Red Oak Blog
News that affects your business and ours.
Investment Advisers and Suitability
Per the SEC, “As an investment adviser, you are a “fiduciary” to your advisory clients.” Most states do not define registered investment advisers as fiduciaries within their statues, but defer to the fiduciary duty imposed on investment advisers by the SEC. As a fiduciary, registered investment advisers bare a great deal of responsibility.
There are many areas in which registered investment advisers operate that may or not be covered by specific statues. So one might think that if they are, or are not doing something, that they think they should or should not be doing, but there’s no specific Rule or Rules to address the activity, that there are no issues. Well, this is where the fiduciary duty kicks in. Regardless of whether you are registered with the SEC or a State or States, if there is something that you are, or are not doing, and a client is harmed because of the action, or inaction, the regulators will cite you for failing to comply with your fiduciary duty to the client.
In my years as an examiner for a state regulatory authority I found that one of the most common areas in which advisers are deficient is the collection and maintenance of client suitability information. Although the Investment Advisers Act of 1940, and most states’ statutes, do not address or require the collection of suitability information, per an SEC issued interpretive release, “As fiduciaries, investment advisers owe their clients a duty to provide only suitable investment advice. This duty generally requires an investment adviser to determine that the investment advice it gives to a client is suitable for the client, taking into consideration the client’s financial situation, investment experience, and investment objectives.”
As previously stated, most states’ statutes do not contain language to address the collection of suitability either. I repeat most states. It is important to check with the Statutes of the state in which the Adviser is registered to determine if they are bound by State law to obtain, maintain and even update client suitability information. For instance, §116.5(a)(9) Minimum Records of the Rules and Regulations of the Texas State Securities Board require:
“Persons registered as investment advisers whose principal place of business is located in Texas shall make and keep current… For each client, a record listing the client’s: birth year; employment status, including occupation; annual income; net worth, excluding the value of the client’s primary residence; investment objectives; and risk tolerance…. For accounts in existence on the effective date of this section, the investment adviser must obtain the information required in paragraph (9) of this subsection within one year of January 1, 2012, and thereafter must update this information for each client at intervals not greater than 36 months.”
And states that do not have statutes to address the collection of client suitability information will defer to the SEC’s interpretive release.
During my time as a regulator I cited many advisers for not having written suitability information on file for their clients. Almost always they would argue the fact that they brought their clients with them from a previous employer, that they have been clients for years and they know everything aspect of their clients’ lives. As an auditor, I say prove it. If it’s not evidenced in writing, you cannot prove that you know anything. And bear in mind, if you receive a complaint from a client that might have developed dementia, a child who has take over for an ailing parent/client or a beneficiary of a deceased client, you have nothing to show a judge in civil proceeding.
In closing, let’s take a scenario from above. You are a registered representative of a broker dealer. You have a prospect that comes in and decides to engage your services as their adviser. We’ll say this client is in their late fifties. At the time this individual became a client they explain that they have sufficient resources to cover all living expenses and have a substantial amount of money that they wanted to pass down to their children. Based on this fact, they do not have any need to access the assets for 10 or more years, want it to grow substantially, if the markets allow, and tell you that they want to you to employ an aggressive growth strategy with the assets. Ten or so years down the road you decide to start your own adviser. You have the adviser execute an agreement, and transfer their account to your custodian. You do not bother competing a new suitability questionnaire because this person has been a client for many years and you are familiar with every aspect of their financial situation; you know where they work, their income, their net worth, etc.
You continue as the adviser on this client’s account for several more years. One day you receive notice that the regulator under which you are registered has received a complaint from the son of the client. It turns out the client has developed dementia, but you have not noticed because you do not interact with the client regularly enough to notice a change in their behavior. In the process of caring for their parent the son starts looking at their parent’s finances and see that the account which you are managing is invested in aggressive growth equities and carry a great deal of risk. So they took the statements to their local broker dealer branch office to speak with a financial services representative about their parent’s account. The representative is sees the investments and questions the suitability of the investments in the account, and thus you receive the complaint.
Now that the complaint has been filed, the regulators WILL be by to audit your office. They see that you have no suitability information on file for the client; nothing from when the client signed the agreement and nothing to indicate you have been keeping track and updating during the time the client has been with you. Best case outcome in this scenario is that you lose the ensuing civil suit filed by the client’s son, but the regulator takes your word on what happened and puts you on notice that you need to keep written documentation on file for all clients to evidence that you have obtained information to evidence the client’s financial situation, investment experience, and investment objectives, from which you make your recommendations. Worst case outcome is that you lose the civil suit, the regulators do not believe the facts that you present and conduct a thorough exam of your client files, find that you have many clients for whom you do not have written suitability information and find a pattern of what looks like unsuitable activity in the clients’ accounts. Now you’ve lost the civil suit and notice from the regulators that they are filing administrative action against you, which includes a fine and a publicly disclosable reprimand.