CCO Series - Trade Errors

What You Need to Know

In developing policies and procedures for a Registered Investment Advisor ("RIA") a topic that must be addressed is trade errors. To uphold the fiduciary duty owed to clients of your RIA, your policies and procedures must cover how you handle errors that may occur when trading in a client's account. If a trading error occurs in a client's account managed by an RIA there are critical response items to consider in order to uphold your fiduciary duty. Implementing these compliance components can demonstrate to a regulator that you are satisfying your regulatory requirements.

What is a Trade Error?

The most common trade error is buying the wrong security or the wrong amount. Here are a few other examples of events that are considered trade errors:

• Trading in the wrong client account
• Trading in the wrong direction (buy vs. sell)
• Trading at the wrong price (limit orders, etc)
• Incorrect block trade allocation
• Violation of client account restriction (tobacco, oil, military)
• Violation of client account suitability (aggressive vs conservative)
• Delayed execution of trade instructions
• Duplicate execution of trade instructions

How to Handle Trade Errors

Even if the error does not fit into one of these examples you must discuss any potential or actual trade errors with your CCO to ensure compliance. CCOs should document the event within their trade error log and save all related documentation for the RIA's books and records. Consider communicating with the clients as needed to explain events in their statements or other irregular trading activity. Most trade errors can be resolved prior to settlement by the custodian if they are promptly discovered and communicated.

Reviewing Policies and Procedures

Advisors must ensure their policies and procedures require the disclosure of trade errors to the CCO and that trade errors are documented in the Advisor's trade error log. The log must also include any related backup or other documentation, that the trade errors are resolved in a way that makes the client whole and absolves the client of consequences of the Advisor's error. Additionally, trade errors should be reviewed at least annually by the CCO or delegate to ensure that any reasonable changes to the Advisor's business practices that could eliminate future errors are considered for implementation. During this annual review, the CCO or delegate must also update the Advisor's trade error policy as needed to ensure it accurately reflects how trade errors are resolved.

What are the Next Steps for a CCO?

Sample review transactions from your firm’s trading blotter to ensure trades are placed accurately in accordance with documentation and client objectives. Ensure any and all trade errors are documented in your firm's trade error log. Confirm that trade error files maintain documentation related to the specifics of the trade error as well as documentation substantiating the resolution. Consider reasonable changes to business practices that could eliminate the potential for future errors. Finally, remain aware of any changes to trade error policies and procedures that may be imposed by your custodian and ensure your internal policies remain accurate. Ensure proper communication of trade error policies and procedure to supervised persons.

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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CCO Series - Client Suitability

As a fiduciary, an RIA firm is required to make investment decisions in the best interests of its clients. When making decisions regarding the investment options for accounts an RIA firm needs to be able to defend such decisions as being reasonably suitable to the goals and needs of its beneficial owners. Regulators will seek to ensure that decisions made by the firm during the course of providing its services primarily benefit the client and are suitable for a particular account's objectives. Documentation that define a fund's investment objectives or a model portfolio strategy will be compared against the trading history and the decisions made for clients to validate whether or not the firm is making suitable investment decisions when providing its services.

RIA Client Suitability In a Nutshell

Client suitability starts with information about how the RIA firm's investment managers will provide its advisory services and the information about the client or fund that will be relied upon to guide those decisions. For a typical retail RIA situation, this may include your client profile, risk tolerance questionnaire, investment policy statement (IPS), or client notes capturing similar information. For structured investment products this may include the operating agreements, offering documents, and similar information about the funds, parties and entities involved. As these documents are executed, modified, updated or amended the advisor should keep and maintain this additional documentation for their firm's books and records.

Risks related to strategies used by an RIA firm must be disclosed to clients through Form ADV. Specifically in Form ADV Part 2A, the Disclosure Brochure, Item 8 Methods of Analysis, Investment Strategies and Risk of Loss should contain information regarding how the firm's investment management services will be applied to the client's accounts and the potential losses that can occur due to the way the firm will invest the client's assets. It is important for firms to review these disclosures and ensure they accurately reflect the firm's investment methods and cover the risks related to the firm's advisory services.

Confirming Suitability

After collecting a client's information, having them sign an advisory agreement and providing a copy of your ADV and other new client paperwork, suitability becomes a compliance matter for the relationship as you move to digest the information and start making investment decisions for the client's account(s). While your documentation may tell the client to notify your firm of any changes to their profile, goals or objectives, every RIA firm still has an obligation to reach out to the client and confirm the information you have is still accurate and that ultimately to confirm your current understanding of what is suitable for that client.

Confirming suitability can take the shape of having the client complete a new risk questionnaire, sign a new IPS, or to have a meeting with the client where you discuss the management of their account and address suitability matters. Documenting this confirmation is critical to the firm's books and records for compliance purposes on this topic, and can take the form of client notes indicating suitability was discussed and the results of that discussion, or the updated formal documents such as the questionnaire or IPS. For fund managers, this activity means ensuring that the decisions being made for the fund are reasonably accomplishing the objectives of the fund as described in its documentation and ensuring that due diligence documentation is retained for various non-public investments. By having this documentation in your firm's books and records you can demonstrate that your firm has upheld their fiduciary duty when making investment decisions for its various clients.

Through the Regulator's Eyes

Regulators expect RIA firms to maintain documentation on each advisory client to support the investment decisions made for their account(s). During an examination, regulators will typically ask firms to provide their risk questionnaires or similar documents used to obtain information about their clients, and will also request information about trades in client accounts, and will reconcile the two to ensure that decisions made for clients are suitable and that there is a rational basis between the documentation, analysis, and investments. Further, regulators will review the information in your firm's disclosure brochure to reconcile to the types of investments to ensure that the strategies and risks are properly and fully disclosed to clients.

CCO Best Practices

Conduct a random sampling review of client files to verify that suitability is appropriately documented. Run a comparison between the client's trading history and the suitability documented to ensure investment decisions are in line with investment objectives. Validate that the last outreach attempt to each client is within one year. Additionally, review your firm’s client intake/onboarding and ongoing review process to ensure you are capturing adequate information to make, or continue to make, appropriate investment decisions in client accounts and provide advice that is in the client’s best interest.

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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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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RIA Key Person Risk: What are the options?

Years back, when I was on the management team of an institutional asset management firm, our founder used to call it the "truck" question (as in "What would happen if he got hit by one.) My colleagues and I would respond with guarded laughter and move on to a more comfortable subject.*

No, it's not a subject any of us want to dwell on, but the unexpected loss of a key member of your advisory staff could very likely impact your ability to fulfill the fiduciary duty owed to your clients. With some planning, RIA's can easily mitigate this risk by adopting any number of operational or legal options.  Operationally, advisors can start by reducing their firm's reliance on any one individual.  Some ideas on how to do this include:

• Establishing and documenting defined roles and responsibilities;
• Cross-training; and
• Knowledge sharing (so more than one person is familiar with the firm’s investment process and client relationships).

Easier said than done, however these practices will ensure process continuity during unexpected absences. They also provide added flexibility around planned absences, like vacations!

Technology plays a central role here.  The disciplined use of a CRM and a document management system will ensure that your client information is not only safe, but also centrally-stored and easily accessible.  Likewise, an internal website may be used to store your firm’s operations manual, which documents all critical processes and procedures.  In the absence of a formal operations manual, you can post a set of documents that detail your firm's investment process, work flows and operational procedures.

In addition to these operational efforts, RIAs may also consider establishing a legal agreement that governs the firm in the event of the death or incapacitation of a key person or owner. Single-owner firms can establish a “continuity agreement.” A continuity agreement is a legal contract that appoints an “alternate” registered investment adviser to assume client responsibilities in the event of the death or incapacity of an individual.  If this were to occur, the “alternate” adviser would be responsible for offering to assume their advisory role (clients reserve the right to decline, of course.) The extent of the alternate adviser’s responsibilities can vary.  Their role may be limited to interim oversight (to give clients the opportunity to seek a new advisor) or the alternate RIA may be charged with overseeing the sale of the business (including the possibility of acquiring the business themselves.)

RIAs with multiple owners may opt to establish a “buy-sell agreement.”  Buy-sell agreements establish guidelines for an orderly internal sale of the advisory firm to the other owners.  Typically these owners are employees of the firm and should be familiar with the firm’s clients and investment process.

After taking steps to ensure business continuity, advisors should include these items in their business continuity plan and quarterly compliance risk matrices. In fact, I suggest that advisors include the topic of operational controls and continuity in their presentation materials. Just because clients don't ask the question (and who wants to ask the "truck" question?) doesn't mean that they haven't thought about it.

*As an aside, my dear friend and founder of that firm did not get hit by a truck, but did implement a successful management transition and officially retired a few weeks ago.