New ADV form heightens attention to the issue

March 30, 2011 — 2:19 PM UTC by Les Abromovitz, Columnist

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On Feb. 17, 2011, the SEC imposed remedial sanctions against an Investment Adviser Representative (“IAR”) in Aliso Viejo, Calif., barring that person from working with an RIA for five years. The SEC’s complaint alleged that the IAR employed high-risk investment strategies without disclosing how risky they were. The complaint further alleged that the IAR engaged in those strategies, even though he was aware they were unsuitable for clients with minimal tolerance for risk. The SEC’s complaint charged that the IAR knew these strategies were too risky in view of clients’ age, retirement status, and need for funds in the near future.

According to the SEC’s complaint, the IAR misrepresented that the investments were guaranteed. He also told clients that there was practically no risk involved with his investment strategy.

The lesson here: The SEC cares, a lot, about your investment strategies and how well they match your clients’ profiles. In fact, Item 8 of the new Form ADV Part 2 requires Registered Investment Advisers (“RIAs”) to thoroughly explain the material risks associated with each significant investment strategy or method of analysis they use. With Item 8 fresh in your mind, it is a good time to reexamine the suitability of certain strategies for your clients.

Suitability is always an important part of your fiduciary obligation

As we all know, an RIA’s fiduciary obligation goes well beyond determining whether investments are suitable for a client. Even though it is second nature for IARs to act as a fiduciary, it is still extremely important for them to document that they made a suitability determination for each and every client. Although the Investment Advisers Act of 1940 does not explicitly impose a suitability requirement, RIAs should be able to prove to examiners that the firm’s advice is suitable in view of the client’s financial situation, risk temperament, and investment objectives.

See: The suitability standard, defined and One-Man Think Tank: Would your investment strategy stand up in court?.

State securities regulators also want proof of suitability

State securities regulators also expect to see documentation that you met your duty to only recommend suitable investments. As an example, the South Carolina Securities Division Investment Adviser Examination Program Overview reiterates that examiners will review records relating to suitability. Furthermore, an RIA’s compliance/supervision manual should contain policies and procedures for determining and documenting suitability.

South Carolina’s Examination Program Overview also requires RIAs to maintain written information about each advisory client, which is the basis for making recommendations and giving investment advice to that individual. An RIA must retain adequate information about its customers to document the suitability of recommendations made to them.

Even if risks are disclosed in Form ADV, strategies must still be suitable

If an investor complains to the SEC or the state about the suitability of investments you recommended, a regulator may look first at your new disclosure brochure. For that reason, it is imperative that you provide a detailed description of any significant or unusual risks arising from your methods of analysis and investment strategies. If you recommend a particular type of security, the brochure should explain the material risks involved.

Aside from making sure that you provided full and accurate disclosure of all risks, a regulator will look for books and records showing that your recommendations were suitable. This is accomplished through documentation such as:

• Investment policy statements;

• Client questionnaires and responses;

• Risk tolerance quizzes;

• Correspondence and memos to confirm suitability analysis; and

• Fact sheets detailing investment objectives and other relevant information.

All of these documents must be retained for the period set forth in the Books and Records Rule.

RIAs should document that they asked for updated information during meetings with clients. Although many advisory contracts state that it is clients’ responsibility to notify the firm of changes in their financial situation and investment objectives, RIAs should take steps to ensure that client information is current.

Finish that brochure and focus on suitability

Whether an RIA is describing its investment strategy in advertisements or in the new Form ADV Part 2, the firm should avoid marketing hype and any language that might be construed as a guarantee. It is important to articulate any material risks faced by advisory clients who rely upon your advice. Now that those risks are fresh in your mind, document that you looked at every client’s situation and those strategies are suitable for them.

But first, assuming your fiscal year ended on Dec. 31, 2010, make sure that you’ve filed your Form ADV disclosure brochure by March 31 to diminish the risk of regulatory repercussions. Though regulators may not be satisfied with the content of your brochure, you are at least making a good faith effort to be compliant. When you deliver those brochures to existing clients, you can include a reminder that they should contact you if their investment goals or financial situation change.

Les Abromovitz is a senior consultant with National Compliance Services, Inc. Les, an attorney, is the author of Growing Within the Lines: The Investment Adviser’s Advertising and Marketing Compliance Guide (Available on Amazon.com or through NationalUnderwriterStore.com). He can be reached at 561-330-7645, Ext. 213, or at LAbromovitz@ncsonline.com. He recently wrote for RIABiz on What not to do during a state or SEC audit.


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