Overview of Priorities for Retail investors

Overview of Priorities for Retail investors


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Full video transcript available below:

Hello and thank you for joining today's webinar Best Practices to Master an SEC Exam. Our presenters today join us from Northpoint Compliance, Victoria Hogan and Colleen Montemarano.

Great, thank you, Joe. The 2018 Priorities came out, perhaps you have read them, and there were a number of topics addressed in these priorities, and we'll be reviewing those topics today that are most directly applicable to the investment adviser community. This year, just as last year, there was a large focus on retail investors, with a number of subtopics many of which we'll discuss today, and then we will go ahead and discuss cybersecurity and anti-money laundering program, which also appear on the 2018 Priorities.


While we discuss the priorities, we'll also going to be giving you and inserting tips regarding your policies and procedures and also some ideas on how you can test and review different elements of your compliance program based on the topics. So, Joe, we can see the next slide.


Okay, so as I said before, retail investors was the main focus on the 2018 priorities, and listed here are the subtopics that we're going to discuss today. Many of these are not new, and they don't come as much as a surprise as they've been seen on priorities from last year. They've been found in a risk alert and also published by the SEC and IM guidance documents.


Three topics are fond to retail investors. I just want to make mention now that we're not going to discuss because we feel they would be applicable to fewer of the attendees, but we just have to mention them, would be municipal advisers and underwriters, is also a topic under retail investors, fixed income order execution, another topic, and third, that we won't be discussing, but would like you to know about is, cryptocurrency and market trading in such securities. While these are all interesting topics, I mean, for me particularly with respect to cryptocurrency, it's particularly not relevant to most of the listeners, I imagine. But we still just want to bring them to your attention.


We're going to move one to our first polling question, and the polling question is, "Does your current advisory firm provide products and services to retail investors?" And you can select one, either "no," "yes, over 50% of the number of clients are retail investors," "yes, but less than 50% of the number of clients are retail investors," or "you're not sure."


Okay, so we have the results in and 43% of the firms, of the participants say that they do not have retail investors. 27% say over 50% of the number of clients are retail investors. Less than 50% say that they do have retail investors, but it's less than 20%, and 11% of the audience are not sure if they have retail investors. So, it looks to me that we have about 47% with retail investors, 42% without retail investors. While every dollar an adviser has to manage and is under their fiduciary duty, whether it's from a retail investor or an institutional investor, it should be kept safe of course, and invested appropriately, we've always had as ex-former examiners at the SEC and also now as consultants, we do have increased compliance sensitivity with respect to retail investors. Each dollar for a retail investor could mean more in terms of the percentage about retail investor compliance for the last [inaudible 00:07:01]. There's the sense that retail investors could potentially be less sophisticated investors, and also more susceptible to fraud. So, this is likely why in the 2018 Priorities there was such an emphasis, again, on retail investors, so.


Moving on to the next slide, so we can talk a little bit more in-depth about retail investors. So the SEC ... Listed here are four bullet points that the SEC pulls out with respect to retail investors. We can first of all, expect the SEC to scrutinize the products and services that are provided to retail investors by your firm. The SEC would expect for retail investors there to be a diversification of assets in the portfolio, and they've also wouldn't expect portfolios that contain some exotic securities that may not be [inaudible 00:07:58] by clients. Now, I'm making generalizations here, but for the most part, this would be something, if I'm an SEC examiner I would expect to see the products and the services offered and the types of securities that are in a retail investor account.


So a test that you could do as a CCO, if you are the CCO of your firm, is that if you run a list, like a security cross-reference list of all holdings at your firm, you can isolate those products or those securities that are not necessarily vanilla, and then you can find out, "Okay, why is this product holding at our advisory firm? And is it held by a retail account?" And if so, has the appropriate disclosure been made to investors about the product? Have they been educated with respect to the product or the security? And then also, has the appropriate disclosure about the risk of investment investing in that product been made? That's a test that you can do. Start with just a holdings report, and make sure that if they're is an investment in a security or in a product that is not quite vanilla, that all the rest of disclosures are made to those retail clients.


You also want to look at your policies and procedures. You want to make sure that if any unique products are held, that these are reviewed by the CCO and in no situations you would have appropriate backup to show the rationale for investing in that type of product for the client or that type of security. This is important because is questioned by the SEC or if the investment, for example, or with a service or a product were to go south and not get the investment returns that were expected, you already created documentation with respect to your rationale for investing. This is good. Again, it's questioned by the SEC you can provide this or if you have a client that is not so happy with the investment performance, you have proof that they were educated about the investment and proper disclosure was made.


The next bullet point with respect to retail investors and that would also set forth in the OCEI 2018 Priorities is the disclosure of the cost of investing. This is also a focus area during SCC examination. Again, this is really nothing new, but the SCC did highlight this. You want to all of the costs of investing and there's a number of different elements with respect to cost, and ensure that they're disclosed and that they're done with consistency between your ADV, your website, in the management agreements and any other documents that you're firm produces.


A test here, which respect to the cost of investing is, if I were the CCO I would start with the firm's income statement and look at all of the sources of income, understanding the nature of the income and then making sure that any income did present a conflict of interest or did come from clients that we know that it needs to be disclosed on the ADV and elsewhere. Another thing that I would do is check the trade blotter to look and perhaps some [inaudible 00:11:18] as well or trade confirmation, and look to see what's commissioned and other transactions these are to make sure that those are also appropriately being disclosed on the form ADV.


Another test would be. There a number of tests, but a final test that I'd like to add here is you can interview some of the embedded costs of the products that you're offering or the securities that you're recommending to clients, such as the cost of different insurance contracts and the embedded cost in mutual funds, what the expenses are and of ETF, as well.


With respect to your policies and procedures and under the topic of disclosure of the cost of investing, one thing you can do is you can implement an employee questionnaire to make sure that employees are reporting all of their sources of income. So, examples would be, if an employee of yours is perceiving a cash fee for recommending a third-party investing adviser to a client. I mean, this is something as the CCO you should know, but when you require employees to fill out a questionnaire and having signed it, something that may have been missed could be revealed during this questionnaire process.


Also, you can request in this questionnaire any fee, something earned as register representative, and then dabble a little bit further in the nature of such fees, just to make sure you have proper understanding that you can make sure your properly communicating that to your ADV and other disclosure documents.


And here in your questionnaires you can also ... We're going to speak about conflicts of interest, next, in retail investors, but you can also list the information with respect to conflicts of interest in your questionnaires, as well, such as any outside business activities and income derived in that way, and if any of that income derives from clients, for example. That could be a potential conflict of interest you might need to disclose.


So, next on the slide is the disclosure of conflicts of interest. Remember, even I you earn a fee solely based on assets and the management your [inaudible 00:13:25] adviser, we see this often. Our clients [inaudible 00:13:29] to see in the investment, as a community, we see that advertisers, "Oh, hey! We're conflict-free. We have no conflicts because we only earn an advisory fee," but we always advise to stay away from that because there are still ... while they might not be as the same, necessarily ... where you have a register rep signing an investment product where there could be a difference in the amount of money that's earned by the representative depending on the product. You really can't say that you're conflict-free because you still have an incentive to spend more time on a higher-paying account, potentially invest in riskier investments if the goal is increasing your [inaudible 00:14:07] management. And so just to receive a fee is a conflict that you should disclose, and also, please, again, with just a little bit of a warning, we also tell our advisers, "you're really not conflict-free. There might be [inaudible 00:14:22] conflicts. Just because you're a [inaudible 00:14:25] adviser does not make you free from conflicts with respect to the cost of investing.


Earning a commission to sell a product and [inaudible 00:14:33] a client a higher commission product is common, and it's an obvious conflict, so of course, I just have to say, make sure it's fully disclosed. We even see in client-investment management agreements an acknowledgement by a client of the fact that they understand that their financial adviser, or their representative earns commissions on the different products, which will fund variable insurance contracts and such, and that they understand there's conflict. This has become ... for the adviser too, it becomes in a sense, like a [inaudible 00:15:08], so that if that client or a purchase [inaudible 00:15:11] you have this big conflict, "and I would never have invested in X, Y, Z product had I known," you can then say, "look, we informed you. We educated you. In fact, you even acknowledged that you understood that we were receiving fees." So we always think of this is as like the next step of best practices and recommends to our clients.


And also, of course, be sensitive with respect to the appropriateness of the share class that you're recommending. As the CCO that's something that should absolutely be on your radar, to review and make sure that you where there's an opportunity to invest in different share classes in mutual funds that appropriate share class is being recommended.


Number two, some conflicts can be a little bit more innocuous. For example, even if an adviser were to recommend a private fund to a client and then in that same private fund if an employee wanted to invest an account [inaudible 00:16:10]. So, say you need a million dollars to invest in a private fund but for employees you only need 500,000, that would be of conflict somewhat, so, I try to bring to your attention that there are some conflicts that are really innocuous, so we also recommend that advisers from a conflicts [inaudible 00:16:25] they can brainstorm these more as [inaudible 00:16:29] to have a conflict and make sure that they're disclosed.


Finally, I'll just describe the calculation of fees charged to advisory clients. We have advisers and clients that will hire an intern or save themselves to find somebody on staff to go ahead and do a review of all fees charged and to make sure that they are appropriate for a certain time period. And, even though as advisers of the best compliance programs, seem to come back and find that there was a miscalculation. So, something you can do and on a test basis that you can include this in your ongoing testing review process if you take some management agreements and look at the methodology, ake sure that the evaluation on which you're calculating your advisory fees was properly disclosed and is proper. So, test this account and document your tests, of course.


One thing I want to bring to your attention, again, is to be sensitive to all older accounts that might have had a different fee ten years ago from your standard fee schedule that you're using now. And also remember to check anytime you bring a new client on, the fee that is charged for that first, let's say, quarter, of managing their assets. Any time there's a terminated account, that you're reviewing any pro-rata fee or pro-rata calculation that's made of advisory fees.


This webinar was co-hosted with Victoria Hogan and Colleen Montemarano of NorthPointCompliance.com

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