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Thursday, August 8, 2019

Risk Alert - Compliance, Supervision, and Disclosure of Conflicts of Interest

By Cory Roberson, Principal of FIN Compliance, Lancer, Ventures
By David McNeal, Contributor of My Compliance Blog 

August 6, 2019.  In a seemingly exhaustive path towards proper record keeping and disclosures, many advisory firms are falling short of communicating its business practices to regulators.

Understandably, many of these disclosure types can be highly subjective.  In addition, compliant disclosures will likely require further examination into an advisor’s business activities through communication passed down from staff in management and compliance working in tandem—not any easy feat.  Oftentimes, smaller firms will have principals that must wear both hats.

Time and time again – some of the largest firms in the U.S. securities industry are rocked with disclosure violations and hefty fines handed down from the SEC, FINRA, and on occasion, even State Securities Regulators (see. “State Street Settles SEC Charges for Adding Undisclosed Markups on Client Expenses”)

State Street, one of the largest custodial firms in the U.S, agreed to pay $88 million to settle claims of overcharging its mutual fund and investment advisory clients for undisclosed expenses associated with its the firm's custodial services.

What is going on

In some cases, the rules on disclosure making can become so cumbersome or subjective that 100% compliance becomes an elusive feat for firms – even those with ample resources like state street.

Over the last two years, the SEC engaged in a broad sweeping crackdown on similar issues, including disclosures related to the disciplinary history associated with many of its registrants.  

In September 2017, the SEC Office of Compliance Inspections and Examinations (“OCIE”) adopted a “Supervision Initiative”1, a series of examinations to assess the oversight practices of SEC-investment advisers which previously employed, and/or currently employ, any individual with a history of disciplinary events.

This action focused on each advisors’ protocols in certain areas, including compliance programs and supervisory oversight practices, disclosures, and conflicts of interest. The initiative identified a variety of observed deficiencies.

Many of these shortcomings related to disclosure issues, including undisclosed conflicts of interest.

A Look into Disciplinary History

Advisers were identified for examination through a review of information about disciplinary events and other legal actions involving supervised employees under each firm.

The information analyzed included legal actions that are not required to be reported on Form ADV (e.g., private civil actions).2

In aggregate, of the more than fifty audits performed on advisors, firms managed approximately $50 billion in assets for nearly 220,000 clients, the vast majority of whom are retail investors.

The examinations did not focus solely on supervisory practices of individuals with prior disciplinary histories, but rather on the importance of those practices in relation to the management and the firm’s overall compliance culture.

Reviews included:

1 - The staff reviewed whether compliance policies and procedures were reasonably designed to detect and prevent violations of the Advisers Act by the firm and its supervised persons, with a particular emphasis on practices covering the activities of previously-disciplined individuals and their prior events.3(4) 

2 - Additionally, staff focused on whether disclosures in public statements or documents (e.g., marketing materials) and filings were complete and fair, included all material facts, and were not misleading.5  

3 - Finally, the staff assessed whether the adviser identified, addressed, and completely disclosed all material conflicts of interest that could affect the advisory relationship, particularly those conflicts dealing with compensation arrangements and account management.6.

Findings – Disciplinary Events, Fees, and Conflicts of Interest

The OCIE staff observed that many advisers failed to adopt and implement compliance policies and procedures that addressed the risks associated with employing individuals with prior disciplinary histories.

Notably, several advisers had adopted policies and procedures that were inconsistent with their actual business practices and disclosure guidelines.

For example, advisers did not have processes reasonably designed to determine:

1- Whether supervised persons’ self-attestations completely and accurately described disciplinary events.

2- Whether supervised persons’ self-attestations truthfully disclosed reportable events or recent bankruptcies at all (see “CFP Board Snafu”).


3 - Adequate annual compliance review processes.  Annual reviews that were examined were insufficient because the firms failed to adequately document supervised persons reviews and appropriately assess the risk areas applicable to its own firms or attempt to identify any risks at all.

Fee Disclosure Violations are commonplace

The study also revealed the categories which commonly showed the most inconsistent compliance practices, involved areas addressing commissions, fees, and expenses.

(e.g., solicitation fees, management fees, compensation related to hiring personnel, and oversight of firm compensation practices, including such practices within branch offices).

Conflicts of Interest from undisclosed compensation:

Several advisers had undisclosed compensation arrangements, which resulted in conflicts of interest that could have impacted the impartiality of the advice the supervised persons gave to their clients.

For example, some of these advisers did not disclose that:

1 - Forgivable loans were made to the advisers or their supervised persons. Furthermore, the terms of which were contingent upon certain client-based incentives that may have unduly influenced the investment decision-making process, resulted in higher fees and expenses for the affected clients, or both.

2 - Supervised persons were required to incur all transaction-based charges associated with executing client transactions, which created incentives for the supervised persons to trade less frequently on behalf of their clients.

Findings Specific to Disciplinary Histories:

The staff observed that nearly half of the disclosure-related deficiencies of the entire panel of advisers examined were due to the firms providing inadequate information regarding disciplinary events.7

Some examples are:

1 - Omitted material disclosures regarding disciplinary histories of certain supervised
persons or the adviser itself due to the firm’s reliance on these supervised persons to self-report to the firms’ information about their required disclosures (ref “CFP Board snafu”).

2 - Incomplete, confusing, or misleading information regarding disciplinary
events.  For example, a firm did not include the total number of events,
the date for each event, the allegations, or whether the supervised persons were found
to be at fault (i.e., whether fines, judgments or awards, or other disciplinary sanctions
were imposed).8

3 – Firms did not timely update and deliver disclosure documents to clients, such as updating Form ADV for new disciplinary events of supervised persons reported on CRD (e.g. Form U5s).9
OCIE’s Best Practices for improvement of compliance and disclosure policies and procedures:
Much of the compliance and supervisory deficiencies observed with this panel of advisers may help other firms address the weaknesses discussed above.
Advisers that may hire or employ supervised persons with disciplinary histories in the future, or that have not already adopted a successful compliance program, may want to consider additional considerations not covered within this analysis.  These can include:

1 - Adopting written policies and procedures that specifically address what must occur prior to hiring supervised persons that have reported to the adviser disciplinary events.
2 - Enhancing due diligence practices associated with hiring supervised persons to identify disciplinary events. Through this evaluation, it was confirmed that firms with written hiring policies and procedures, more consistently included: (1) conducting background checks (e.g., the firms confirmed employment histories, disciplinary records, financial background and credit information), (2) performing internet and social media searches, (3) fingerprinting personnel, (3) utilizing third parties to research potential new hires, (4) contacting personal references, and (4) verifying educational claims.

In addition, some advisers:

- Requested that potential new hires provide the firm with copies of their Form U5s, where applicable.

- Reviewed new hires’ Form U5 filings 30 or more days after they are hired (this type of procedure may identify termination notices the new hire did not disclose that were filed after the hiring decision was made), when applicable.

- Initially checked CRD/IARD for supervised persons’ filings and re-checked the filing information after a designated period of time, such as three months later.

3 - Establish heightened oversight practices for supervised persons with certain disciplinary histories. The staff observed that many of the advisers had not adopted supervision practices or compliance procedures that addressed the risks of hiring people with previous disciplinary history (e.g., disciplinary history relating to misappropriation, unauthorized trading, forgery, bribery, and making unsuitable recommendations). 

The examined advisers who had written, and implemented policies and procedures specifically addressing the oversight of supervised persons with disciplinary histories were far more likely to identify misconduct by supervised persons than advisers without these written protocols.

4 - Adopt written policies and procedures addressing client complaints related to supervised persons. The staff observed that advisers with written policies and procedures addressing client complaints regarding their supervised persons were more likely to have reported the receipt of at least one such issue related to their supervised persons.  In addition, these advisers were consistently more likely to escalate matters of concern raised in these complaints than advisers without written protocols.

5- Include oversight of persons operating out of remote offices in compliance and supervisory programs, particularly when supervised persons with disciplinary histories are located in branch or remote offices.
Summary of thoughts from the SEC:
The examinations within the scope of this review resulted in a range of actions. In response to the staff’s observations, some advisers elected to amend disclosures, revise compliance policies and procedures, or change other practices.
In light of the findings from this investigation, there are far too many compliance issues that are not being met. It is vital to the integrity of our industry, and the clients we represent that advisors are doing their due diligence to identify risks associated with hiring, and employing persons with disciplinary history, and advising them of appropriate procedural conduct specific to their history.
Furthermore, compliance policies and procedures should be drafted and implemented that are unique to every firm. Full and truthful disclosure of facts within a supervised persons disciplinary record, as well as an advisors record, should be appropriately documented and reviewed at necessary intervals to avoid mis-management and rogue activities.
Finally, advisors must commit to following through with their implemented policies to maintain the standards set forth in the Advisers Act, and to avoid the unacceptable problems that have been identified through this initiative’s efforts.
In conclusion, the OCIE encourages advisers when designing and implementing their compliance and supervision frameworks, to research the regulations within the Advisers Act, to consider the risks presented by, as well as the disclosure requirements triggered by, the hiring, and employing of supervised persons with disciplinary histories, and adopt policies and procedures to address those risks and disclosure requirements while improving upon their supervisory practices and compliance programs.

1. See NEP Risk Alert: Examinations of Supervision Practices At Registered Investment Advisers (Sept. 12, 2016). For
purposes of the Supervision Initiative, and as referenced in this Risk Alert, “supervised persons” include principals and officers of the adviser, and other individuals performing services on behalf of the adviser (other than clerical), regardless of whether these individuals are independent contractors or employees of the adviser. See also Investment Advisers Act of 1940 (“Advisers Act”) Section 202(a) (25) (defining “supervised person”).
 2. See Form ADV, Part 2A, Item 9 and Part 2B, Item 3 (Disciplinary Information). All registered advisers must promptly
disclose any legal or disciplinary events that would be material to a client’s or a prospective client’s evaluation of the adviser’s integrity or its ability to meet its commitments to clients. See also Advisers Act Rules 204-3(b) (4) and 204(2)(a)(14)(iii).
3 Advisers Act Rule 206(4)-7. Section 203(e)(6) of the Advisers Act also highlights that establishing supervisory procedures
reasonably designed to prevent and detect such violations and following these procedures are important steps an adviser should take in supervising persons subject to its supervision. The Commission has brought enforcement actions against advisers that did not adopt or implement any policies or procedures regarding their supervision of certain personnel. See, e.g., In re James T Budden and Alexander Budden, Advisers Act Release No. 4225 (Oct. 13, 2015) (settled).
4 See, e.g., SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963) and Amendments to Form ADV, Advisers Act Release No. 3060 (Jul. 28, 2010) (“as a fiduciary, an adviser has an ongoing obligation to inform its clients of any material information that could affect the advisory relationship”). See also General Instruction 3 to Form ADV, which states that “[u]under federal and state law, [an adviser is] a fiduciary and must make full disclosure to [its] clients of all material facts relating to the advisory relationship.”
5 An adviser’s obligation as a fiduciary is enforceable through Advisers Act Section 206. As fiduciaries, advisers must
provide full and fair disclosure of all material facts to their clients and prospective clients. Also, it is unlawful for advisers to make untrue statements or omit any material facts in applications or reports filed with the Commission (Advisers Act Section 207) or to have advertising (as defined in Advisers Act Rule 206(4)-1) that is false or misleading or that contains any untrue statement of a material fact.
6 Advisers Act Section 206. Also, General Instructions to Form ADV, such as General Instruction 3, state that an adviser’s
disclosure obligation “...requires that [the adviser] provide the client with sufficiently specific facts so that the client is able to understand the conflicts of interest [the adviser has] and the business practices in which [the adviser] engage[s], and can give informed consent to such conflicts or practices or reject them.”
7 All registered advisers must promptly disclose in Form ADV certain legal or disciplinary events that would be material to a
client’s or a prospective client’s evaluation of the adviser’s integrity or its ability to meet its commitments to clients. See Amendments to Form ADV, Advisers Act Release No. 3060 (Jul. 28, 2010). See also generally, Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Advisers Act Release 5248 (June 5, 2019).
8 See Form ADV, Item 11 and Criminal Disclosure Reporting Page (DRP), which requires advisers to report details regarding certain disciplinary events
9 See General Instructions to Form ADV, which specifies that an adviser must promptly file an “other-than-annual
amendment” to its Form ADV when certain information becomes inaccurate in any way, including reportable disciplinary events. CRD (Central Registration Depository) is a database maintained by FINRA. It is used to store and maintain information on registered broker-dealers and their associated individuals. Many supervised persons of advisers are representatives of both broker-dealers and advisers
10 Advisers Act Rule 206(4)-1

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FIN Missions ( provides business support group sessions for other entrepreneurs.  In addition, Cory has volunteered for more than fifteen youth programs in locations such as like S. Korea, China, S. Africa, Thailand, and India.

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