June 27, 2016

CCO Series: Top Regulatory Deficiencies for RIAs -- Advisory Agreements

What you need to know

Examiners will review agreements that the advisor uses for its client engagements during an examination as a standard request item. This will include a review of the agreement templates that you use for your prospective clients and a sample of agreements that your firm has executed with existing clients. In reviewing agreements examiners report finding two common deficiencies: 1) the fees are not fully disclosed in the agreement and 2) that firms do not have an executed copy of its client agreements in the advisor’s books and records.

Common Deficiency: Fees fully disclosed

The written advisory agreement must detail the relationship that the client is entering into with the advisor, including how fees are calculated and the payment methodology. The fees section of the agreement must be comprehensive to cover all fees being charged for the services, when the fees are being charged, and how they are to be paid. The information in the client agreement should also align with the general disclosure of fees made in Form ADV Part 2A Disclosure Brochure in Item 5. Any additional compensation that the firm receives in its advisory practice should also be described in Form ADV Part 2A in Item 14.

Common Deficiency: Books and records

Advisors are required to keep and maintain all written agreements (or copies thereof) entered into by the advisor with any client.1Examiners are reporting to the North American Securities Administrators Association that advisors are not creating written agreements for all of their client relationships. They also noted that when written agreements are created, the agreements are not clearly noting, and adequately explaining, the advisory fees as described above.2

How do we avoid these deficiencies?

To avoid these deficiencies at your firm AdvisorAssist recommends the best practices of:

  • Reviewing the language in your Form ADV Part 2A Disclosure Brochure to ensure that it adequately discloses for each type of fee the following:
    1. How fees accrue for each service offered.
    2. How fees are billed to the clients.
    3. Whether the advisory fees include other fees, such as brokerage trading fees.
    4. How fees are impacted by contract termination, such as a pro-rata refund if collected in advance.
    5. Whether the fees represent any compensation for the sales of securities or other conflicts of interest.
  • For each new client onboarded, ensure that a written agreement is executed for the services that the client will receive and the fee is consistent with Form ADV Part 2A.
  • Review client agreement[s] templates and Form ADV Part 2A at least annually to ensure that the fees described are consistent and fully disclosed.

1. See 17 CFR §275.204-2(a)(10). Link.
2. See North American Securities Administrators Association, “2015 Investment Adviser Coordinated Exams,”. Link.

AdvisorAssist’s CCO Series: Regulatory Deficiencies for RIAs is a series of articles that will help your firm understand and avoid the most common compliance deficiencies found by regulators. Our goal is to help you increase your confidence that your firm remains “exam ready” as well as some practical steps to help Chief Compliance Officers address this topic.

Contributors:
Brendan Furey
Michael Conlon

June 20, 2016

Cybersecurity: Best Practices and Webinar Replay

Webinar Replay

AdvisorAssist recently hosted a webinar titled "Cybersecurity for RIAs: How Safe are You?" Click here to watch or download the replay.

What you need to know

When seeking to act in their client’s best interest, registered investment advisors collect private information from their clients. This information forms the basis for the advice they will provide to their client, whether through consultation or discretionary investment management. Understandably, the advisor is in continuous possession of private client information while servicing a particular client, investor, or related participant.

Section 30(a) of Regulation S-P under the Gramm-Leach-Bliley Act of 1999 requires advisors (along with broker-dealers and investment companies) to adopt policies and procedures that create administrative, technical, and physical safeguards for the protection of customer records and information. These policies and procedures must must be reasonably designed to:

  • Ensure the security and confidentiality of customer records and information;
  • Protect against any anticipated threats or hazards to the security or integrity of customer records and information; and
  • Protect against unauthorized access to or use of customer records or information that could result in substantial harm or inconvenience to any customer.

The SEC has said that an RIA’s policies and procedures must include how advisors conduct periodic risk assessments, implement a firewall, encrypt private client information stored electronically, and maintain a response plan for cybersecurity incidents. Advisors are expected to anticipate potential cybersecurity events and have clear procedures in place rather than waiting to react once a breach occurs.1.

Why You Should Care

Identify theft, cyber fraud and high profile security breaches have become common occurrences, especially among commercial merchants and asset managers. Previously, we covered common misperceptions that sometimes stop advisors from properly protecting advisory clients from cyber threats. Since then, the SEC Office of Compliance Inspections and Examinations (“OCIE”) published a series of Risk Alerts announcing a priority for examinations to identify cybersecurity risks and assess cybersecurity preparedness in the securities industry.

The focus of the OCIE during exams will be on the following areas:

  • Governance and Risk Assessment, including the level of communication to, and involvement of, senior management and boards of directors.
  • Access Rights and Controls, including a review of controls associated with remote access, customer logins, passwords, protocols to address customer login problems, network segmentation, and tiered access.
  • Data Loss Prevention, including how advisors verify the authenticity of a customer request to transfer funds.
  • Vendor Management, including due diligence with regard to vendor selection, monitoring and oversight of vendors, and contract terms.
  • Training, including how procedures for responding to cyber incidents under an incident response plan are integrated into regular personnel and vendor training.

Our Recommendations

To ensure that your firm is keeping up with regulatory requirements and industry best practices in this area AdvisorAssist recommends that the CCO:

  • Review written policies and procedures to ensure they include:
    1. Identification of Cybersecurity risks
    2. Controls in place to detect and mitigate the Cybersecurity risks
    3. Assessment of points of vulnerability, both operational and technological
    4. A mechanism to gauge the effectiveness of policies and procedures that protect the your networks and sensitive information
    5. Descriptions of how you will respond to a breach of security
  • Train your employees on cybersecurity policies. The policies must be communicated and enforced by the highest levels of management.
  • Document all testing and monitoring of cybersecurity policies.
  • Engage an independent third party provider to conduct internal and external vulnerability assessment scans and penetration tests.
  • Review your Privacy Policy and update as needed.

1. See SEC Release No. 4204 published September 22, 2015. ↩ Back to note 1

Contributors:
Brendan Furey
Michael Conlon

May 27, 2016

Department of Labor Fiduciary Rule: Webinar Q&A

Last week, Advisors4Advisors (A4A) hosted a webinar on the DOL Fiduciary Rule change presented by members of the AdvisorAssist team. You must be a paying A4A member ($60 annually) to attend webinars, view replays, and receive CPA, CFP or IMCA CE credit. Click here for information on joining A4A, and Click here to access the webinar replay.

The following questions were raised after the webiar about the new DOL Fiduciary Rule. We cover the DOL Fiduciary Rule in more detail in a previous post

1. In RIA with Rollover, since AUM increases, but fees decrease or services increase then are you a conflict? Trusted advisor is increasing income, but client getting something for it.

A: This question seems to be asking when an Advisor is managing a client’s retirement plan assets and recommends a rollover to another vehicle, such as an IRA, since the Advisor’s assets under management (AUM) will increase but overall fees paid by the client will decrease, or services received by the client increase, then are you in a conflict? The Advisor’s compensation is increasing but the client getting something for it.

The recommendation of a rollover creates a potential for a conflict of interest. Therefore, the Advisor making the recommendation should document with the client why the rollover is in the client’s best interest. The fact that overall fees paid by the client will decrease, or services received by the client will increase with the rollover are good reason why the rollover is in the client’s best interest and therefore, should documented in the client’s profile and if it is not already in the client agreement, the client should receive notice that the Advisor is a fiduciary acting in the client’s best interest.

The definition goes on to explain what constitutes a “recommendation” and what may be excluded from that definition, such as providing certain services or information regarding the plan or IRA, such as marketing or making available to a plan fiduciary a platform or similar mechanism where the plan fiduciary may select or monitor investment alternatives; identifying investment alternatives that meet objective criteria specified by the plan fiduciary; providing objective financial data and comparisons with independent benchmarks to the plan fiduciary.

2. If an Advisor recommends that a client rollover from a 401(k), hence increasing the Advisor’s AUM and the client’s fees (regardless of investment), does not that create a conflict of interest?

A: Correct, the recommendation of a rollover creates a potential for a conflict of interest. Therefore the Advisor making the recommendation should document why the rollover is in the client’s best interest.

3. How do you get the expenses of the 401(k) that the employee was paying?

A: Clients should be able to produce documentation regarding the expenses that they are currently paying for their 401(k) plan. The Advisor will want to collect the current fee structure of their client’s 401(k) plan as a factor in making an informed recommendation about why any rollover from that plan is in the client’s best interest.

4. How do we get the expenses of the 401(k) to the client?

A: If you are trying to obtain information about a client’s 401(k) you should contact the plan sponsor. However, this question seems to be asking how do Advisors ensure they are not responsible for the expenses of a client’s 401(k).

Unless an Advisor is engaging clients in a “wrap fee” program, where the client pays a single advisory fee for the management and services of their account including custodian and brokerage fees, then the clients should be responsible for paying expenses related to the management of their account. Advisors should ensure that their client agreements and Form ADV Part 2A, Item 5(C) fully and accurately disclose which party is responsible for fees related to the account management.

Although an RIA may not be compensated by a commission or revenue sharing, Form ADV requires disclosure to clients regarding potential conflicts and compensation arrangements. Hybrid advisors receiving commission compensation will want to ensure they are satisfying the BICE. Therefore as a best practice we recommend that even firms without commission or revenue sharing fees should provide notice to retirement clients that they are providing their services in the client's best interest to uphold their fiduciary duty and review and update disclosures of any potential conflict of interest. This will ensure that you are availing your firm of the BICE and creating a presumption of compliance with the Rule.

5. If I'm an RIA and already a fiduciary, and serve ERISA qualified plans as a 3(21) advisor and 3(38) manager capacity, and already have level fees fully disclosed and transparent within Advisory Agreements. (408b2 compliant), how am I really impacted by the DOL Rule? The only thing I've read is needing to document rollovers if I will get compensated for the rollover into an IRA (versus keeping funds in a 401k Plan, for instance) - which I already do to some degree.

A: Correct. The ongoing receipt of a Level Fee such as a fixed percentage of the value of a customer’s assets under management, where such values are determined by readily available independent sources or independent valuations, typically would not raise prohibited transaction concerns for the Advisor.

Under these circumstances, the compensation amount depends solely on the value of the investments in a client account, and ordinarily the interests of the Advisor in making prudent investment recommendations, which could have an effect on compensation received, are aligned with the Retirement Investor’s interests in increasing and protecting account investments. However, there is a conflict of interest when an Advisor recommends that a participant roll money out of a plan into a fee-based account that will generate ongoing fees for the Advisor that he would not otherwise receive, even if the fees going-forward do not vary with the assets recommended or invested.

As stated in question 1, for a level fee fiduciary to recommend a rollover the Advisor should document information supporting the recommendation in the client’s profile. Additionally, if it is not already in the client agreement, the client should receive notice that the Advisor is a fiduciary acting in the client’s best interest. It is our view that this written notice can also be communicated to the client via Form ADV.

6. Are there any best practices yet regarding the type of disclosure of the compensation arrangement and conflicts of interest (slide 13) - which I already disclose in our Firm's ADV?

A: The best practices regarding disclosure of compensation arrangement and conflicts of interest will evolve as we get closer to the full implementation date of this rule, January 1, 2018. That being said, if you are not a level fee Advisor and seeking to make use of the Best Interest Contract Exemption you will want compensation arrangements and conflicts of interest disclosed in a separate Best Interest Contract or as an addition to existing agreements along with the other requirements of the Best Interest Contract Exemption.

Also in the preamble to the final rule, the Department of Labor recommended the creation of web disclosure, which they state should contain: A schedule of typical account or contract fees and service charges, and a list of product manufacturers with whom arrangements have been made to provide payments to the Advisor, including whether the arrangements impact Advisor compensation. The DOL also suggests disclosure of the business model and the Material Conflicts of Interest, including payout grids and non-cash compensation and rewards.

7. Not sure if you covered this.... what about my existing clients that generate trails?

A: At this time we do not believe that trail compensation from commission transactions based on prior recommendations would be relevant to the DOL Rule change. If it is in the client’s best interest to transition those assets to another vehicle, or if a new recommendation that would involve a commission trail should arise, those would be relevant to your compliance for your fiduciary duty and the DOL fiduciary rule, respectively.

8a. [Is there a] Conflict if [a] Fee Only RIA is NOT advisor to the qualified plan but solicits retiree to rollover to IRA? (the value added is RIA gives advise (sic) whereas existing qualified plan does not give that advice.

A: The recommendation of a rollover of retirement plan assets creates a potential for a conflict of interest. Therefore, the Advisor making the recommendation should document why the rollover is in the client’s best interest. Advisors should also be aware if any of their solicitors are making such recommendations and ensure they have documentation to support the recommendation. The statement that the IRA has more options available to it for investment, and therefore more opportunity for different strategies by means of advisory services from the RIA, can be given by the Advisor that the rollover may be in the client’s best interest given the full profile of the client.

8b. Does DOL recognize that distinction?

A: Yes. The DOL Fiduciary Rule would consider you to be a Level Fee Advisor.

8c. Am I giving client that disclosure or just adding to my ADV and client file?

A: Form ADV should be completely and accurately disclosing fees charged by the Advisor in Item 5, and any other compensation received in Item 14. Advisors are typically required to deliver Form ADV to all new clients, and existing clients annually or upon a material change. The DOL Fiduciary Rule would require full disclosure of all fees related to a client’s retirement plan assets when certain recommendations are made, such as a rollover.

9. Are [these] rules [applying] to discount brokers or robo advisors?

A: The DOL Fiduciary Rule applies to anyone making the recommendations to clients in qualified plans for a fee. ERISA contains an exemption to prohibited transactions in section 408(b)(14) that covers robo-advisors and is available for robo-advice involving prohibited transactions if its conditions are satisfied. However, robo-advisors that are Level Fee Fiduciaries may rely on the Best Interest Contract Exemption with respect to investment advice to engage the robo-advice provider for advisory or investment management services for Plan or IRA assets, provided they comply with the conditions applicable to Level Fee Fiduciaries, as discussed in question 1 above.

10a. Doesn't the rule impose a significant burden on the fee only RIA to know the fees charged in the 401(k)? Sometimes is it very hard to find this out fully. Clients don't always provide this information and it is not always correct.

A: The new rule sets forth a requirement for certain information when making a recommendation to Retirement Investors. It requires that the Advisor, when providing investment advice to the Retirement Investor, that at the time of the recommendation, such advice reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor. Therefore, we would recommend performing all the necessary due diligence, whether with the client or directly with the plan sponsor of the client’s 401(k) in order to substantiate the recommendation(s) made, including current fee structure on 401(k) plans affected by the advice.

10b. Since we have no access to the 401(k), how do you confirm the information?

A: As stated in question 10a above, due diligence requirements should include gathering information from all sources available including contacting the sponsor of the plan, if needed.

11a. What do you mean by "level fee" advisor?

A: Level fee advisors are those that meet the definition of a level fee fiduciary by receiving the same compensation regardless of the particular investments the client makes, whether based on a fixed percentage of assets under management or a fixed dollar fee.

The full definition of a Level Fee Fiduciary is located in Section VIII(h) of the Best Interest Contract Exemption Final Rule

11b. Are you talking about an AUM %? or something else?

A: An Advisor whose compensation is based on the client’s assets under management would be an example of a Level Fee Fiduciary for the purposes of the DOL Fiduciary Rule.

12. Does the ADV Part II provide adequate disclosure for fee only RIAs?

A: It is our view that this written disclosure can also be communicated to the client via Form ADV.

13. Would an RIA be considered a level fee fiduciary if they charge differently for equities/bonds/cash?

A: Based on the definition of Level Fee Fiduciary above that does not sound like it would meet the requirements for the purposes of the DOL Fiduciary Rule since the Advisor would receive different compensation depending on what investments were made.

Contributors:
Brendan Furey
Michael Conlon

May 20, 2016

Analyzing the Department of Labor Fiduciary Rule

The revised Department of Labor (DOL) fiduciary rule (Rule) was published in its final form in the Federal Register and can be accessed by clicking this link. Although effective starting June 7th, 2016 the DOL has granted time for affected service providers of retirement plans to adjust to fiduciary status and partial compliance is not required until April 10, 2017 with full compliance required by January 1, 2018.

The focus here is determining if fiduciary status applies to your firm based on the advice provided to retirement plans or participants, what exemptions may apply, and what steps must be taken to maintain compliance.

Definition of Fiduciary

Under the Rule a fiduciary will now include a person providing investment advice regarding money or property within the plan for a fee or other compensation, directly or indirectly, to a plan, plan participant or beneficiary, IRA or IRA owner. Investment advice relevant to this definition include the following:

  1. A recommendation as to the advisability of acquiring, holding, disposing of, or exchanging, securities or other investment property, or a recommendation as to how securities or other investment property should be invested after the securities or other investment property are rolled over, transferred, or distributed from the plan or IRA;
  2. A recommendation as to the management of securities or other investment property, including, among other things, recommendations on investment policies or strategies, portfolio composition, selection of other persons to provide investment advice or investment management services, selection of investment account arrangements (e.g., brokerage versus advisory); or recommendations with respect to rollovers, transfers, or distributions from a plan or IRA, including whether, in what amount, in what form, and to what destination such a rollover, transfer, or distribution should be made; and
  3. The investment advice is made, directly or indirectly (through an affiliate), by a person who:
    1. Represents or acknowledges that it is acting as a fiduciary within the meaning of the ERISA or the IRS Code;
    2. Renders the advice pursuant to a written or verbal agreement, arrangement, or understanding that the advice is based on the particular needs of the advice recipient; or
    3. Directs the advice to a specific advice recipient or recipients regarding the advisability of a particular investment or management decision with respect to securities or other investment property of the plan or IRA.

The definition goes on to explain what constitutes a “recommendation” and what may be excluded from that definition, such as providing certain services or information regarding the plan or IRA, such as marketing or making available to a plan fiduciary a platform or similar mechanism where the plan fiduciary may select or monitor investment alternatives; identifying investment alternatives that meet objective criteria specified by the plan fiduciary; providing objective financial data and comparisons with independent benchmarks to the plan fiduciary.

The definition also clarifies that an advisor is not a fiduciary when providing advice to an independent person who is a fiduciary of a plan or IRA, if that fiduciary is a bank, insurance carrier, registered investment adviser, broker-dealer, or other person that holds or has assets under management of at least $50 million. This means the old definition has been expanded to focus on advice given to IRA owners and people rolling over their employer sponsored plan (e.g., 401(k) account) into an IRA. Finally, education and general marketing materials that a reasonable person would not view as investment recommendations are not included in the definition of retirement investment advice, so advisors may continue to provide general materials on retirement saving without triggering fiduciary duties.

As a fiduciary, an advisor must adhere to a “best interest” standard for a client, rather than a “suitability” standard for an investment product. Therefore, an advisor cannot receive fees that could be seen as creating conflicts of interest (i.e. commission or revenue-sharing), unless a qualified exemption applies.

Best Interest Contract Exemption (BICE) and Impartial Conduct Standards

This exemption, published at this link, provides relief for compensation, such as commissions and revenue sharing, that an advisor and the advisor’s employing firm might receive in connection with investment advice to retail retirement investors. The BICE requires financial institutions and advisors to acknowledge fiduciary status for itself and its advisors, adhere to basic standards of impartial conduct by giving prudent advice in the client’s best interest, avoid misleading statements, and receive only reasonable compensation. Additionally, financial institutions must adopt policies and procedures reasonably designed to mitigate any harmful impact of conflicts of interest, disclose basic information about their conflicts of interest and the cost of their advice. Level Fee fiduciaries are subject to more streamlined conditions.

Principal Transactions Exemption

The other main exemption from the Rule is the Principal Transactions Exemption, published at this link, which permits advisors to sell or purchase certain debt securities and other investments out of their own inventories to or from plans and IRA owners. The exemption applies even though this transaction results in payment to the advisor. However, similar to the BIC exemption, the advisor must adhere to Impartial Conduct Standards and disclose to the client any conflicts of interest in order to make use of the exemption.

How should a Chief Compliance Officer respond to the Rule?

In all cases, the advisor will want to retain documentation of compliance with this new rule, including contracts, policies, procedures, and disclosures, to support your Books & Record requirements. However, there are no additional record retention requirements for detailed data on inflows, outflows, holdings, and returns for retirement plan or IRA clients.

Chief Compliance Officers should review the information in their Form ADV Part 2A and client agreements to determine whether or not they are acting as a fiduciary based on the recommendations provided to clients regarding retirement plans, participants, beneficiaries or IRAs, and ensuring that their client agreements and ADV contains all disclosures required by the Rule regarding conflicts of interest and compensation arrangements, including a statement as to whether or not they are a fiduciary.

Although an RIA may not be compensated by a commission or revenue sharing, Form ADV requires disclosure to clients regarding potential conflicts and compensation arrangements. Hybrid advisors receiving commission compensation will want to ensure they are satisfying the BICE. Therefore as a best practice we recommend that even firms without commission or revenue sharing fees should provide notice to retirement clients that they are providing their services in the client's best interest to uphold their fiduciary duty and review and update disclosures of any potential conflict of interest. This will ensure that you are availing your firm of the BICE and creating a presumption of compliance with the Rule.

Contributors:
Brendan Furey
Michael Conlon

May 3, 2016

CCO Series: Top Regulatory Deficiencies for RIAs -- Books and Records

What you need to know

Registered investment advisors are required to maintain and preserve books and records in an easily accessible place for a period of not less than five years from the end of the fiscal year during which the last entry was made on such record, the first two years in an appropriate office of the investment advisor.1 We cover books and records compliance in more detail in a previous post.

Annually, the North American Securities Administrators Association (“NASAA”) issues a report about common deficiencies found in state coordinated investment adviser examinations.2 The most common books and records deficiencies described by NASAA are lack of documentation of “recommendations made or proposed and any advice given or proposed,”3 which will include 1) the advisor’s analysis of client suitability for an investment product and 2) when acting as a fiduciary why the advice is the client’s “best interest”.

Common Deficiency: Client Suitability Records

Examiners noted the lack of documentation about the suitability of an investment product and lack of documentation that the advice is the client’s “best interest”. The mantra of an examiner is that if it is not documented then it was not done. Since July of 2012 when the FINRA suitability obligations went into effect,4 a major focus of the examiner’s books and records review has been on whether suitability is being properly documented in the client profile.

Common Deficiency: Focus on Fiduciaries

In addition, with the new Department of Labor fiduciary rule being published on April 8th, and effective in April 2017, examiners will be focused on reviewing suitability and “best interest” documentation. With the new fiduciary rule advisors serving clients in qualified retirement plans and IRAs will need to document how the advice is in the client’s “best interest” similar to other ERISA clients. Also, in certain cases the advisor’s client agreement may need to satisfy a Best Interest Contract Exemption pursuant to the new rule.

How do we avoid these deficiencies?

To avoid these deficiencies at your firm AdvisorAssist recommends the best practices of:

  • Perform an annual review of the advisor’s books and records archive to ensure you are keeping the required documentation for the required duration.
  • Preparing and maintaining a comprehensive profile on each client. This profile should be created during the onboarding of the client, confirmed with the client annually and updated as any new accounts or new information is received from the client.
  • Ensure your books and records contains all necessary backup documentation in addition to the client profile as needed to support your investment recommendations or advice.
  • Create and maintain Best Interest Contracts as needed for DOL-regulated transactions involving retirement plans.
  • Document in the client profile why advice regarding rollovers and other major transactions are in client’s best interest. Stay up to date with Fiduciary Rule Changes by clicking this link.

1. See 17 CFR §275.204-2(e)(1). Link.
2. See North American Securities Administrators Association, “2015 Investment Adviser Coordinated Exams,”. Link.
3. See 17 CFR §275.204-2(a)(7). Link.
4. See FINRA Regulatory Notice 11-02. Link.

AdvisorAssist’s CCO Series: Regulatory Deficiencies for RIAs is a series of articles that will help your firm understand and avoid the most common compliance deficiencies found by regulators. Our goal is to help you increase your confidence that your firm remains “exam ready” as well as some practical steps to help Chief Compliance Officers address this topic.

Contributors:
Brendan Furey
Michael Conlon