SEC’s Top 10 Hits: Investment Adviser Regulatory Review 2019 – Part 1

ACA Foreside

Based on regulatory developments from 2019, here are our suggestions for updates to your RIA compliance program for 2020.

1. Get ready for Form CRS

The SEC’s top regulatory initiatives in 2019 defined the standard of conduct for broker-dealers and investment advisers and required disclosure to retail clients to explain these standards. Part of that initiative included Form CRS Relationship Summary (“Form CRS”), a new disclosure document to be filed with the SEC and delivered to retail investors by both broker-dealers and investment advisers. The SEC has defined a retail investor as “a natural person, or the legal representative or such a natural person, who seeks to receive or receives services primarily for personal, family or household purposes”.

For investment advisers, Form CRS will be Part 3 of Form ADV. The form is a two-page document with five required topics:

  • Introduction (including a link to, a page on the SEC’s Office of Investor Education website that will offer educational information about investment professionals)
  • Relationship and Services
  • Fees, Costs, Conflicts and Standard of Conduct
  • Disciplinary History
  • Additional Information

Firms can use graphics such as charts, hyperlinks, and electronic formats. The SEC allows the use of embedded hyperlinks in electronic versions to cross-reference more detailed information on fees, services and conflicts. Firms are also required to disclose how their financial professionals are compensated, along with the conflicts the payments create. Firms must disclose whether the firm and any of its financial professionals have reportable disciplinary history and tell clients where they can find more information about these events instead of including descriptions in the form.

Registered investment advisers, or those with a pending registration application with the SEC before June 20, 2020, have from May 1, 2020, to June 30, 2020, to file the initial Form CRS. After June 30, 2020, investment advisers seeking registration must include the Form CRS as part of their application.

Recommendation 1

Start drafting Form CRS now. This will be a formidable challenge for firms serving retail clients, since, in the words of Blaise Pascal, “I have only made this letter longer because I have not had the time to make it shorter.” After including all the SEC-mandated language, there is little room for anything else so advisers will have to be creative to include the required disclosure. Start by reviewing the Instructions to Form CRS and the SEC Compliance Guide to Form CRS Relationship Summary. The guide provides an excellent overview of a firm’s obligations about content, formatting, delivery, updating, filing, and recordkeeping requirements. The Instructions to Form CRS walk you through the details. Check out our resources, including Hardin’s Regulatory Update for October 2019, and our webpage, Form CRS Relationship Summary, where we will be adding more tools as the June 30 deadline gets closer.

Recommendation 2

Revise your policies and procedures to address Form CRS delivery obligations, since all firms (both broker-dealers and registered investment advisers) that offer services to retail investor clients must provide them with Form CRS. Firms should discuss requirements to give a new Form CRS to existing and prospective retail investor clients before or at the time:

  • the firm opens a new account that is different from the retail investor’s existing account;
  • when the firm recommends a roll-over from a retirement account to an IRA; or
  • when recommending a new service or investment outside of a formal account (e.g., variable annuities, direct investment in a mutual fund, or private placement) to a retail investor.

Also, include a requirement to update the Firm’s website to Include Form CRS, which must be prominently displayed (if the firm has a website).

Recommendation 3

Amend your record-keeping policies to include your new obligations under Form CRS. Amended recordkeeping rules (Advisers Act Rule 204-2(a)(14)(i) and Securities Exchange Act Rule 17a-3(a)(24)) require firms to make and preserve a record of the dates that each relationship summary was provided to each retail investor, client or prospective client.

2. Up your game for identifying and disclosing conflicts of interest in Form ADV. Avoid using the word “may” whenever possible.

Just like last year, the SEC is aggressively pursuing investment advisers for failing to disclose, or to adequately disclose, conflicts of interest. To hammer its point home, in September, the SEC announced 17 settlements with investment advisers for “disclosure failures” in connection with its Share Class Selection Disclosure Initiative (the “SCSD Initiative”). This is in addition to the settlements with 79 investment advisers announced in March 2019. In its press release, the SEC noted that 16 of the firms had self-reported during the SCSD Initiative. All told, the advisers were required to refund money to clients, along with prejudgment interest, for a total of nearly $10 million.

Private funds are also feeling the SEC’s ire. In an administrative proceeding against Levati Wealth Management (LWM), the SEC found violations of fiduciary duty, disclosure obligations, and best execution. LWM recommended and invested client assets in various private placements that included a sales commission. LWM failed to tell clients that investment adviser representatives of LWM (who were also registered representatives of a broker-dealer) received those commissions. LVM also kept mum about the fact that the private placements also offered share classes without commissions, which would have saved these clients money. Consequently, LWM was required to pay disgorgement of close to $1 million and a civil penalty of $150,000. Remember, no matter what product is being recommended, investment advisers have a fiduciary duty to select the share class that is best for their clients. The SEC brought a case against Foundations Asset Management, LLC (“FAM”), Michael W. Shamburger (“Shamburger”), and Rob E. Wedel (“Wedel”) for similar disclosure violations. In that case, FAM was recommending that its clients invest in a private investment fund and told them that the firm received compensation as a result of client investments in the fund. What FAM did not tell clients was that the firm received more than double its usual advisory fee for a client’s investment in the fund as a placement fee, that the annual trailing fees were higher than its typical advisory fee, and that the firm received a significant amount of income as a result of selling shares in the fund.Just like last year, the SEC is aggressively pursuing investment advisers for failing to disclose, or to adequately disclose, conflicts of interest. To hammer its point home, in September, the SEC announced 17 settlements with investment advisers for “disclosure failures” in connection with its Share Class Selection Disclosure Initiative (the “SCSD Initiative”). This is in addition to the settlements with 79 investment advisers announced in March 2019. In its press release, the SEC noted that 16 of the firms had self-reported during the SCSD Initiative. All told, the advisers were required to refund money to clients, along with prejudgment interest, for a total of nearly $10 million.

Administrative fees and markups are also in the SEC’s crosshairs. The SEC brought suit in federal court against Cetera Advisors, LLC (“Cetera”), a dually registered investment adviser and broker-dealer, alleging that Cetera violated its fiduciary duties by having its investment adviser representatives recommend and invest assets in share classes that paid 12b-1 fees when cheaper share classes were available. Cetera was also cited for failing to disclose that it received 12b-1 fees and revenue sharing payments from fund companies. But the news flash here is that the SEC claims Cetera also failed to disclose the conflicts of interest that resulted from (i) some mutual funds paying Cetera a fee for performing administrative duties, such as handling client inquiries and maintaining client accounts, and (ii) for charging mark-ups on non-transaction services provided to client. Advisers should check their Form ADV disclosure to make sure they include similar disclosures, if applicable.

In addition to these cases, advisers should review the SEC’s FAQs on Conflicts of Interest and the Commission Interpretation Regarding Standard of Conduct for Investment Advisers (discussed below in item 3). In the FAQs, the Division of Investment Management provides guidance on what it considers the material facts about a firm’s practices and disclosures for payments received in connection with client investments, along with a caveat that the disclosures “should be concise and in plain English”. The SEC also indicates that offsetting or rebating 12b-1 fees or sales charges may be the appropriate course of action for an adviser to meet its fiduciary duties. Reading between the lines, the Commission is de facto expecting a higher fiduciary standard from advisers, similar to the standard imposed by the now-dead DOL Fiduciary Rule.

The SEC has also identified some other disclosure failures that may seem less obvious. For example, in its case against Hefren-Tillotson, Inc., (“Hefren”) a dually-registered investment adviser and broker-dealer. Hefren had a deal with an unaffiliated clearing firm that charged Hefren $7.95 for clearing and execution charges on each trade, and Hefren passed this charge on to its clients. Eventually, Hefren negotiated a reduction in this charge to $6.00 per trade, although it continued to charge clients $7.95 and kept the $1.95 difference. This practice was not disclosed in the firm’s Form ADV Part 2A. The SEC said the arrangement resulted in a conflict of interest since Hefren did not have a similar deal with other firms and was more likely to trade with the unaffiliated clearing firm to increase its revenue. Moreover, the deal incentivized Hefren to trade client accounts more frequently. According to the SEC, Hefren should have disclosed these in the Form ADV. This failure resulted in a violation of Section 206(2) anti-fraud provision under the Advisers Act.

The SEC has also been on the warpath in situations where the disclosure provided is insufficient for clients to understand the conflict and give informed consent. For example, the SEC brought a case against Valley Forge Asset Management, LLC (“VF”), a dually-registered investment adviser and broker-dealer that was ultimately acquired by BB&T Securities. Most of VF’s retail clients signed up for a brokerage option called the “Affiliated Brokerage Option”, which promised “full service” brokerage for a discount of 70% of the firm’s retail commission rates. What the firm failed to mention in its Form ADV was that clients who selected this option paid commissions about 4.5 times higher than others and received no additional services. The SEC found that VF’s Form ADV disclosure that it would “benefit monetarily” under the Affiliated Brokerage Option was inadequate and misleading, considering the wide disparity among the rates charged to clients.

Recommendation 1

Advisers should include “full and fair” disclosures in their Form ADV Part 2A addressing these topics:

  • Payments made and received by the firm and its affiliates, including referral fees, revenue sharing, 12b-1 payments, shareholder servicing fees, and recordkeeping fees;
  • Clients who may also have vendor or business relationships with the firm and whether they receive favorable treatment as a result of those relationships;
  • Affiliated service providers, such as broker-dealers, custodians, consultants, or administrators, the extent to which the adviser uses these service providers, and how the firm mitigates conflicts of interest;
  • Benefits the firm receives from service providers, such as providing access to educational seminars related to current products and industry issues. This disclosure should also include the firm’s participation in sales events, conferences, and programs held by mutual fund distributors; and
  • Outside business activities of executives and IARs.

Advisers should make sure their disclosures are “clear and detailed enough for the client to make an informed decision to consent to the conflict of interest or reject it”. Finally, all advisers, even those to whom share class selection conflicts do not apply, should stop using the word “may” when discussing potential conflicts. The SEC continues to find terms like “may,” “might,” and “could” as woefully inadequate when describing conflicts of interest.

Recommendation 2

Firms should consider rebating fees paid by clients if such payments end up in the firm’s pocket, such as sales commissions.

Recommendation 3

Advisers should tell not just the truth, but the whole truth. As evidenced by the cases against Hefren-Tillotson, Inc., BB&T Securities, Foundations Asset Management, and Levati Wealth Management, advisers should ask themselves: “If the client actually knew what was going on, would he or she accept the products and services being offered?”

Recommendation 4

Make sure your Form ADV disclosures are consistent throughout the document. For example, in the case against Foundations Asset Management, the SEC cited the firm for false statements in its Form ADV for incorrectly responding to Items 5.E. and 14.A., which ask about compensation and other economic benefits received. Item 5.E. asks whether the firm or any of its supervised persons accept payment for the sale of securities or other investment products and, if so, to explain that this practice constitutes a conflict of interest. Item 14.A. asks whether the firm receives any economic benefit, directly or indirectly, from any third party for advice rendered to clients.

3. Review your policies and procedures to determine whether they meet SEC’s Standard of Conduct.

Advisers should review the Commission Interpretation Regarding Standard of Conduct for Investment Advisers” (the “Interpretation”) to ensure they are covering all the areas addressed by the SEC. Briefly, an adviser’s fiduciary obligations include client account monitoring, selecting the appropriate account type for clients, performing due diligence on investment products, providing full and fair disclosure on conflicts of interest, meeting best execution obligations, and making a reasonable inquiry into a client’s investment objectives.

The SEC breaks down an adviser’s fiduciary obligations into two essential duties, a duty of care and a duty of loyalty. The duty of care means an adviser must provide advice in the client’s best interest, seek best execution where the adviser has the responsibility to select broker-dealers to execute trades and monitor the client’s portfolio over the course of the relationship. The duty of loyalty hinges on the adviser making full and fair disclosures of conflicts of interest to its clients so they can make an informed decision about whether to hire the adviser.

Performing due diligence on investment products is essential to providing advice that is in the best interest of a client. The Commission cites the Larry Grossman case as a not-so-subtle reminder of the consequences of failing to investigate securities before recommending them to clients (disgorgement and an industry bar). More recently, the SEC fined Steve Morris Bruce, founder and CEO of Charter Capital Management, LLC (“CCM”), $40,000 for telling investors that he had conducted extensive due diligence on an investment, when in fact he had only made a few phone calls and conducted some Google searches.

Recommendation 1

Advisers should implement a process to document periodic client account reviews. It may be as simple as requiring investment adviser representatives to review client holdings monthly or quarterly, comparing those holdings to the client’s stated investment objectives, and noting whether there have been any changes to the client’s personal situation that would require changes. The review should address whether the client’s current account or program type continues to be in the client’s best interest (see discussion below). Finally, the review should include an analysis of investment performance. These periodic reviews should be documented and retained in the firm’s books and records.

Recommendation 2

Advisers should require investment adviser representatives to discuss with retail clients which account type best meets their needs and document the reasons for their recommendations. Firms should consider adopting standard criteria for making account recommendations.

Recommendation 3

Advisers should document the due diligence performed on investment products offered to clients, including the services of sub-advisers. The process should review whether the products and services meet the client’s investment goals, have an acceptable performance record, and charge reasonable fees as compared to the market. Firms should ask whether they have addressed the risks and conflicts associated with the products and services and whether they have procedures in place to monitor risks and police any such associated conflicts of interest. The answers to these questions should be documented.

  • Consider assembling a Product or Investment Committee to perform due diligence on investment products and engage representatives from portfolio managers, finance, operations, sales and client service, and compliance to participate.
  • Evaluate the types of products and services the firm offers to determine whether they are appropriate for specific types of clients. Consider developing guidelines for financial advisers, including a recommended list. Recommendations of products should be based on pre-determined guidelines, not on incentives, to mitigate conflicts of interest.
  • Train and supervise advisors to make sure that the recommendations are appropriate.

Recommendation 4

The Form ADV Part 2A should address the following issues, to the extent applicable:

  • The limitations on the advice and products offered. If the adviser only offers proprietary products or products offered by its affiliates, clients should understand why and what this means. If an advisory firm recommends that clients invest in a mutual fund that the firm manages, this should be disclosed, along with an explanation as to how the adviser mitigates conflicts and why the investment is in the best interest of the client.
  • Special incentives. Firms should either expressly prohibit any incentives or rewards that might encourage employees from acting in the best interest of the clients or have processes to mitigate the incentive by ensuring that investments are selected based on the client’s needs and objectives. For example, a mitigating factor could be that the firm’s compensation policy is based on neutral factors tied to the differences in the services delivered to clients and not the amount of payment received in connection with a specific investment recommendation.
  • Investment monitoring. Advisers should address the extent and frequency with which they monitor client investments.
  • Allocation conflicts. Advisers should address how the firm allocates investments among clients, especially limited investment opportunities such as IPOs.
  • Conflicts among clients. The SEC says that “it would be inadequate to disclose that the adviser has ‘other clients’ without describing how the adviser will manage conflicts between clients if and when they arise…” Typically examples of client vs. client conflicts occur when limited investment opportunities are allocated (e.g., some investment opportunities like IPOs are only awarded to institutional clients) and when similarly situated clients pay different fees for the same services (e.g., clients acquired as a result of an acquisition or merger may be subject to different fee schedules).

4. Take a fresh look at your firm’s proxy voting policy

The SEC issued Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, letting advisers know what it expects from advisers that take on proxy voting duties. The SEC made two crucial points in its guidance on proxy voting:

  1. Advisers do not have to accept proxy voting authority.
  2. Advisers that accept proxy voting authority must treat it as a fiduciary obligation.

Some advisers may decide against offering proxy voting services given the time and cost it will take to meet the SEC’s expectations.

The SEC followed up the guidance with two administrative actions against advisers for their proxy voting practices. The SEC found Amadeus Wealth Advisors and Three Bridge Wealth Advisors voted proxies on behalf of clients even though their Form ADV Part 2A brochures explicitly stated that they did not accept proxy voting authority. The Commission found that these actions violated the anti-fraud provisions under Section 206(2) of the Advisers Act. The SEC fined Three Bridge Wealth Advisors $60,000 and Amadeus Wealth Advisors $40,000.

Recommendation 1

Review your investment advisory agreements, Form ADV disclosures, and compliance manual to determine whether these documents reflect the firm’s current proxy voting practices. As noted in the Guidance, an investment adviser is not required to accept the authority to vote client securities and can agree in the investment advisory agreement that the client will be responsible for voting. However, in the case of ERISA clients, if the investment advisory agreement is silent on proxy voting, then the adviser must vote proxies on behalf of the client.[1]

Recommendation 2

Advisers that accept proxy voting responsibilities should review the Proxy Voting Rule (Advisers Act Rule 206(4)-6), the relevant record-keeping requirements in Rule 204-2, and confirm that their policies and procedures address the regulatory requirements. Rule 206(4)-6 requires advisers to:

  • Adopt and implement written policies and procedures (see ISS’ 2020 policy as an example) that are reasonably designed to ensure that you vote client securities in the best interest of clients, which procedures must include how you address material conflicts that may arise between your interests and those of your clients;
  • Disclose to clients how they may obtain information from you about how you voted their securities; and
  • Describe to clients your proxy voting policies and procedures and, upon request, furnish a copy of the policies and procedures to the requesting client.

The record-keeping rules also require that investment advisers maintain:

  • Copies of proxy statement received on behalf of clients (advisers can rely on a third-party service provider or get it from EDGAR);
  • A record of each vote cast by the adviser on behalf of the client (again, advisers can rely on third-party service providers to do this); and
  • Copies of any documents created by the adviser that were material to making the proxy voting decision.

Proxy voting should not be a “one-off” service. Advisers that choose to vote client proxies must develop processes, policies and procedures for proxy voting. At a minimum, this entails:

  • Determining who or which group or persons within the firm has responsibility for proxy voting (e.g., portfolio managers, investment committee, proxy voting committee);
  • Deciding which proxy voting issues are routine and can be voted per a pre-determined policy and which votes require more detailed analysis;
  • Addressing how to deal with potential conflicts of interest;
  • Deciding whether to handle proxy votes in-house or select a third-party service provider to manage the process;
  • Determining limitations on the scope of proxy voting authority, such as only voting on corporate events (like mergers and acquisitions), always voting with management, or not voting proxies where the cost of voting exceeds the benefit to the client (such as foreign securities);
  • Developing a process for ensuring the proxies get voted, including instructing the custodian where proxies should be sent as part of the account opening process; and
  • Periodically verifying that the proxies for client accounts are being voted, and that they are being voted per firm policy.

Recommendation 3

For firms that use proxy voting advisory firms, review the SEC’s advice from the Guidance and confirm that you are performing the following tasks:

  • Perform due diligence on the proxy voting firm.
  • Sample the proxy votes cast as part of the adviser’s annual review of compliance policies and procedures to determine whether the votes are being cast consistently with the firm’s voting policies and procedures.
  • Perform periodic reconciliation between the adviser’s list of client accounts being voted and the list maintained by the proxy voting service.

[1] See Interpretive Bulletin Relating to the Exercise of Shareholder Rights and Written Statements of Investment Policy, including Proxy Voting Policies or Guidelines.

Stay tuned for more advice on how to focus your compliance efforts in SEC’s Top Hits: Investment Adviser Regulatory Review 2019 Part 2.

Recommended Resources

Cash Solicitation and Referrals


Conflicts of Interest and Disclosures

Form CRS and Conflicts of Interest

Private Funds, Hedge Funds and Private Equity

Proxy Voting

Standard of Conduct for Investment Advisers

Photo Credits: Photo by Kyle Glenn on Unsplash

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