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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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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Exam Priorities: Multi-Branch Adviser Initiative

Each year the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) creates initiatives in order to address priorities for examinations of SEC-registered investment advisors (“Advisors”). The OCIE recently issued a risk alert about their ongoing initiative to make Advisors with multiple branch offices an examination priority. This initiative will center on examining the effectiveness of supervisory practices over advisory personnel in branch offices.

What you need to know

The OCIE perceives an increase in Advisors having numerous branch offices and operations that are geographically dispersed from the main office. With this increase in the use of a branch office model additional and unique risks are created. In particular, the design and implementation of a compliance program and the supervision of people and processes in branch offices. There are risks that those individual(s) responsible for compliance and oversight will not be able to review adherence to and/or enforce the use of policies and operating procedures.

Review of Compliance Programs

Under SEC Rule 206(4)-7, Advisors are required to implement written policies and procedures reasonably designed to prevent and detect violations of the Advisers Act and related rules by Advisors and their supervised persons. According to the risk alert, during examinations, Advisors will be asked about the oversight of the staff at branch offices and the exam will review the staff’s compliance with your policies and procedures. Through interviews of the staff and inspection of books and records, the exam will assess the:

• Implementation of policies and procedures in the branch offices.
• Supervision structure, including an assessment of how such supervision is tailored to the unique risks in particular branches.
• Role and empowerment of compliance personnel charged with overseeing branch offices, including their level of access to documents and relevant information.
• Accuracy of information on filings regarding branch offices, including Form ADV, as compared to actual business practices.

Review of Investment Recommendations

As a fiduciary, an Advisor has an obligation to act in the best interests of its clients and to identify and disclose any material conflict of interest. According to the risk alert, during the examination, the Advisor will be asked about the process for formulation of investment recommendations and the management of client portfolios at branch offices. In particular the exam will focus on policies and procedures and supervisory controls that cover the following:

• Oversight. Supervision and review of investment recommendations made to clients within specific branch offices and across branch offices, including processes and controls regarding investment authority, suitability of the investment advice, and any due diligence that the adviser has told clients is undertaken with respect to investments.
• Conflicts of Interest. Identification, management, and disclosure of conflicts of interest that arise through branch office activities and personnel, including conflicts arising from various compensation arrangements and supervised persons’ outside business activities.
• Allocation of Investment Opportunities. Allocation of investment opportunities among client accounts, including how branch offices’ trading activity is monitored and what disclosures are made to clients regarding trade allocation.

Additional Areas of the Review

In addition, the exam may focus on assessing compliance and testing controls in one or more of the following risk areas:

• Fees and Expenses. The calculation of fees and other expenses, including the effectiveness of controls over the billing and invoicing processes.
• Advertising. Controls over advertisements, such as the process for reviewing and approving advertisements, particularly those created or disseminated by its branch offices.
• Code of Ethics. The implementation of the code of ethics, including oversight and monitoring of personal securities transactions and whether have properly identified access persons at branch offices.
• Custody. Controls related to the identification of accounts which the Advisor maintains custody and the involvement of branch office personnel in making such determinations.

CCO Best Practices

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

• Perform an annual review of your books and records archive to ensure you are keeping the required documentation.
• Review your compliance program documents to ensure that they are up to date and correct.
• Ensure your staff certifies their understanding and adherence to your compliance program at least annually.
• Test your staff’s adherence to the policies and procedures in your compliance program at least annually.
• Compile all of your findings into summary reports to document the annual completion of your oversight responsibilities.
• Conduct formal meetings with any compliance staff in any branch locations to demonstrate supervision to and compliance by those branches.

AdvisorAssist’s CCO Series: Exam Priorities is a series of articles that will help your firm understand and prepare for the most common compliance exam topics. 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
Brian Young

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SEC Announces Cyber Security Exams

Financial Advisor Magazine reports that the SEC will begin conducting Cyber security exams for investment advisory firms by late September.

More at http://www.fa-mag.com/news/cyber-security-exams-coming-for-advisors--says-sec-16805.html?section=101

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