Examining Regulatory Risk

Among the SEC’s enforcement priorities is the new marketing rule

Journal of Financial Planning: September 2022


Ken C. Joseph, Esq. is a managing director and head of the Financial Services Compliance and Regulation practice for the Americas at Kroll, LLC.  He is also a fellow of the Kroll Institute, providing thought leadership on a variety of financial services and regulatory matters, as well as head of the firm’s Cryptocurrency Task Force. Ken focuses on serving clients who need informed and proven strategies to successfully navigate a broad spectrum of threats arising from investigations, compliance examinations, litigation, and crisis scenarios.

Anna Povinelli is a managing director in the Financial Services Compliance and Regulation practice at Kroll, LLC. She is a trusted adviser to a number of wealth advisers and investment advisers, hedge funds, and PE firms, and is relied upon to identify issues and craft practical solutions.

Almost two years into the chairmanship of Gary Gensler, the Securities and Exchange Commission (SEC), and sister regulators, have provided a clearer picture of their regulatory agenda and compliance philosophy relating to financial advisers of all stripes. In many respects, financial planners and advisers are operating in an environment where the regulatory risk has increased, and the financial and reputational costs of non-compliance with applicable securities rules, regulations, and policies have had a significant impact on individual advisers and on their supervisors and firms. The SEC will continue the push to hold gatekeepers accountable for securities law violations. The regulator’s agenda is informed by its increased ability to triage tips, complaints, and referrals and to use data analytics to identify potential wrongdoing.

In this article, we will share our insights regarding the areas that we believe pose the highest regulatory and compliance risks to financial advisers (FAs) and to provide guidance on the basic “blocking and tackling” techniques that can be applied to mitigate the most negative consequences if caught in the regulatory crosshairs.

Marketing, Solicitation, and Electronic Communications

In May 2021, the SEC adopted amendments to the Investment Advisers Act of 1940 regarding marketing. Advisers have until November 4, 2022, to implement Rule 206(4)-1. A provision of the new marketing rule that many advisers find appealing is the allowance of testimonials and endorsements in advertising. However, disclosures are required regarding compensation and conflicts of interest relating to those providing the testimonials and endorsements—and the material accuracy of such information is of paramount importance. Compensation can be direct or indirect cash or non-cash compensation. The new marketing rule defines non-cash compensation very broadly and can include such items as reduced advisory fees, fee waivers, directed brokerage, sales awards, gifts, and entertainment. The adviser must also enter into a written agreement with the person providing the testimonial or endorsement unless they are an affiliate or receiving $1,000 or less. Testimonials and endorsements are still subject to the anti-fraud provisions of the securities laws and must be materially accurate and complete.

Electronic communications gained notoriety this year with headlines about SEC enforcement of a large broker–dealer for widespread failures by employees to maintain and preserve written communications. The fine of $125 million and admission of wrongdoing was a hefty price and enough to gain the attention of industry leaders. Advisers have recordkeeping obligations and are required to ensure that all business communications are appropriately recorded and only conducted on platforms approved by advisers and captured within the books and records of such advisers. It has been challenging for many firms with the advent of texting, applications, and other communication platforms whereby such business communications cannot be captured, retained, and reviewed by the adviser. Advisers have a duty and are required to either find methods to capture such communications or prohibit their use for business purposes.

Fiduciary Duty—Undivided Loyalty and Duty of Care Owed to Clients

The SEC’s regulatory actions have continued to reiterate the core fiduciary duty owed by financial advisers to their clients, which has been the paramount obligation and at the center of training of FAs. Yet, violations of this deceptively simple standard continue to result in numerous SEC enforcement actions and examination deficiencies where investment advisers are alleged to have misused or misappropriated client assets, misrepresented or omitted material information to clients, misallocated expenses to client accounts, “cherry-picked” investments for themselves or favored clients, failed to disclose compensation paid to the adviser, fabricated account statements to clients, failed to perform adequate due diligence on investments and sub-advisers, failed to adequately monitor client accounts, misvalued client assets, failed to safeguard client information, “reverse-churned” wrap fee accounts, and failed to disclose and mitigate conflicts of interest—to name a few. Financial advisers have been charged with fraud violations, paid millions in monetary penalties and reimbursements to investors, and in some instances barred from segments of the financial services industry for both intentional and unintentional misconduct.

Conflicts of Interest—Many Forms and Flavors

Clients and regulators alike demand high standards. Integral to fulfilling the fiduciary duty is conflict identification, disclosure, and mitigation. Conflicts of interest, in their many forms, must be disclosed to actual and prospective clients in regulatory filings such as Form CRS, Form ADV 2A, in marketing literature and client presentations, and on a firm’s website, for example. However, disclosure goes beyond handing a client a document; disclosure of conflicts should be woven into the conversations advisers have with their clients. Examples of situations to consider when identifying where conflicts can arise are, but not limited to, management fees received, commissions, additional fees charged on certain investment products, an adviser’s ownership interest in investment entities or products related to an investment recommendation, economic benefits received from vendors and custodians, referral arrangements, and more.

Another area that gives rise to conflicts of interest is outside business activities. There are situations where advisers serve on boards of directors or as trustees, have financial interest in private investments or vendors who supply services to clients, and in insurance agencies, tax advisory, bill-paying and concierge service firms, for example. These outside activities may be in the adviser’s financial interest and may also result in some efficiencies when advising clients, but there should be no doubt providing such ancillary services without full and fair disclosure to clients would spark regulators’ interest and call into question whether the adviser can truly fulfill the client’s best interest in light of the adviser’s financial interest in the potential recommendations.

The SEC is hypervigilant on ensuring advisers meet their disclosure obligations to clients and prominently provide disclosures to ensure that clients have the information necessary to make informed decisions about the relationships with their financial advisers.

Fees and Expenses—a Fruitful Area for SEC Enforcement and Examination Activity

During an exam, expect the SEC to “follow the money.” In that regard, we cannot underscore the importance of disclosing all fees and expenses that the client will incur in connection with the advisory relationship, as well as adviser compensation and benefits in all its forms that derive from that relationship. Omitting or misrepresenting disclosures of fees and expenses for a particular investment could distort the investment decision and impact the performance of such investment. It is also important that the adviser’s compliance program is reasonably designed to detect and prevent fee and expense calculation and allocation errors, that periodic testing is conducted and documented to confirm whether the adviser is following obligations outlined in client agreements, that clients are paying appropriate management fees, getting the benefit of fee discounts, offsets and rebates, and that departed clients are not overcharged because of the adviser’s failure to rebate fee advances.

The SEC has indicated that it will examine the types of holdings in wrap account programs and, as trading commissions have been reduced to zero by many executing brokers, whether wrap programs are still in the best interest of clients. As it relates to mutual fund share class selection, will an adviser select no-transaction fee shares at a higher cost, or will the adviser collect Rule 12b-1 fees? The SEC has remained sharply focused on the types of fees charged to mutual fund shareholders and the revenue sharing practices of mutual fund advisers and their affiliates. Disclosure of affiliated broker–dealers and the revenue earned by such affiliates must be disclosed to clients, especially as it relates to Rule 12b-1 fees and the additional compensation to be received as a result of that class of mutual fund.

DOL’s Fiduciary Focus—More Rules to Follow

In addition to the long-standing SEC concerns over fiduciary duty compliance, the Department of Labor issued the fiduciary rule adopting the Prohibited Transaction Exemption 2020-02, which requires advisers to document the analysis of a retirement asset rollover recommendation and why it is in the best interest of the client. Clients must be provided with the adviser’s acknowledgment of fiduciary duty, a detailed rollover analysis that identifies all fees and expenses for the existing and proposed transaction, and a comparison of conditions between the existing and proposed transaction. Accessing a plan’s Form 5500 can provide helpful information to identify fees and expenses for certain 401(k) and other retirement assets. Clients must acknowledge the review and receipt of such analysis prior to the adviser executing the retirement asset rollover.

Investment Due Diligence and Suitability

Investment recommendations using model portfolios are increasingly being used by advisers on behalf of clients. It is imperative that both client and adviser not only understand the assumptions that go into creating hypothetical models but to also confirm hypothetical fees and expenses have been included in order to assess hypothetical performance. This information is crucial in evaluating whether an investment in a hypothetical model is in the best interest of the client and if hypothetical performance is truly reflective.

As daunting as complying with regulations is, the mission of protecting investors and preventing fraud should be a goal shared by all investment professionals. Compliance should be the core of a firm and its advisers’ DNA. After all, the provision of advisory services is based on trust, duty, disclosure, and confidence—a special bond that is backed by an ever-vigilant regulator that holds advisers and their supervisors accountable. 


Ten Compliance Questions for Financial Advisers and Planners

  1. Have you complied with the firm’s code of ethics obligations and certified as to outside business activity, securities holdings and transactions, and actual or potential conflicts?
  2. Are you using approved marketing documents in communications with clients that have been vetted for accuracy and completeness and contain appropriate risk disclosures?
  3. Have you fulfilled initial and ongoing due diligence on recommended investments and on sub-advisers?
  4. Have all material conflicts, especially those involving affiliates, been identified and disclosed?
  5. Have you disclosed all forms of compensation that you are entitled to obtain as a result of the client relationship?
  6.  Have you complied with the requirements of the SEC’s custody rule, which is targeted to protecting the safety of client assets?
  7. Has the firm followed its policies and disclosures when valuing client assets, especially in situations where management fees are based on periodic asset value?
  8. Have the adviser and the firm taken appropriate steps to handle accounts of elderly retail clients, especially those who may be considered unsophisticated investors or who are vulnerable?
  9. Has the firm reviewed wrap accounts for suitability and reverse churning activity?
  10. Are you using approved modes of communications that comply with the firm’s books and records obligations to communicate with clients?
Professional Conduct & Regulation
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