CCO Series (2019) - Financial Statements

The financial statements that you maintain for your RIA firm, which include income statements, balance sheets, statements of cash flows, are powerful tools. Apart from the fact that they are a required to be maintained for books and records purposes, the data that they contain hold the key to many other critical regulatory and practice management activities.

RIA Financial Statements In a Nutshell

Maintaining complete and accurate financials on your business simply makes good business sense. However, the primary purpose here is the maintenance of financial statements for compliance purposes, which may include:

• Balance Sheet and Income Statement
• Cash Journals - Documentation including cash receipts and disbursements, records, and any other records of original entry forming the basis of entries in any ledger
• Banking Information - All checkbooks, bank statements, cancelled checks and cash reconciliations for your firm
• Business Expenses - All bills or statements (paid or unpaid) relating to the business of your firm
• Other Financial Statements - All trial balances, financial statements, and internal audit working papers relating to the business of the firm

While maintaining proper financial statements is required in order to avoid regulatory sanctions, it can also be a useful tool for RIAs. Creating and reviewing financial statements on a regular basis can prove to be an indicator of the health of the firm. The financial statements can demonstrate that the firm is performing as intended and disclosed, or act as a tool to show areas where it can improve. Ensuring financial stability of a firm is an important step in gaining client and regulatory confidence. Proving to be solvent and possess secure financials could be the difference between gaining and losing clients, or spending more time with regulators during an exam.

State Specific Requirements

Many of the regulations regarding financial statements for RIAs are dependent on the advisor’s principal state of business. Along with U.S Securities and Exchange Commission ("SEC") requiring specific actions regarding financial statements, each state also has specific requirements on the issue. It is important to recognize your specific state’s requirements in order to avoid unnecessary regulatory issues. Currently, there are states that require financial statements to be sent to their state regulatory agency each year. This applies only if the firm is registered with the state, and does not apply to SEC registered firms.

It is important to stay updated on your specific state’s requirements in order to avoid unnecessary regulatory issues. Depending on the state, there may be minimum net worth requirements that are to be demonstrated through the financial statements. Where applicable, your firm’s books and records archive should contain the necessary financial statements.

Through the Regulator's Eyes

Regulators have put an emphasis on monitoring the financial statements of newly-registered advisors. If they are not completed correctly, it may be a sign that a further examination is needed. Accurate financial statements prove to the regulators that the firm is running effectively. Proper maintenance and submission, if required, of updated financial statements is one key way to avoid regulatory sanctions.

CCO Best Practices

• Do not approach financial statements as just a way to avoid regulatory sanctions. They are important at spotting financial irregularities which might benefit you.
• Utilize financial statements as a powerful tool to indicate advisory effectiveness and compliance.
• Always stay informed of specific state requirements, which may differ from SEC and other states’ regulations.
• Maintain accurate financial statements, in accordance with generally accepted accounting principles (GAAP).

The AdvisorAssist CCO Series is a collection of blog posts that cover each of the elements of your RIA's compliance program.  Each post will provide an overview of one compliance topic, including our insights on how regulators view each topic as well as some practical steps to help Chief Compliance Officers address this topic. As always, we would welcome your comments and thoughts.

Thomas Yates

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CCO Series (2019) - Voting Client Proxies

The right to cast votes on certain corporate matters is an important power given to shareholders of publicly traded companies and mutual funds. Your RIA firm is expected to address its role with respect to voting proxies on behalf of clients. You may agree to take on the responsibility to vote proxies on securities your client's own, or you may elect to not vote their proxies. In each instance, regulators expect you to disclose your proxy voting practices. In addition, that you have clearly defined and communicated policies and procedures related to this aspect of corporate governance so clients understand your proxy voting practices.

Advisor Proxy Voting In a Nutshell

Shareholders of publicly traded companies and mutual funds have the right to express their opinion on certain business matters that impact the value of the securities they own. Board of director elections, mergers and acquisitions and changes in fee schedules (in the case of mutual funds) are examples of voting decisions that are delegated to shareholders.

Since most shareholders do not attend annual meetings in person, their opinions on these matters are communicated by casting a ballot either electronically or via mail.

Accepting the responsibility to vote on behalf of your clients is a significant undertaking, so it is important to consider the pros/cons of doing so. On one hand, clients may appreciate that you serve as their voice in significant matters that affect the value of their investments. But agreeing to vote client proxies requires a significant amount of process monitoring and record keeping.

For this reason, most RIA firms elect to not vote proxies.

Your firm’s policies and procedures on voting proxies should be disclosed and clearly described in:

• Form ADV Part 2A, Item 17 - Voting Client Securities
• Advisory Agreements, either in the section that describes your investment discretion authority or in a standalone section

Note: If you have discretionary investment authority over client accounts and your ADV and agreements remain silent on this topic, it is assumed that you vote proxies.

If your firm does not vote proxies

If your firm does not intend to vote proxies, and you do not intend to advise clients on how to vote proxies, you must disclose this in Form ADV and communicate to clients that they retain the authority and responsibility for voting their own proxies.

If a client has questions regarding a particular proxy vote, you may assist them in understanding the background and intent of the proxy. However, your guidance must not influence their voting decision. As best practice, you should remind them that they assume the responsibility for the voting decision and making the contractual decision of their voting shares. Also, that you are prohibited from providing the service of that advice.

Your clients will receive proxy statements directly from the Custodian. The proxy statements should not be sent directly to you. If you do receive a proxy statement, you should immediately forward it to your client and remind them that they maintain sole authority for voting proxies. In addition, you should take proactive steps to have proxy statements delivered to the client moving forward.

If your firm does vote proxies

You are required to vote proxies in the best interest of your clients. When assisting your clients in setting up new accounts at the custodian, ensure that the account opening paperwork designates your authority to receive and vote proxies.

In addition, regulators consider it fraudulent for advisors to exercise proxy voting authority without fulfilling the following three requirements:

• Develop and implement policies and procedures that are reasonably designed to ensure that your firm votes proxies in the best interest of its clients,
• Describe your firm’s proxy voting policy to clients (via Form ADV 2A and advisory agreements) and provide copies to clients upon request, and
• Disclose how clients can obtain information on how your firm voted their proxies.

Through the Regulator's Eyes

When it comes to proxy voting, regulators simply expect that you clearly communicate your policy on voting proxies for your clients. When you do accept this responsibility, you are expected to exercise this duty in the client's best interest, avoid and disclose any conflicts of interest that may come up in these corporate matters and maintain proper books and records that demonstrate that you are fulfilling this duty in accordance with the Advisers Act.

CCO Best Practices

• Consider whether or not your clients would gain a material benefit by your advising their proxy voting responsibilities, and if that benefit would be worth the related compliance responsibilities.
• If your firm does not vote client proxies:
  • Review client activities to ensure that your firm has not voted proxies for any clients.
  • Review any exceptions made to the proxy voting policy and all supporting documentation and ensure that all were properly documented and approved by the CCO.
  • If you ever decide to start voting proxies, revise your proxy voting policy, ADV 2A and agreements to comply with the Adviser's Act.
• If your firm does vote client proxies:
  • Confirm that existing proxy voting policies and procedures are adequately designed to ensure that votes are consistent with client interests.
  • Conduct a forensic test by reviewing a sample of proxies voted during a particular period and confirm that each proxy was voted in accordance with your policy and that each were voted in the best interest of the client.
  • Review any exceptions made to the proxy voting policy and all supporting documentation.
  • Ensure that all exceptions were properly documented and approved by your firm’s CCO.
  • Review your firm’s books and records to confirm that for the previous five years you can produce a copy of each proxy you received, records for all proxies voted (with any related back up), a log of any proxy voting information requests by clients and your firm’s responses to those requests.

The AdvisorAssist CCO Series is a collection of blog posts that cover each of the elements of your RIA's compliance program. Each post will provide an overview of one compliance topic, including our insights on how regulators view each topic as well as some practical steps to help Chief Compliance Officers address this topic. As always, we would welcome your comments and thoughts.

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Senior Safe Act

On May 23, 2019, the Securities and Exchange Commission (“SEC”), the North American Securities Administration Association (“NASAA”), and the Financial Industry Regulatory Authority (“FINRA”) issued a fact sheet designed to raise awareness among broker-dealers, investment advisers, and transfer agents of The Senior Safe Act (the “Act”). The Act was signed into law on May 24, 2018, and addresses the hurdles financial professionals encounter in reporting suspected senior financial exploitation or abuse to authorities.
The Act protects “covered financial institutions”, which includes investment advisors and their eligible employees, from liability in any civil or administrative proceeding for reporting potential exploitation of a senior citizen to a covered agency. Investment advisors and their representatives often times may be apprehensive to report instances of financial abuse or exploitation in fear of being mistaken or breaching one’s privacy. The Act does not require firms to implement policies and procedures but rather delivers the steps necessary to qualify for legal immunity under the Act.
The fact sheet provides an introduction and definition of the Act and further describes the individuals eligible for immunity under the Act. Advisors should identify individuals that have contact with senior clients as part of performing their roles with the Advisor. Examples of this may include advisors, traders, or individuals reviewing and approving client documents.
Advisors will be required to ensure training is conducted as soon as reasonably practicable for current employees, affiliated persons and associated persons. When the Advisor brings on new individuals the training should occur no later than a year from their hire date. Advisors must maintain a record of which individuals completed the training along with the content provided during the training. This record may be requested by a regulator through the course of an examination.
In order to qualify for immunity, individuals must:

1. be an employee of the firm who serves as a supervisor, in a compliance/legal function or an investment adviser representative of an investment advisor
2. undergo sufficient training that encompasses the following: (i) how to identify common red flags that may indicate the financial exploitation of a senior citizen; (ii) how to report the suspected exploitation of a senior citizen both internally and, as appropriate, to government officials or law enforcement authorities; (iii) discuss the need to protect the privacy and respect the integrity of each client; and (iv) be appropriate to the job responsibilities of the individual attending the training.

Other considerations to keep in mind:

• Individual and institutional immunity differ. An eligible employee that has completed their training and makes a disclosure to a covered agency in good faith with reasonable care would receive individual immunity pursuant to the Act. A covered financial institution also receives institutional immunity when an eligible employee makes a disclosure to a covered agency and all employees have received training to the extent necessary to qualify for immunity under the Act.
• Immunity established through the Act applies only to disclosures made by a covered institution or an employee of the institution to a “covered agency,” this would not apply to other third parties.

Additional resources are available below:
SEC Resources: SEC Seniors webpage
NASAA Resources: Serve Our Seniors website

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Insufficient Resources for Compliance Program

On November 6, 2018, the Securities Exchange Commission ("SEC") announced a settlement with a former Chief Executive Officer ("CEO") of a now-defunct Registered Investment Advisor. The settlement included the CEO’s censure from the industry and a monetary fine of $45,000.

The bulk of the SEC’s findings centered around the fact that the CEO did not take appropriate action to rectify inadequate resources to effectively implement their compliance program.
On multiple occasions, the named Chief Compliance Officer ("CCO") brought deficiencies and recommendations to increase the firm’s internal or external resources to effectly address compliance functions in the firm’s compliance program to the CEO and management’s attention. These recommendations were largely ignored, which led to many of the Adviser’s Act violations found by the SEC.
Key reminders & tasks related to Compliance Resourcing and Authority:

• Management must set the tone for compliance.
• Management must provide adequate resources to properly affect the firms’ compliance program.
• The CCO must be in a position of authority to effect change and policy within the firm.
• For those multi-hatted CCO’s, exploration in adds to staff or the delegation to internal (or external) resources to assist with the compliance program is advisable.

To read the entire enforcement case, see the SEC Administrative Proceedings.

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Mock Exams: Dress Rehearsals for the Real Thing

In the September/October 2018 edition of the Investment & Wealth Monitor Magazine, AdvisorAssist’s Ann Keitner and Conor Anderson wrote an article targeting CCOs on mock exams; discussing their importance and steps on how to run one.

A mock exam is a valuable tool for a firm to assess their readiness for an actual regulatory exam. All advisors benefit from this exercise, including new advisors that have never been examined and mature advisors who have been through multiple regulatory exams.

The article covers the below areas:

• Determining the goal of the exam
• Deciding the type of exam to conduct
• Planning for the exam
• Deciding who will conduct the exam
• What to do with the exam results

To read the full article, please see: Click Here

Contributors:

Ann Keitner
Conor Anderson

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5th Circuit Court Vacates DOL Rule

On March 15, 2018, the Fifth Circuit Court of Appeals ruled via split decision to “vacate” the well-publicized DOL fiduciary rule. This decision does not come as much surprise. It has long been rumored that the DOL rule was destined for failure after President Trump ordered a formal review in March 2017. Speculation by industry watchers is that the next step for the DOL rule could be the U.S. Supreme Court.

While this decision is limited in scope, it creates an opportunity for the Securities and Exchange Commission (“SEC”) to take the lead on a uniform fiduciary standard for both RIAs and broker-dealers. The SEC is the more natural choice for marrying the fiduciary standard across both RIAs and broker-dealers.

We expect the SEC to prioritize a new fiduciary rule proposal. Although the timing is uncertain, we expect to learn more prior to 2019.

What does this mean for you?

With or without the DOL, you still have a fiduciary responsibility to act in the best interest of your clients. You may not have to go to the extent of best interest contracts. However, “Know Your Clients” requirements are never going away and the regulators will always want documentation of how you operate as a fiduciary. It may still make sense to adopt some of the documentation standards of the DOL’s “Level Fee Fiduciary” when making rollover recommendations.

Contributors:

Brian Young
Brendan Furey

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SEC 2018 Examination Priorities

Each year, the Office of Compliance Inspections and Examinations (“OCIE”) of the U.S. Securities and Exchange Commission (“SEC”) communicates its examination priorities for the upcoming year. The SEC has narrowed their focus on the following common themes:(1) Retail Investors (2) Compliance and risks in critical market infrastructure (3) Cybersecurity. Based on these themes, the SEC has pinpointed several key areas of concern that will be focus areas for 2018. Some of which are similar to years past, however, continue to be a priority for the SEC. We have provided an overview below of the key topics that RIAs need to be mindful of in 2018.

Disclosure of the Costs of Investing

The SEC will focus on the calculation of fees and expenses paid to the Advisor as well as any compensation that is paid to affiliates of the Advisor.

Focus areas include:

• Consistency of the advisory fee calculations and the advisory fee methodology disclosures.
• If charging an asset-based fee, the consistency of the valuation of client securities and the valuation methodology disclosures.
• Advisors that receive financial incentives to recommend mutual fund share classes (ie. high sales loads or distribution fees).
• Client accounts that are not re-assigned to a new IAR when an employee leaves the firm.
• Advisors that transition from commission based accounts to fee based accounts.

Electronic Investment Advice

As in prior years, the SEC will continue to focus on advisors that offer investment advice through automated programs (ie. robo-advisors).

Focus areas include:

• Oversight of the algorithms used to generate general investment advice.
• Marketing materials.
• Policies and procedures related to client data protection.

Wrap Fee Programs

For advisors that charge a wrap fee (ie. fee that includes both advisory fees and execution costs), they will need to demonstrate that the wrap fee is in the best interest of the client.

Focus areas include:

• Any conflicts of interest are disclosed.
• Review for best execution.
• Disclosure of execution costs with broker-dealers.

Never Before Examined Investment Advisors

Due to the large volume of newly registered advisors and the limited resources of the SEC, the SEC will continue to prioritize advisors that have “elevated risk profiles”. This likely includes advisors that fall under the scenarios outlined by the 2018 exam priorities.

Senior Investors and Retirement Accounts and Products

Advisors that provide investment advisory services to seniors and/or retirement accounts will continue to be a focus for the SEC. Advisors will need to have internal controls in place to identify and mitigate financial exploitation of seniors.

Focus areas include:

• Investment product recommendations.
• Sales of variable insurance products.
• Usage of target date funds.
• Advisors that serve state and local government employees and non-profit employees (ie. 403(b) and 457 plans).

Mutual Funds and ETFs

As the primary investment products for retail clients, the SEC will focus on the types of mutual funds and ETFs recommended to clients.

Focus areas include:

• Funds that experienced poor performance or liquidity.
• Funds that are managed by advisors with little experience managing a fund.
• Funds that hold securities that are difficult to value due to market stress (ie. securitized loans or mortgage backed securities).
• Ensure that risk disclosures are provided to investors.

Cryptocurrency, Initial Coin Offerings (ICOs), Secondary Market Trading, and Blockchain

Cryptocurrency has wildly risen in popularity over the past year. The SEC will monitor this space as advisors engaged in this market continues to grow.

Focus areas include:

• If advisors maintain controls and safeguards to protect assets from theft.
• If advisors are providing adequate disclosures associated with the risks of these type of investments including: investment losses, trading liquidity, price volatility, and potential fraud.

Cybersecurity

Cybersecurity continues to be a priority for the SEC as we have witnessed large scale cyber attacks over the past year.

Focus areas include:

• Governance and risk assessment.
• Access rights and controls.
• Data loss prevention.
• Vendor management.
• Training.
• Incident response.

Please remember that OCIE and the SEC communicate these as PRIORITIES, and not an all-inclusive list of all focus areas. To read the full report, click here: "2018 National Exam Program Examination Priorities"

Contributors:

Brian Young
Conor Anderson

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Three Actionable Tips to Become SEC Examination Ready

Over the summer, we heard rumblings that the SEC was conducting unannounced examinations on RIAs in the Boston area. While we have certainly seen a significant uptick in the examinations of never before examined advisors, none of which have been unannounced. Regardless if it is a routine exam or unannounced, it is best practice for advisors to stay examination ready regardless of location or if registered with the SEC or applicable State(s). As we preach to our clients, make sure you take proactive measures to become “examination ready”. Don’t wait until the SEC or a state level examiner comes knocking at your door!

Here are three (3) actionable tips to consider:

1. Customize your Compliance Program

We see far too many advisors that think they are “plain vanilla” and therefore think they can get by with a generic compliance manual (Wrong!). Most firms do not create their compliance manual from a blank page. They start with a model document to address the broad regulatory structure and industry requirements. Although, a model document is a good starting point, it does not amount to a finished product. RIAs need to know that a one-size-fits-all compliance manual does not exist and no consultant or legal resource knows the firm better than the people actually operating it on a daily basis. The creation of a firm specific compliance manual should include three broad steps:

• Review the model document for content and applicability (ask questions).
• Customize the model document to be firm specific, which means customize language specific to your business practice and make sure to remove language that is not relevant to your firm. Then operate your firm in a manner that is consistent with your compliance manual.
• Regularly review, and update your compliance manual as the dynamics of the business evolve and the regulatory environment changes. A compliance manual should never be considered a final document but a current draft of a “living document”.

Always remember that SEC or State regulators expect there to be evidence to demonstrate that policies and procedures are being implemented. Simply put, if there is no evidence, it did not happen.

2. Complete an annual review of your Policies and Procedures

On an (at least) annual basis, you should complete a review of the adequacy and effectiveness of your compliance program. Ideally, the firm should conduct risk assessments of your compliance program throughout the year to test the risk controls and identify any weaknesses. If any issues are identified, make sure to take corrective action and document, document, document! If you don’t document the steps you have taken, (*in the regulator’s eyes) it never happened!

Keep in mind that an effective compliance program should identify potential risks and mitigation opportunities. If the established controls never identify a risk or a mitigation opportunity, the controls should be evaluated and potentially revised.

3. Organize your Books and Records

During the examination process, the regulators will want to complete a sampling of your books and records. You should make sure that your books and records are maintained in an organized fashion to ensure they can be readily delivered. The examination process typically starts with a document request letter including (but not limited to):

• Financial Statements including income statements, balance sheets, and other key accounting records.
• Client Records including a full list of current and past client accounts, supporting client agreements, profiles, investment policy statements and trade data.
• Communications with existing or prospective clients including emails, advertisements, and social media accounts.
• Regulatory filings and other compliance program documents including your ADV 2A/2B, compliance manual, compliance certifications, business continuity plan, code of ethics, and cyber-security policy.

This is by no means an exhaustive list, but should get you started on the right track. If you have any additional questions, please feel free to post a comment below or send an email to info@advisorassist.com.

Contributors:

Brian Young
Dan Rome

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Custody Rule: Standing Letter of Authorizations

There has been a level of uncertainty for Registered Investment Advisors (“RIA”) over the past year in regards to the SEC’s position on Rule 206(4)-2 (“Custody Rule”) (see the AdvisorAssist blog post on Custody for additional information) and how it applies to standing letters of authorization (“SLOA”) for a client at a qualified custodian (“Custodian”). It​ has been a common business practice for RIAs and clients to establish a SLOA at the Custodian which authorizes the RIA to instruct the Custodian to disburse client funds to a third party account or payee. Generally speaking, the intent of this practice is to minimize the administrative steps for RIAs to service the money movement requests of their clients. However, there has been much confusion by both RIAs and examiners ​as to​ which ​SLOA scenarios ​constitute custody of client funds and trigger the Custody Rule requirements for the RIA.

On February 21, 2017, the SEC provided clarity to this question through a no-action letter. The SEC confirmed their stance that the business practice of using SLOAs as instructions for payments to third parties fall under the definition of custody. Thereby requiring RIAs to disclose that they have custody of client funds. However, the SEC also provided some relief for RIAs as it relates to the independent surprise examination requirement of the Custody Rule.

The SEC advised that they would not seek enforcement action against RIAs who do​ not obtain a surprise examination as long as the RIA follow the below guidelines:

The client provides an instruction to the Custodian, in writing, that includes the client’s signature, the third party’s name, and either the third party’s address or the third party’s account number at a Custodian to which the transfer should be directed.

The client authorizes the RIA, in writing, either on the Custodian’s form or separately, to direct transfers to the third party either on a specified schedule or from time to time.

The client’s Custodian performs appropriate verification of the instruction, such as a signature review or other method to verify the client’s authorization, and provides a transfer of funds notice to the client promptly after each transfer.

The client has the ability to terminate or change the instruction to the client’s Custodian.

The RIA has no authority or ability to designate or change the identity of the third party, the address, or any other information about the third party contained in the client’s instruction.

The RIA maintains records showing that the third party is not a related party of the RIA or located at the same address as the RIA.

The client’s Custodian sends the client, in writing, an initial notice confirming the instruction and an annual notice reconfirming the instruction.

CCO Best Practices

To ensure that you are properly dealing with custody issues AdvisorAssist recommends the best practices of:

Perform an assessment to determine whether or not you have custody of client assets or securities

Review all current SLOA to identify any that are established to send funds to an account at a different Custodian or to a third party payee.

RIAs have until October 1, 2017 to comply with the above described actions. Also, there will be a new requirement for RIAs to state client assets that are subject to a SLOA on their ADV1, Item 9.

Contributors:
Brian Young
Conor Anderson
Brendan Furey

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Risk Assessments: Why and How?

Why:

Rule 206(4)-7 of the Investment Advisers Act of 1940 requires that registered investment advisers implement a compliance program that is reasonably designed to prevent violations of the securities rules and regulations. Risk assessments can assist you in evaluating your existing compliance program’s effectiveness and ensure it is designed appropriately, given the way you run your RIA.

How:

Identify all risk areas

Begin by reviewing all of your business activities across your firm. Think about your firm’s business model, who your clients are, the role of your employees, and the products and services you offer. Expand your thought process to include conflicts of interest, potential regulatory violations, and potential breach of contract and client mandates. Review findings from recent SEC or State inspections and include any deficiencies that were identified.

Assign a Rating to Potential Risks

Once you have gathered all of your business activities and potential risk areas you must assign a rating to each. Many advisors utilize something simple, like low, medium, and high as risk categories. When assigning a rating consider the regulatory risks, financial risks, and operational risk of each item. Consider the probability of having an issue in the particular business activity, as well as the impact an issue would have on your organization.

Map each risk to your policies and procedures

For each risk identified above, ensure the proper policy and procedure have been implemented. Higher risk areas often require additional internal controls and more extensive policies and procedures.

Perform annual review

Your policies and procedures are meant to be updated on an ongoing basis as needed. At least annually the Advisor should review all business activities and update the risk assessment and policies and procedures.

Next:

Each week I will post a risk assessment on a specific business area and discuss some of the specific applicable risks.

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