compliance survivor: simplifying complex regulatory concerns

Compliance Survivor: Compliance Survivor: Simplifying Complex Regulatory Simplifying Complex Regulatory

ConcernsConcerns

Illinois CPA Society: Investment Advisory Services/Personal Financial Planning Special Interest

Group

June 13, 2006

PRESENTED BY:

James J. Eccleston and Jeffrey M. GershonShaheen, Novoselsky, Staat, Filipowski & Eccleston, P.C.

Copyright 2006 by Shaheen, Novoselsky, Staat, Filipowski & Eccleston, P.C. All rights reserved.

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We are a full service law firm dedicated to senior

executives, business owners and high net

worth individuals.

WHO ARE WE?

Founded in 1960.

A-V Rated by Martindale-Hubbell.

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TRANSACTIONAL / CONSULTING• Business Organization• Mergers & Acquisitions• Succession Planning• Sales & Distribution• Structured Finance• Estate Planning and Probate• Employee Benefits & Executive

Compensation• Tax Planning• Real Estate• Health Care• Securities Law

LITIGATION / TRIAL PRACTICE• Investment Fiduciary• Business Litigation & Appeals• Securities Arbitration &

Litigation• State & Federal Taxation &

Litigation• Employment Relations &

Litigation• Estate & Trust Litigation

OUR PRACTICE GROUPS

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Securities Law and Consulting

We help you implement an effective compliance program…

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Securities Law and Consulting

…so you comply with rules and regulations and defend against regulators.

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Securities Arbitration & Litigation

We arbitrate, mediate and litigate regulatory, compliance, and breach of fiduciary duty matters…

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Securities Arbitration & Litigation

…so you recover investment losses and protect qualified retirement funds.

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Regulatory Issues

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CONFLICTS OF INTEREST• Requirement to disclose material

Conflicts of Interest in a full and fair manner to ensure your clients understand any material Conflicts of Interest before taking action.

Regulatory Issues

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DUTY TO DISCLOSE• Under the Advisers Act, an adviser has

a fiduciary obligation to act in the best interests of its client and to place its client’s interest before its own

Regulatory Issues

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Examples of failure to disclose:• Failing to disclose fees charged to a

client• How fees are charged; whether fees are

negotiable• Failing to disclose an affiliation with a

broker-dealer or solicitors

Regulatory Issues

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Examples of failure to disclose (contd):

• Failing to disclose that the adviser recommends securities to clients in which he has a proprietary interest

• Failing to disclose the risk by having clients invest in private investments (Illiquidity is an issue)

Regulatory Issues

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Examples of failure to disclose (contd):• Failing to disclose the types of products

and services it obtains through “soft dollar” arrangements

• Failing to explain to clients that they pay both a Direct Management Fee to their advisers and an Indirect Fee to their advisers of their mutual fund

Regulatory Issues

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Examples of failure to disclose (contd):• Failing to amend its form ADV on an

annual basis or updating information more frequently when it becomes out of date

• Stating that the adviser does not have custody and possession when in fact it does

Regulatory Issues

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LACK OF INTERNAL CONTROLS

Regulatory Issues

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POLICIES AND PROCEDURES

Regulatory Issues

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REQUIREMENTS• Monitoring employees’

personal trading• Adopting effective or relevant

compliance policies and procedures

Regulatory Issues

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VIOLATIONS• Front-running• Scalping• Trading on non-public

information• Taking investment

opportunities for themselves

Regulatory Issues

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CUSTODY AND POSSESSION

Regulatory Issues

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Record Keeping

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BOOKS AND RECORDS

Record Keeping

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ADVERTISING• Performance based• Adviser Act Rules prohibit

use of testimonials from clients regarding an adviser’s services

Record Keeping

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ADVERTISING• Advisers cannot use any

advertising that contains any untrue statements of a material fact, or which is otherwise false or misleading

Record Keeping

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Record Keeping

FAILURE TO ACCURATELY STATE PERFORMANCE RESULTS

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Record Keeping

PERFORMANCE CLAIMS

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Record Keeping

ADVISORY AGREEMENTS

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Record Keeping

RISK IDENTIFICATION PROCESS

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Record Keeping

EMAIL

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Record Keeping

ELECTRONIC STORAGE

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The SEC’s investor assistance staff received 76,221 complaints, questions, and other contacts in 2005.

SEC Investor Complaints and Questions

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COMPLAINT TYPE

1. Advance Fee Fraud 2,2192. Spam: Unwanted Emails or Faxes 1,1463. Transfer of Account Problems 8444. Account Closing: Problems with

Redemption, Liquidation, or Closing 8415. Manipulation of Securities, Prices, or Markets 7416. Bankruptcy or Issuer Reorganization 7287. Theft of Funds or Securities 6978. Unauthorized Transactions 6539. Account Records: Errors or Omissions 64510. Delivery of Funds or Proceeds 629


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COMPLAINTS AGAINST BROKER-DEALERS ONLY

1. Transfer of Account Problems 6222. Unauthorized Transactions 5333. Account Closing: Problems with

Redemption, Liquidation, or Closing 5184. Account Records: Errors or Omissions 4335. Unsuitable Recommendations 395


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ARBITRATION

CASES FILED

NASD Complaints:Dispute Resolution Statistics

Year Cases

2003 8,945

2004 8,201

2005 6,074

Through

April 20061,800

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CONTROVERSIESINVOLVED IN

ARBITRATION CASES


Type of Controversy

2005

Margin Calls 78

Churning 315

Unauthorized Trading

395

Failure To Supervise 1,828

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CONTROVERSIES

INVOLVED IN

ARBITRATION

CASES


Type of Controversy

2005

Negligence 2,225

Omission of Facts 1,123

Breach of Contract 1,987

Breach of Fiduciary Duty 3,514

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CONTROVERSIES

INVOLVED IN

ARBITRATION

CASES


Type of Controversy

2005

Unsuitability 1,926

Misrepresenta-tion 1,826

Online Trading 7

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SECURITY TYPES

INVOLVED IN

ARBITRATION

CASES


Type of Security

2005

Corporate Bonds 106

Certificates of Deposit 31

Mutual Funds 888

Options 153

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Type of Security

2005

Common Stock 1,348

Limited Partnerships 24

Annuities 460

SECURITY TYPES

INVOLVED IN

ARBITRATION

CASES

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RESULTS OFCUSTOMER CLAIMANT

ARBITRATION AWARD CASES

NASD Complaints: Dispute Resolution Statistics

Year Decided

% of Customer Award Cases

2000 53%

2001 54%

2002 53%

2003 49%

2004 47%

2005 43%

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• Variable Insurance Products• Mutual Fund Share Sales Practices• Electronic Communications• Branch Office Sales Practices• Sales Seminars• Equity Indexed Annuities

Improving Examination ResultsMay 2006: NASD Examination Priorities

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• Private Securities Transactions• Heightened Supervision and Supervisory

Controls• New Products and Non-Conventional

Instruments• Broker-Dealer Self and Affiliate Offerings• Real Estate Investment Trusts

Improving Examination ResultsMay 2006: NASD Examination Priorities

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• Is the account information accurate?

– Update

– Do not just conform to activity

Suitability Revisited

Key Considerations: (Seminar for the Securities Industry Association, Compliance and Legal Division)

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• What is the nature of the account and who initiates transactions?– Control– Conservative presumption for

retirees, widows, trusts and ERISA plans

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• Are the securities being purchased appropriate for the client?– Risk ratings– Product complexity versus client

sophistication– Margin use

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• What is the size of the commitment relative to both the nature of the account and the client’s financial information?– Liquid net worth– Securities concentration



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• How active is the account?

– Risks

– Costs

– Similar results with less risk / activity



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• Does the activity make sense?

– Irrelevant that client agreeable, or

– Account performing well



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• Customer young with a lifetime of earning potential

– Versus actual financial position and needs


Popular Defenses Rejected:

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• Customer wanted it

– Acquiescence irrelevant– Recommendation must be

consistent with financial position and needs



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• Customer informed of all the risks

– Customer must understand the risks

– Customer must be able to bear those risks

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• Customer a sophisticated investor because of college degree

– Rejected



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• Adviser informed customer’s mother, accountant and attorney of recommendation– Irrelevant because duties owed

to customer notwithstanding the awareness of others



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• Children– Education– Support, etc.

• Changes in employment• Retirement• Change in marital status

– Marriage– Death of a spouse– Divorce, etc.

• Declining health

Suitability RevisitedChanging Personal or Financial Circumstances:

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• In short, anything that affects investor’s ability to accumulate or replace assets

Suitability RevisitedChanging Personal or Financial Circumstances:

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• Investment objectives• Investment policy statements• Investment strategies• Asset allocation models• Financial plans

Suitability RevisitedChanging Personal or Financial Circumstances May Require Changes in:

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“Critical Functions”

(NYSE Series 7 Examination Content Outline, 1995)

• 3-5) Considers the tax implications for a customer of particular investments

• 4-9) If there is to be any power of attorney over the account, obtains the necessary documents and approvals

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• 7-1) Routinely reviews the customer’s account to ensure that investments continue to be suitable

• 7-2) Suggests to the customer which securities to acquire, liquidate, hold or hedge

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• 7-3) Explains how news about an issuer’s financial outlook may affect the performance of that issuer’s securities

• 7-4) Keeps the customer informed about the customer’s investments

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Monitoring

• Common problems:– Over-concentration in single position– Large, unrealized gains where

portfolio needs rebalancing– Client changes his situation

• Need new questionnaire• Objectives

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Themes of Mistakes

• Failure to document

• Failure to control

• Digging the hole deeper

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Documentation Mistakes

• Not getting complete financial picture from client

• Allowing parts of questionnaire to go unanswered

• Documenting what the objectives are for the funds you manage

• Advisers filling out the questionnaire

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Avoiding Documentation Issues

• Define the scope of the engagement

– What part of the whole are you responsible for giving advice about?

• Have clients fill out applications and questionnaires in their own writing

• Get all information from client before giving advice

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Problems With Control

• Letting the client control the advice you give

Example: Clients who want to retire young, but have not yet saved enough

Your choices:–Tell clients what they want to hear–Deliver bad news

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Typical Example:

• Someone who is 55 and married just retired from his job and took a lump sum distribution:– Recommend an aggressive asset

allocation to get the numbers to “work”– Tell client “to go back to work and earn

some more money”

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Avoiding This Problem

• Having a research-backed, consistent methodology

• Articulate that methodology in the Form ADV• Follow it with each client, even when it means

saying: “You may want to retire, but you can’t.”

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Handling The Spendthrift Client

• Identifying potential spendthrift clients– Clients with limited earning potential

– Retirees with lump sum distribution

– Heirs and Trust beneficiaries

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• Signs of problems– Living expenses beyond reasonable

levels

– Unwilling to limit expenses or change lifestyle


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• Solving problems– Communication with customer

regarding expenses

– Avoiding growth investing for income model

– Reevaluating client goals and expectations


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• Documenting problems and solutions offered


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Digging the Hole Deeper Or “No good deed goes unpunished.”

• Admitting that a past strategy was not a good idea

• Offering to waive fees or give a discount for poor performance

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Digging the Hole Deeper

• When a client does not have the stomach to take losses, don’t fight him

• Sell a position that is going down and revise the questionnaire to reflect that the client “can’t sleep” with certain investments

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Avoiding Digging the Hole Deeper

• If you and a client no longer have the same ideas about investing, end the relationship

• Document any time that a client took an action against your advice

• Never admit that an investment was a bad idea or a mistake

• Never give a refund/discount for services due to investments performing poorly

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Dealing With A Customer Complaint

• Once a customer has made a written complaint, a reportable event has occurred

• DO NOT meet with the customer or communicate with the customer before speaking to an attorney

• Immediately notify any insurance carrier

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Bond Recommendations (NTM 04-30)

• NASD Study – 60% do not understand that, as

interest rates rise, existing bond prices fall, and that long term bonds are more exposed to this interest rate risk than short term bonds

– 49% do not understand the definition of a “junk bond”

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• NASD requires determining that bond or bond mutual fund is suitable “for investment in general”

Understand:• Terms, conditions, risks and rewards • Credit rating of the bond • Conditions under which the bond issuer

may call the bond or the investor may redeem the bond

• Tax consequences of the product

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• NASD requires that bonds and bond funds recommended must be suitable, regardless of adequate risk disclosure

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– NASD cautions “against relying too heavily upon a customer’s financial status as the basis for recommending particularly risky bonds or bond funds,” because a “customer’s net worth alone is not necessarily determinative of whether a particular product is suitable.”

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– NASD warns that, “Certain high-yield, high-risk products may be suitable for recommending to only a very narrow band of investors capable of evaluating and being financially able to bear those risks.”

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• NASD requires that advisers “present a fair and balanced picture of the risks, costs and benefits” of investing in bonds and bond funds

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– Disclosing the credit rating of the bond is not sufficient, standing alone, because customers must be told “how that [credit] risk might affect the safety of the invested principal”

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– Disclosing interest rate risk, as a concept, is not sufficient, because the NASD requires reps to discuss how “the risk that changes in the interest rates during the term of the bond might affect the market value of the bond prior to the call or maturity date”

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• Additionally, with bond mutual funds, must discuss:– They never mature, so that there is no

guarantee of the return of principal – Ongoing fees and expenses associated

with ownership

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• NASD reminds reps and their firms that “simply providing a prospectus does not cure unfair or unbalanced sales or promotional materials”

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Hedge Fund and Fund of Funds

Due Diligence (NTM 03-07)

• Must ensure that sales promotions provide balanced disclosures of risk and return

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Hedge Fund and Fund of Funds Due Diligence (NTM 03-07)

– Disclosing that hedge funds / fund of funds often engage in leveraging and other speculative investment practices that may increase the risk of loss

– Can be highly illiquid – Are not required to provide periodic

pricing or valuation information to investors

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– May involve complex tax structures and delays in distributing important tax information

– Are not subject to the same regulatory requirement as mutual funds

– Often charge high fees

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• Must perform due diligence to determine that the hedge fund or fund of hedge funds is suitable for any customer

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– Heightened responsibility” to investigate, and “substantial due diligence” to perform

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– Before making a recommendation to any customer, member firms must do at least the following: • Investigate the background of the hedge

fund manager • Review the offering memorandum• Review the subscription agreements • Examine references • Examine the relative performance of the fund

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• Must perform a customer-specific suitability determination – Customer’s wealth is not an indicator

of suitability – Wealth does not provide a basis for

recommending risky investments

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• Furthermore, acting as a placement agent still may bring the firm within the definition of “recommendation”, citing NTM 96-60

– The firm brought the specific hedge fund or fund of hedge funds to the attention of the customer

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Questions ?

NOTICE: The Internal Revenue Service requires us to state that advice contained in this document is not intended or written by the writer to be used, and cannot be used by the reader, for the purpose of avoiding penalties under the Internal Revenue Code.

THANK YOU

JAMES J. ECCLESTON [email protected]

JEFFREY M. GERSHON [email protected]

20 N. Wacker Drive

Suite 2900

Chicago, IL 60606-9719

312.621.4400312.621.0268 (fax)

www.SNSFE-law.com

www.FinancialCounsel.com

Copyright 2006 by Shaheen, Novoselsky, Staat, Filipowski & Eccleston, P.C. All rights reserved.

compliance survivor: simplifying complex regulatory concerns

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