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Compliance Survivor: Simplifying Complex Regulatory Concerns

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  • 1. Compliance Survivor: Simplifying Complex Regulatory Concerns Illinois CPA Society: Investment Advisory Services/Personal Financial Planning Special Interest Group June 13, 2006 PRESENTED BY: James J. Eccleston and Jeffrey M. Gershon Shaheen, Novoselsky, Staat, Filipowski & Eccleston, P.C. Copyright 2006 by Shaheen, Novoselsky, Staat, Filipowski & Eccleston, P.C. All rights reserved.
  • 2. 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.
  • 3.
    • 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
  • 4. Securities Law and Consulting We help you implement an effective compliance program…
  • 5. Securities Law and Consulting … so you comply with rules and regulations and defend against regulators.
  • 6. Securities Arbitration & Litigation We arbitrate, mediate and litigate regulatory, compliance, and breach of fiduciary duty matters…
  • 7. Securities Arbitration & Litigation … so you recover investment losses and protect qualified retirement funds.
  • 8. Regulatory Issues
  • 9.
    • 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
  • 10.
    • 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
  • 11.
    • 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
  • 12.
    • 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
  • 13.
    • 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
  • 14.
    • 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
  • 15.
    • LACK OF INTERNAL CONTROLS
    Regulatory Issues
  • 16.
    • POLICIES AND PROCEDURES
    Regulatory Issues
  • 17.
    • REQUIREMENTS
    • Monitoring employees’ personal trading
    • Adopting effective or relevant compliance policies and procedures
    Regulatory Issues
  • 18.
    • VIOLATIONS
    • Front-running
    • Scalping
    • Trading on non-public information
    • Taking investment opportunities for themselves
    Regulatory Issues
  • 19.
    • CUSTODY AND POSSESSION
    Regulatory Issues
  • 20. Record Keeping
  • 21.
    • BOOKS AND RECORDS
    Record Keeping
  • 22.
    • ADVERTISING
    • Performance based
    • Adviser Act Rules prohibit use of testimonials from clients regarding an adviser’s services
    Record Keeping
  • 23.
    • ADVERTISING
    • Advisers cannot use any advertising that contains any untrue statements of a material fact, or which is otherwise false or misleading
    Record Keeping
  • 24.
    • FAILURE TO ACCURATELY STATE PERFORMANCE RESULTS
    Record Keeping
  • 25.
    • PERFORMANCE CLAIMS
    Record Keeping
  • 26.
    • ADVISORY AGREEMENTS
    Record Keeping
  • 27.
    • RISK IDENTIFICATION PROCESS
    Record Keeping
  • 28.
    • EMAIL
    Record Keeping
  • 29.
    • ELECTRONIC STORAGE
    Record Keeping
  • 30.
    • The SEC’s investor assistance staff received 76,221 complaints, questions, and other contacts in 2005.
    SEC Investor Complaints and Questions
  • 31.
    • COMPLAINT TYPE
    • Advance Fee Fraud 2,219
    • Spam: Unwanted Emails or Faxes 1,146
    • Transfer of Account Problems 844
    • Account Closing: Problems with Redemption, Liquidation, or Closing 841
    • Manipulation of Securities, Prices, or Markets 741
    • Bankruptcy or Issuer Reorganization 728
    • Theft of Funds or Securities 697
    • Unauthorized Transactions 653
    • Account Records: Errors or Omissions 645
    • Delivery of Funds or Proceeds 629
    SEC Investor Complaints and Questions
  • 32.
    • COMPLAINTS AGAINST BROKER-DEALERS ONLY
    • Transfer of Account Problems 622
    • Unauthorized Transactions 533
    • Account Closing: Problems with Redemption, Liquidation, or Closing 518
    • Account Records: Errors or Omissions 433
    • Unsuitable Recommendations 395
    SEC Investor Complaints and Questions
  • 33.
    • ARBITRATION
    • CASES FILED
    NASD Complaints: Dispute Resolution Statistics 1,800 Through April 2006 6,074 2005 8,201 2004 8,945 2003 Cases Year
  • 34.
    • CONTROVERSIES
    • INVOLVED IN
    • ARBITRATION
    • CASES
    NASD Complaints: Dispute Resolution Statistics 1,828 Failure To Supervise 395 Unauthorized Trading 315 Churning 78 Margin Calls 2005 Type of Controversy
  • 35.
    • CONTROVERSIES
    • INVOLVED IN
    • ARBITRATION
    • CASES
    NASD Complaints: Dispute Resolution Statistics 3,514 Breach of Fiduciary Duty 1,987 Breach of Contract 1,123 Omission of Facts 2,225 Negligence 2005 Type of Controversy
  • 36.
    • CONTROVERSIES
    • INVOLVED IN
    • ARBITRATION
    • CASES
    NASD Complaints: Dispute Resolution Statistics 7 Online Trading 1,826 Misrepresenta-tion 1,926 Unsuitability 2005 Type of Controversy
  • 37.
    • SECURITY TYPES
    • INVOLVED IN
    • ARBITRATION
    • CASES
    NASD Complaints: Dispute Resolution Statistics 888 Mutual Funds 153 Options 31 Certificates of Deposit 106 Corporate Bonds 2005 Type of Security
  • 38. NASD Complaints: Dispute Resolution Statistics SECURITY TYPES INVOLVED IN ARBITRATION CASES 460 Annuities 24 Limited Partnerships 1,348 Common Stock 2005 Type of Security
  • 39.
    • RESULTS OF
    • CUSTOMER
    • CLAIMANT
    • ARBITRATION
    • AWARD CASES
    NASD Complaints: Dispute Resolution Statistics 47% 2004 53% 2002 49% 2003 43% 2005 54% 2001 53% 2000 % of Customer Award Cases Year Decided
  • 40.
    • Variable Insurance Products
    • Mutual Fund Share Sales Practices
    • Electronic Communications
    • Branch Office Sales Practices
    • Sales Seminars
    • Equity Indexed Annuities
    Improving Examination Results May 2006: NASD Examination Priorities
  • 41.
    • 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 Results May 2006: NASD Examination Priorities
  • 42.
    • 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)
  • 43. Suitability Revisited Key Considerations : (Seminar for the Securities Industry Association, Compliance and Legal Division)
    • What is the nature of the account and who initiates transactions ?
      • Control
      • Conservative presumption for retirees, widows, trusts and ERISA plans
  • 44. Suitability Revisited Key Considerations : (Seminar for the Securities Industry Association, Compliance and Legal Division)
    • Are the securities being purchased appropriate for the client ?
      • Risk ratings
      • Product complexity versus client sophistication
      • Margin use
  • 45.
    • 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
    Suitability Revisited Key Considerations : (Seminar for the Securities Industry Association, Compliance and Legal Division)
  • 46.
    • How active is the account ?
      • Risks
      • Costs
      • Similar results with less risk / activity
    Suitability Revisited Key Considerations : (Seminar for the Securities Industry Association, Compliance and Legal Division)
  • 47.
    • Does the activity make sense ?
      • Irrelevant that client agreeable, or
      • Account performing well
    Suitability Revisited Key Considerations : (Seminar for the Securities Industry Association, Compliance and Legal Division)
  • 48.
    • Customer young with a lifetime of earning potential
      • Versus actual financial position and needs
    Suitability Revisited Popular Defenses Rejected :
  • 49.
    • Customer wanted it
      • Acquiescence irrelevant
      • Recommendation must be consistent with financial position and needs
    Suitability Revisited Popular Defenses Rejected :
  • 50. Suitability Revisited Popular Defenses Rejected :
    • Customer informed of all the risks
      • Customer must understand the risks
      • Customer must be able to bear those risks
  • 51.
    • Customer a sophisticated investor because of college degree
      • Rejected
    Suitability Revisited Popular Defenses Rejected :
  • 52.
    • Adviser informed customer’s mother, accountant and attorney of recommendation
      • Irrelevant because duties owed to customer notwithstanding the awareness of others
    Suitability Revisited Popular Defenses Rejected :
  • 53.
    • Children
      • Education
      • Support, etc.
    • Changes in employment
    • Retirement
    • Change in marital status
      • Marriage
      • Death of a spouse
      • Divorce, etc.
    • Declining health
    Suitability Revisited Changing Personal or Financial Circumstances:
  • 54.
    • In short, anything that affects investor’s ability to accumulate or replace assets
    Suitability Revisited Changing Personal or Financial Circumstances:
  • 55.
    • Investment objectives
    • Investment policy statements
    • Investment strategies
    • Asset allocation models
    • Financial plans
    Suitability Revisited Changing Personal or Financial Circumstances May Require Changes in:
  • 56. “ 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
  • 57. “ Critical Functions” (NYSE Series 7 Examination Content Outline, 1995)
    • 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
  • 58. “ Critical Functions” (NYSE Series 7 Examination Content Outline, 1995)
    • 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
  • 59. Monitoring
    • Common problems :
      • Over-concentration in single position
      • Large, unrealized gains where portfolio needs rebalancing
      • Client changes his situation
        • Need new questionnaire
        • Objectives
  • 60. Themes of Mistakes
    • Failure to document
    • Failure to control
    • Digging the hole deeper
  • 61. 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
  • 62. 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
  • 63. 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
  • 64. 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”
  • 65. 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.”
  • 66. Handling The Spendthrift Client
    • Identifying potential spendthrift clients
      • Clients with limited earning potential
      • Retirees with lump sum distribution
      • Heirs and Trust beneficiaries
  • 67.
    • Signs of problems
      • Living expenses beyond reasonable levels
      • Unwilling to limit expenses or change lifestyle
    Handling The Spendthrift Client
  • 68.
    • Solving problems
      • Communication with customer regarding expenses
      • Avoiding growth investing for income model
      • Reevaluating client goals and expectations
    Handling The Spendthrift Client
  • 69.
    • Documenting problems and solutions offered
    Handling The Spendthrift Client
  • 70. 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
  • 71. 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
  • 72. 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
  • 73. 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
  • 74. 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”
  • 75. Bond Recommendations (NTM 04-30)
    • 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
  • 76. Bond Recommendations (NTM 04-30)
    • NASD requires that bonds and bond funds recommended must be suitable, regardless of adequate risk disclosure
  • 77. Bond Recommendations (NTM 04-30)
      • 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.”
  • 78. Bond Recommendations (NTM 04-30)
      • 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.”
  • 79. Bond Recommendations (NTM 04-30)
    • NASD requires that advisers “present a fair and balanced picture of the risks, costs and benefits” of investing in bonds and bond funds
  • 80. Bond Recommendations (NTM 04-30)
      • 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”
  • 81. Bond Recommendations (NTM 04-30)
      • 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”
  • 82. Bond Recommendations (NTM 04-30)
    • 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
  • 83. Bond Recommendations (NTM 04-30)
    • NASD reminds reps and their firms that “simply providing a prospectus does not cure unfair or unbalanced sales or promotional materials”
  • 84. Hedge Fund and Fund of Funds Due Diligence (NTM 03-07)
    • Must ensure that sales promotions provide balanced disclosures of risk and return
  • 85. 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
  • 86. Hedge Fund and Fund of Funds Due Diligence (NTM 03-07)
      • 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
  • 87. Hedge Fund and Fund of Funds Due Diligence (NTM 03-07)
    • Must perform due diligence to determine that the hedge fund or fund of hedge funds is suitable for any customer
  • 88. Hedge Fund and Fund of Funds Due Diligence (NTM 03-07)
      • Heightened responsibility” to investigate, and “substantial due diligence” to perform
  • 89. Hedge Fund and Fund of Funds Due Diligence (NTM 03-07)
      • B efore 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
  • 90. Hedge Fund and Fund of Funds Due Diligence (NTM 03-07)
    • 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
  • 91. Hedge Fund and Fund of Funds Due Diligence (NTM 03-07)
    • 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
  • 92. 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.
  • 93. THANK YOU JAMES J. ECCLESTON [email_address] JEFFREY M. GERSHON [email_address] 20 N. Wacker Drive Suite 2900 Chicago, IL 60606-9719 312.621.4400 312.621.0268 (fax) www.SNSFE-law.com www.FinancialCounsel.com Copyright 2006 by Shaheen, Novoselsky, Staat, Filipowski & Eccleston, P.C. All rights reserved.