMENT ADVISERS
Based on the results of the examinations, NASAA recommends the following guidance to assist advisers as they develop compliance practices and procedures.
Review and revise Form ADV and disclosure brochure annually to reflect current and accurate information.
Review and update all contracts.
Prepare and maintain all required records, including financial records.
Back-up electronic data and protect records.
Document all forwarded checks.
Prepare and maintain client profiles.
Prepare a written compliance and supervisory procedures manual relevant to the type of business to include business continuity plan.
Prepare and distribute a privacy policy initially and annually.
Keep accurate financials. File timely with the jurisdiction.
Maintain surety bond if required.
Calculate and document fees correctly in accordance with contracts and ADV.
Review all advertisements, including website and performance advertising for accuracy.
Implement appropriate custody safeguards, if applicable.
Review solicitor agreements, disclosure, and delivery procedures.
Source: North American Securities Administrators Association.
Mandatory arbitration clauses that say “any dispute between customer and adviser must be settled by arbitration,” were another common no-no turned up by examinations. “In Mississippi, we suggest that advisers change the ‘must be settled by arbitration,' to ‘may be settled.' Make it optional, or make it suggested,” Huggs says.
Advertising Mis-steps
Advertising is another common area for compliance deficiencies among investment advisers, particularly online advertising. Investment advisers need to treat Websites as a form of advertisement like they would any other client communication, says Huggs. For example, do not make false guarantees, misrepresent qualifications or services, or fail to match the advertised fees.
Online social media is somewhat of a new problem for investment advisers, Mallon says, and deficiencies are likely to increase as more firms use these tools to advertise their business. “What a lot of these managers don't realize is that using these tools also is deemed to be advertising,” he says.
To ensure advertising protocols are followed, firms should have a designated individual to evaluate online practices, such as a chief compliance officer. “Review all of the firm's interactions on the Internet with respect to these sites, or they need to have a lawyer review their marketing materials and their Internet activities to make sure they're in compliance,” Mallon says.
Then there are the compliance challenges around custody. Many firms view “custody” as having physical possession of a client's cash or securities; in actuality, if a firm transfers a client's money or assets in any way, most states deem that investment adviser as having custody, Mallon says. This includes, for example, directly deducting a fee from a client account (even if this is done by the custodian).
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