PRACTICE MANAGEMENT Five Things Regulators Want to Know about the Way You Do Business April 9, 2015 20 Views In letters detailing the regulatory issues of greatest concern, SEC and FINRA fail to distinguish between RIAs, broker-dealers and other regulated entities. This Practice Management article is intended for financial advisors only (registered representatives of broker/dealers or associated persons of Registered Investment Advisors). When it comes to compliance issues, the line between RIAs and broker/dealers seems to be getting f uzzier. At the beginning of the year, when the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) published letters detailing the issues of greatest concern f or examiners, compliance experts noted a surprising similarity. And in laying out its examination priorities, the SEC s Of f ice of Compliance Inspections and Examinations broke with past practice and f ailed to distinguish between areas of concern specif ic to registered investment advisors (RIAs), broker/dealers, and other regulated entities. The f act that they kind of jumbled everyone together in the same sandbox, at least excluding exchanges, was interesting in that they re treating broker/dealers and advisors all of a piece, says Glen Barrentine, a corporate partner at the law f irm Winston & Strawn, where he chairs the broker/dealer regulatory practice. It s also very closely coordinated with FINRA s priorities. Compliance experts are quick to note that the SEC s annual examination letter is by no means comprehensive, and they stress that when examiners visit a practice, their review will not be limited. Yet the priorities letter is the commission s way of putting registrants on notice that they ignore the issues identif ied at their own peril. RIAs should look through this entire letter and really use this as a way of testing their compliance program, says Brian Hamburger, CEO of MarketCounsel, a compliance consulting f irm. What issues are the regulators watching now? A close reading of the examination guidance f rom both the SEC and FINRA suggests that these five issues are now the top areas of concern. 1) Retirement Rollovers The SEC begins its exam priorities with a warning about protecting retail investors and investors saving f or retirement, and highlights as areas of concern the products advisors recommend and the sales practices they engage in when pitching retiring employees on rolling over their 401(k) plans. FINRA similarly warns about rollovers and other wealth events involving the transf er of large sums of money. In the rollover space, the SEC is concerned that advisors and brokers are engaging in improper or misleading practices to steer clients out of their employer-sponsored plans and into other 1
investments that could carry higher f ees and greater risks. The potential f or a conf lict in rolling over an employer plan arises when the advisors will pocket a commission or increase their management f ees by goosing their assets under management (AUM). Some people, their first thought is, Oh, I ve got a chance to move this over. I ve got a chance to gain some AUM here. That can t be the f irst thought, says Jason Wainscott, chief compliance of f icer at OJM Group, an RIA headquartered in Cincinnati. There s really no reason to do it just to get it into your firm if it s not in your clients best interest. I think the SEC is picking up on that. Part of being a f iduciary is making sure that your client understands what they re getting into because if you don t, it s going to come back to haunt you, Wainscott adds. Both the SEC and FINRA have noted investors increasing reliance on IRAs in planning f or retirement. The commission also points out that advisors and brokers are presenting retail clients with a growing menu of complex investment products and advice, raising questions about the suitability of their recommendations. It s not just broker/dealers it s registered investment advisors who have to be concerned about suitability as well, and these products are getting more and more complex, says Jay Baris, chair of the investment management practice at the law f irm Morrison & Foerster. I would tell [advisors]: First of all, make sure your disclosure to customers is state of the art and not misleading, Baris continues. Number two, I would remind them that they re f iduciaries, and if you re a registered investment advisor you need to put your clients interests f irst. Some advisors, however, argue that the regulatory concerns may be misplaced. Craig Rollins, a partner at LJCooper Wealth Advisors in Orem, Utah, said his team helps clients roll over their 401(k) plans all the time but that the conversation always starts with a review of the f eatures of the old plan and an examination of what s in the best interest of the client. Too of ten, Rollins argues, employers impose restrictions on 401(k)s f or f ormer employees, cutting of f active management and making those plans a less attractive retirement vehicle than many other options. He worries that the heightened scrutiny f rom regulators could compel advisors to shy away f rom rolling over clients 401(k)s, even when that would be the best move f or the client. Rollovers for RIAs? Frankly, I m a little bit baffled at why they re tackling this at all, Rollins says. The problem in our industry has always been there are a f ew bad actors that create situations while the rest of us in the industry who are trying to do it the right way are penalized. Washington watchers note that there hasn t been much enf orcement activity against advisors working in the retirement space, but anticipate that that could soon change. I think that s coming, says Duane Thompson, senior policy analyst at f i360, a f iduciary training firm. I think that is one of the areas that the SEC and FINRA are going to continue to look at, and I would guess that this year or next you are going to start seeing headlines. 2) Cybersecurity Amid a steady stream of headlines announcing the latest hack into one corporate network or another, it s no surprise that f inancial regulators are growing more concerned about the industry s cybersecurity def enses. The SEC gave the issue only a passing reference in last year s guidance, but the agency convened a cybersecurity roundtable soon af ter and launched a sweep of exams f ocusing on the ways advisors and brokers were saf eguarding systems and data. Those exams will continue during 2015, and expand to include transf er agents, the commission said. 2
The SEC identif ies cybersecurity as a market-wide risk in its 2015 exam priorities and Hamburger cautions that advisors must treat the issue as much more than a check-box compliance exercise. This really should be important f or advisors, not because of the regulatory issue. It s almost embarrassing when the SEC comes in and f inds cybersecurity violations, Hamburger says. Advisors really should be paying attention because it s good business, he adds. This is loss of confidence from your clients. This is a far greater currency that you re trading with. Hamburger anticipates that the SEC could put forward a proposed rule or at least a concept release as it mulls how to strengthen the industry s cybersecurity standards although regulating or legislating in an area as f ast-moving and technically complex as cybersecurity is inherently challenging. And don t expect that small RIA shops will get a pass, Hamburger says: If they re a big enough firm to collect sensitive data, they re a big enough firm to protect it. 3) Fee Selection Last year, the SEC issued a warning to advisors who were dually registered as RIAs and brokers, cautioning the industry to take care when placing clients in accounts where f ees are assessed on commissions or as a percentage of AUM. Among the chief concerns was the fear that dual registrants would place an account that they knew would be traded lightly if at all in the advisory side of the practice simply to garner the management f ee. This reverse churning issue appears again in this year s letter, though regulators also warn of the potential harms that can arise with all manner of other f ee structures, including wrap f ees, hourly fees and performance-based fees. Where an adviser of f ers a variety of f ee arrangements, we will f ocus on recommendations of account types and whether they are in the best interest of the client at the inception of the arrangement and thereaf ter, including f ees charged, services provided and disclosures made about such relationships, OCIE says in its letter. That issue is already very much on the radar at large independent broker/dealers like Commonwealth, where Chief Compliance Of f icer Paul Tolley says his team reviews an automated f eed that f lags inactive accounts. With that inf ormation in hand, Tolley s surveillance team might approach an advisor to inquire about the basis f or the account placement and conf irm that the client is, in f act, receiving additional planning or advice to warrant the management f ee. This is a subject that we have looked at for years, Tolley says. We have long since had a report that identif ies... households in managed accounts where there is a period of inactivity. It s not to say [an advisor should] trade for the sake of trading. It s to say, you ve got to be managing those clients, those accounts, those assets on an ongoing basis. With f ees, as with complex products, compliance experts stress the importance of providing clients with f ull disclosures, and then generating a thorough record to document why the account type or investment vehicle is in the client s best interest. What they re saying is, you have to look at all the various fees you offer, and how you disclose those to your clients. Are there fees that are obviously better or worse for your clients within that structure? Barrentine says. You have a duty to make sure that either you put people in the fee structure that is in their best interest, or you make sure that if they re making those decisions, they understand what the f ee structures are. Wainscott says he presents advisors at his f irm with a simple test when evaluating f ee arrangements. 3
If you can t explain the fee structure to me in a way that I understand it right away, then I m generally going to advise against getting anyone into it, he says. That s part of being a f iduciary, is making sure that your client is comf ortable and understands what they re getting into because if you don t, it s going to come back to haunt you. 4) Big Branch Offices In a further hint at greater regulatory overlap for advisory and broker/dealer firms, the SEC is calling attention to issues arising with branch of f ices, raising the concern that registered representatives and advisor representatives could be out of step with the standards of conduct at the f irm s headquarters. You see a convergence of the regulatory concerns here, Baris says. What they re looking f or here is: Are there cowboys... in the branch office? That issue is a concern at LJCooper, which has branches in Colorado and Florida. You always run the risk when you ve got people operating out of a branch, which is why a lot of our stuff is centralized, says Rollins, who has helped put in place a consolidated operating structure. Branch personnel have limited autonomy and are subject to periodic reviews, he says, and Rollins and other principals in the f irm will occasionally drop in f or a site visit. All of our approval processes run through the corporate of f ice. We try to keep that very centralized so we know everyone s operating on the same basis, he says. There s always the chance you could have a rogue operator, but that s caught pretty quickly when you re central as opposed to branch to branch. Commonwealth s branch review team is bound by FINRA rules to examine its offices of supervisory jurisdiction at least once a year. Tolley says Commonwealth also makes a practice of visiting each of its RIAs, at a minimum, once every three years, and typically more of ten than that. He stresses the importance of site visits, though he also points out that a centralized oversight system and a well-staffed home office can help fill in the gaps. We are supervising through surveillance, through technology, transactions, communications every single day, Tolley says. We have just a myriad surveillance reports, exceptions reports that touch on a variety of issues. 5) Repeat Offenders There has been this year one more clear message from both FINRA and the SEC: If you re considering a recruit with repeated compliance violations, don t expect that advisor to clean up his act for you. In this year s guidance memo, FINRA offers a blunt warning to the brokers it oversees: Firms that hire or seek to hire high-risk brokers, including statutorily disqualif ied and recidivist brokers, can expect rigorous regulatory attention. The SEC also warns of recidivist representatives, saying that it will use their analytic capabilities to identif y individuals with a track record of misconduct and examine the f irms that employ them. Both Wainscott and Rollins say they would be unlikely to hire any advisors with a blemish on their record a hard line to be sure, but one that comes in consideration of the heightened regulatory scrutiny and reputational hit a rogue rep can bring to a f irm. Our industry is rather unique, Rollins says. If you make a mistake, you can be blackballed very, very quickly, just because it goes on your record. And before we interview anybody, we will go in and look at your record. by Kenneth Corbin 4
Corbin is a Financial Planning contributing writer based in Cambridge, Massachusetts, and Washington, D.C. The inf ormation provided is f or general inf ormation purposes only and is not intended to be legal, tax or investment advice. The inf ormation contained herein has been provided by sources other than Lord Abbett which are believed to be reliable; however Lord Abbett cannot guarantee the accuracy or completeness of this inf ormation. Investors should carefully consider the investment objectives, risks, charges and expenses of the Lord Abbett Funds. This and other important information is contained in the fund's summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, you can click here or contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388. Read the prospectus carefully before you invest or send money. Not FDIC-Insured. May lose value. Not guaranteed by any bank. Copyright 2018 Lord, Abbett & Co. LLC. All rights reserved. Lord Abbett mutual funds are distributed by Lord Abbett Distributor LLC. For U.S. residents only. The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances. 5