Compliance Review. Protecting Your Practice: Ongoing Compliance and Risk Management. Thomas D. Giachetti, Esq., of Stark & Stark

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1 Schwab Institutional Volume 15, Issue 4 June 2006 Ongoing Compliance Updates for Investment Advisors In this issue Understand Your Fiduciary Duty: What Does It Really Mean? Be Prepared for a Risk-Based Regulatory Exam Maintain a Defendable -Retention Policy Consider Whether an Investment-Policy Statement Is Necessary Should You Have an Advisory Board? Be Prepared to Demonstrate How You Seek Best Execution Be Sure You Make Full Disclosure When Clients Direct Brokerage Determine Whether You Must File Form 13F Carefully Check Your Marketing and Advertising Materials Properly Calculate Your Assets Under Management for SEC Registration Use Arbitration Provisions? Get Errors and Omissions Insurance Protect Your Client Relationships and Plan for Firm Succession Protecting Your Practice: Ongoing Compliance and Risk Management Thomas D. Giachetti, Esq., of Stark & Stark With the advent of SEC Rule 206(4)-7 (commonly called the compliance program rule ), which requires SECregistered investment advisers to implement and maintain policies and procedures appropriate for their investment advisory business, it is now more critical than ever for all registered investment advisers to recognize that compliance is an ongoing process. But more than merely satisfying regulatory requirements, a robust and dynamic compliance program should be coupled with some basic risk-management tools to protect an adviser s practice from adverse regulatory actions, liability to clients and loss of value to the firm s principals. Laws and rules change. The scope of SEC examinations continues to grow and become more complex. Your business practices, operations and personnel change. Regulatory filings, disclosures, procedures and agreements with clients and representatives must be reviewed, updated and/or amended. Do not become complacent with respect to regulatory compliance or risk-management matters. This article addresses several common practice-protection issues that all advisers should consider in an ever-changing regulatory and business environment.

2 Understand Your Fiduciary Duty: What Does It Really Mean? In 1963, the United States Supreme Court, in SEC v. Capital Gains Research Bureau, Inc., held that Section 206 of the Investment Advisers Act of 1940 (the Advisers Act ) imposes a fiduciary duty on investment advisers by operation of law. Section 206 of the Advisers Act (generally referred to as the antifraud provision of the Advisers Act) makes it unlawful for an investment adviser to engage in fraudulent, deceptive or manipulative conduct. The general purpose of an investment adviser s fiduciary duty is to eliminate conflicts of interest, and to prevent an adviser from taking unfair advantage of a client s trust. In order to fulfill this duty, an investment adviser is required to always act in the best interests of his or her clients, and to make full and fair disclosure of all material facts, especially when the adviser s interests may conflict with those of his or her clients. Specifically, the Supreme Court in Capital Gains indicated that Congress and the SEC intended that [an investment adviser] should continuously occupy an impartial and disinterested position, as free as humanly possible from the subtle influence of prejudice, conscious or unconscious; he should scrupulously avoid any affiliation, or any act, which subjects his position to challenge in this respect. The SEC has continuously confirmed an adviser s fiduciary duty subsequent to Capital Gains in several Investment Advisers Act Releases. In Investment Advisers Act Release No (November 29, 1993), the SEC, referencing Capital Gains, stated: The Investment Advisers Act imposes on investment advisers an affirmative duty to their clients of utmost good faith, full and fair disclosure of all material facts, and an obligation to employ reasonable care to avoid misleading their clients. What does this mean? Certainly, an adviser s fiduciary responsibility permeates his or her entire business operation and all client relationships. It requires more than a mere attempt at compliance. Rather, it requires that the adviser undertake reasonable ongoing and continuous efforts to comply with his or her obligations under the Act and in his or her dealings with clients. Be Prepared for a Risk-Based Regulatory Exam The SEC has replaced its five-year examination cycle with a risk-based program. As a result, SEC examiners focus reviews on advisers and issues that represent the greatest potential threat to investors. The frequency of exams is based upon the scope of the adviser s operations, the results of previous exams, and, most important, the examiners perception of the advisers compliance risk profile. In order to be prepared, your firm should be familiar with both the examination process and the issues that will be raised during the examination. Conducting a mock examination is a great way to prepare. Advisers that do so are better able to address and correct current deficiencies, enhance current procedures, and recognize and avoid those issues that could result in deficiencies or potential enforcement actions. The SEC s latest examination document request list requires the production of many items that are unfamiliar or inapplicable to most investment advisers. While many of these items are not required by the Adviser s Act, an adviser should be appropriately prepared to respond to all items that are applicable to his or her practice. Otherwise, the firm could face the possibility of substantially longer and/or more frequent SEC inspections. Some of the items requested in exams by the SEC that have caused the most confusion for advisers include questions regarding the risk-management process. Most investment advisers tend to think about risk in terms of investments and portfolio management. However, SEC requests for risk-related documents focus on operational and compliance risks. For example, one section of the most recent examination checklist 2

3 requires the production of the adviser s standard operating procedures for his or her risk-assessment process (e.g., a matrix or spreadsheet that maps the adviser s inventory of risks, or the adviser s most current inventory of risks). As a result, advisers should establish standard operating procedures to assess operational and compliance risks relative to his or her advisory and business operations. These procedures should encompass the major areas that advisers are required to address pursuant to Rule 206(4)-7 (e.g., portfolio management processes, trading practices, personal trading, books and records, safeguarding of client information, marketing, contingency planning, etc.). Recommendations for effective pre-, mid- and postexamination practices include: 1. Make sure that you have properly addressed all deficiencies cited in previous regulatory examinations. Depending upon the nature of the issue, failure to correct previously cited deficiencies can result in a referral to enforcement. These issues should be reviewed by the Chief Compliance Officer (CCO) on a periodic basis to detect and prevent reoccurrence. 2. Ripe areas for SEC deficiencies are the failure to have and to follow policies and procedures that appropriately reflect your business operations. The compliance program rule is designed to protect investors by requiring advisers to have internal programs designed to achieve compliance with federal securities laws. 3. Conduct an entrance interview with the examiners to provide an overview of your advisory practices and operations: what you do and don t do. This will assist the examiner (and your firm) by narrowing the scope of the issues to be addressed during the exam. For example, consider your responses to the following questions: Are you fee-only, or do you receive commission-based compensation? Are you subject to any current complaints, litigation or regulatory proceedings? Do you have soft-dollar arrangements, pay referral fees, publish composite performance, buy IPOs, have custody of client funds or securities, and/or advertise? Do your clients direct brokerage, appoint you or a related person as trustee or executor, and/or vest you or a related person with checkwriting authority? 4. To the extent you can, address and correct issues and/ or deficiencies raised by the examiners before the conclusion of the examination. Advise the examiners on your actions and, if possible, the resolution. Also, know when and how to request clarification of, disagree with or otherwise respond to issues that you believe have been misconstrued or cited in error. We recommend that you speak with legal counsel at least daily to address issues raised during the examination. 5. Request an exit interview in which the examiners discuss their findings with you. We recommend that you make note of all issues cited by the examiners during this exit interview. If the CCO or firm principal responsible for interacting with the examiners effectively executes his or her role, he or she should already be aware of these issues, and will perhaps be able to address and remedy them. If any of the issues cited by the examiners is of substantial concern (i.e., if an issue could potentially result in referral to the enforcement division), immediately begin to address Errors & Omissions Insurance IA Solutions Limit your unnecessary exposure with IA Solutions, financial protection for investment advisors working with Schwab Institutional. This exclusive program, developed by Seabury & Smith, an MMC company, with coverage provided by member companies of American International Group, Inc. (AIG), provides access to professional liability insurance at competitive rates, expanded coverage terms, and limits of liability up to $25 million. Visit > Resource Center > Compliance for more information. compliance review 3

4 the issue with your counsel prior to receipt of any follow-up informational requests or the receipt of a deficiency letter. 6. Respond in a timely and appropriate manner to the issues raised in any follow-up informational requests or deficiency letters. Again, know when and how to disagree or respond to issues that you believe have been misconstrued or have been cited in error. Make sure that you take the corrective action indicated in your response letter. Maintain a Defendable -Retention Policy Electronic correspondence ( , instant messaging, etc.) must be maintained by SEC-registered investment advisers pursuant to recordkeeping Rule 204-2, and by state-registered advisers pursuant to similar state recordkeeping requirements. An SEC-registered investment adviser should be prepared to produce electronic correspondence during a regulatory examination. Unless the adviser has implemented a written policy on the retention and deletion of electronic correspondence before the regulatory examination and unless it follows that policy on a regular basis the SEC will object to filtering (omission) of electronic correspondence not falling under Rule recordkeeping requirements in response to its request for production at the time of the examination. During a regulatory examination, the SEC will initially request electronic correspondence for a limited period of time (e.g., three months to one year), and may subsequently enlarge the review period based upon its findings. The electronic correspondence will include both client correspondence and internal firm correspondence. Consequently, investment advisers should develop a written policy with respect to electronic mail retention and deletion. But is a retention and deletion policy enough? How do you defend your procedure in the event that the SEC asks how you can be sure that your employees are not deleting you are required to retain? Two potential solutions: First, if you do not have the ability to save all to a central server, make sure that you define for your employees, as specifically as possible, which items can be deleted (e.g., unsolicited electronic correspondence received from Internet vendors [spam], personal and/or correspondence unrelated to the firm s investment advisory or business operations), with the understanding that all other must be retained. The alternative is to save all to a central server. By doing so, the firm will be in a much better position to timely produce during an inspection and to ensure that substantive is not being deleted. In either case, as part of the policy, the CCO, on a regular basis (i.e., no less frequently than quarterly), should: (1) review a random sample of , and (2) search the system for certain keywords (e.g., fraud, losses, misappropriation, lawsuit, complaint, etc.) to discern whether the firm or any of its employees has been party to any client complaints or threats of an adversarial proceeding. One final, and very important, issue: During a regulatory examination or a client litigation or arbitration proceeding, be sure not to provide to or from your legal counsel. These messages, together with all other correspondence and verbal communications with counsel, are generally considered privileged and not subject to turnover, disclosure or production during a regulatory proceeding, including a compliance examination, a client lawsuit, or an arbitration proceeding. Consider Whether an Investment-Policy Statement Is Necessary Although neither the Investment Advisers Act of 1940 nor an SEC rule currently imposes an express suitability requirement on investment advisers, the SEC maintains that an investment adviser has a fiduciary duty to reasonably determine that the investment advice and/or services he or she provides to his or her clients are suitable, taking into consideration each client s financial situation, investment experience and investment objectives. 4

5 Accordingly, each firm should be prepared to demonstrate that it has a policy to obtain (and maintain) sufficient information regarding the client s circumstances so as to enable the firm to determine whether certain advice and/ or services are suitable, initially and thereafter. Examples of the type of corresponding documents that investment advisers may decide to implement include client questionnaires, fact sheets, investment-objective confirmation letters and investment-policy statements. Some type of investment-policy statement should be obtained and maintained by an investment adviser. Longer, however, does not mean better. Too often, especially when defending advisory firms in litigation and/or arbitration proceedings, we see advisers falling victim to their own sloppy documentation (a canned questionnaire or an ambiguous form that becomes a minefield of conflicting responses). If the client indicates on page 2 that his or her objective is a 10% annual return, but on page 5 (which, in our view, is too long a document) that he or she can tolerate a principal loss of only 5%, we have a conflict, and the adviser, as a fiduciary, should not begin the investment-management process until the client s objectives and risk parameters are clarified and consistent, and until written confirmation thereof has been obtained. Our general recommendation is to keep the client intake process simple. Have a new client-information document that requires the client to indicate, in his or her own handwriting, the risk parameters, investment objectives, and, most important, any reasonable restrictions that the client desires to impose on your investment-management services. Have the client complete and execute the document, including a written indication if he or she wants to impose any reasonable restrictions. If not, have the client, in his or her own handwriting, indicate none. Thereafter, before commencing the investment-management process, confirm the information obtained in a written investmentobjective or investment-policy statement. The client should either execute the statement or notify you immediately in writing if his or her understanding is contrary to that stated. In addition, the confirming document should advise the client to immediately notify you if there has been a change in his or her financial situation or investment objectives, or if he or she desires to impose, add or modify any reasonable restrictions to the management of his or her accounts. Thereafter, you should send an annual letter to the client, confirming that you continue to manage the accounts in accordance with his or her previously designated investment objectives, and that it remains his or her responsibility to advise you if there has been a change in his or her financial situation or investment objectives, or if he or she desires to impose, add or modify any reasonable restrictions to the management of his or her accounts. This is just one common example of how advisers put their practices at risk by using canned, extremely complex, or ambiguous procedures, when a simpler process will meet the regulatory requirement and perhaps better protect the adviser. Should You Have an Advisory Board? The answer depends upon the role of the board. Will the board members be involved in the investment decisionmaking process, and will they have access to your investment decisions before they are implemented? If yes, or if they are officers or directors of the firm, they would be subject to the firm s code of ethics, including reporting their personal securities transactions. If the answer is no to all they will not be involved in investment decisionmaking, will not have access ahead of decisions, are not officers or directors and their role is passive and macro in scope relative to the firm s general business issues, then there are no reporting requirements. The corresponding issue is how you present this advisory board to your existing and prospective clients. The SEC may take issue if the advisory board comprises wellknown or highly regarded individuals who have no compliance review 5

6 substantive role with the firm. The concern is that their involvement may be interpreted by a client or prospect as an endorsement of the firm s investment management services. As discussed previously, an adviser, as a fiduciary, cannot engage in activities that could be misleading to his or her clients or prospects. Thus, the advisory board must have a legitimate purpose if it is to be held out to clients and prospects. Otherwise, substantive corresponding disclosures and disclaimers will be required, such that the reason to hold out the advisory board could become moot. Be Prepared to Demonstrate How You Seek Best Execution As fiduciaries, investment advisers are obligated to act in the best interest of their clients. Accordingly, an advisor must seek the best available execution for each client s securities trades. The duty of best execution requires investment advisers to have their customers orders executed at prices and expenses that are as favorable as possible given the circumstances. An advisory firm will seek to meet its duty of best execution by selecting brokerdealers that can provide the best qualitative execution, taking into consideration various factors. Such factors include, but are not limited to, the value of research provided (if any), the capability of the firm to execute trades efficiently, the competitiveness of its commission rates and/or transaction fees, and the overall level of customer service. Thus, while the firm should give significant weight to the competitiveness of the available commission/transaction rates, it might not necessarily select the broker-dealer that offers the lowest possible rates for the firm s client account transactions. Additionally, even when the firm uses its best efforts to seek the lowest possible commission rate, it may not necessarily obtain the lowest rate for client account transactions. Depending upon the scope of its trading activities, the firm can determine the availability of best execution by a variety of methods, including its own experience with transactions effected by various broker-dealers, by conducting its own surveys and obtaining execution data from other broker-dealers, and by reviewing trading data from third-party industry research sources. The extent and/or frequency of a firm s review and monitoring procedures is dependent upon the firm s business operations and trading practices. To the extent that a firm s trading activities include the purchase and sale of mutual funds that trade at net asset value at the end of the trading day, the corresponding best-execution obligation is qualified, such that the adviser must reasonably determine that: (1) the broker-dealer/ custodian is effectively processing transactions, and (2) if certain mutual funds are assessed transaction fees, the transaction-fee fund is superior to similar funds available without transaction fees, and the amount of the transaction fee is comparable to (i.e., need not be lower than) the fees charged by similar broker-dealers. Be Sure You Make Full Disclosure When Clients Direct Brokerage In the event that a firm s clients expressly direct the firm to effect all securities transactions through a particular broker-dealer with which the advisory firm does not have a relationship (this should not be confused with clients agreeing to utilize the broker-dealer/custodian generally recommended by the advisory firm a point that too many advisory agreements seem to misunderstand), the firm should be prepared to demonstrate the following: (a) the client made the direction (the best way is to confirm the direction in the investment advisory agreement); (b) it has disclosed to the client (in the advisory agreement and on Schedule F of Part II of Form ADV) that the client will be responsible for negotiating the terms and arrangements for its account with that broker-dealer, and the firm will correspondingly be unable to seek better execution services or prices from other brokerdealers, and it will be unable to bunch the client s transactions for execution through other broker-dealers with orders from other accounts managed by the firm; and (c) it has disclosed to the client that the client may incur higher commissions, other transaction costs or greater 6

7 spreads, or receive less favorable net prices, on transactions for his or her account than would otherwise be the case had the client determined to effect transactions through alternative brokerage relationships generally available through the advisory firm. In the event that transactions for client accounts are effected through a broker-dealer that has referred the client to the firm, the potential for a conflict of interest arises, and corresponding written disclosure (in the advisory agreement and on Schedule F) of such relationship must be made to the client before effecting transactions through the referring broker-dealer. Moreover, if, as a result of such arrangement, the client pays more for commissions/transaction fees, the client should acknowledge in writing (in the advisory agreement) that, as a result of such direction, the client will incur higher commissions or other transaction costs than would otherwise be the case had the client determined to effect transactions through alternative brokerage relationships generally available through the adviser. Otherwise, regulators may find that the client is unnecessarily paying up for trade execution and that the arrangement between the adviser and the referring broker-dealer is a disguised referral fee, thereby subjecting the firm to a potential regulatory enforcement proceeding. Determine Whether You Must File Form 13F In accordance with the Securities Exchange Act of 1934, an investment adviser with $100 million in qualifying securities (discussed below) under its discretionary management must file a Form 13F on a quarterly basis. The initial 13F filing is due by February 14 following the year when the assets under management first reach $100 million. Thus, if assets under management reach $100 million on the last trading day of the calendar year (e.g., December 31, 2005), the initial 13F filing is required by February 14 of the following year (e.g., February 14, 2006). Thereafter, a Form 13F filing is required within 45 days after the end of each calendar quarter. When determining if the firm has $100 million in Section 13(f) securities, the adviser, with very limited exception, must count all assets representing equity securities that are admitted to trading on a national securities exchange or quoted on the automated quotation system of a registered securities association, including closed-end mutual funds and exchange-traded funds. An adviser can confirm if he or she has $100 million in Section 13(f) securities by cross-checking the securities that the firm manages with those on the Section 13(f) list published by the SEC on a quarterly basis: The timing for discontinuing 13F filings would be the last quarter of the calendar year subsequent to the calendar year in which the adviser no longer has $100 million in qualifying 13F discretionary assets under his or her management. Thus, if on December 31, 2005, an adviser s qualifying discretionary assets dipped below $100 million and remained below $100 million during the entirety of 2006, the last required filing would be due on February 14, Carefully Check Your Marketing and Advertising Materials We are constantly amazed by advisers who pay large sums to marketing consultants and advertising agencies that know very little about the advisory industry and its regulations for the preparation of marketing materials, and who fail to have those marketing materials (e.g., brochures, websites, media advertisements, etc.) reviewed by counsel to determine if they run afoul of applicable securities laws or rules. The SEC defines advertising and sales literature to include any notice, circular, letter or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio, television or Internet that offers any report, analysis, graph, chart or formula concerning securities or to be used in determining what securities to buy or sell, or any other compliance review 7

8 investment advisory service with regard to securities. Advisers Act rules, releases, and no-action letters govern the use of advertising and sales literature by the advisory firm. The SEC will generally make its determination as to whether an advertisement is misleading based on all the facts related to the advertisement, and will look carefully at the form and content of the advertisement, the implications or inferences that could reasonably be made from the advertisement in its overall context, and the sophistication of the audience that was receiving the advertisement s message. The SEC objects to the use of superlatives in marketing materials, brochures and websites (e.g., state-of-theart, outstanding, superior, world-leading, etc.). These qualifiers generally cannot be substantiated and are usually unnecessary. They should be minimized and/or eliminated. As a fiduciary, the adviser must ensure that his or her marketing materials are not misleading. When in doubt, qualify any statement with appropriate disclosure. For example, the SEC has been objecting to an adviser s advertising claim that he or she has been named to a particular publication s or ranking organization s best advisers list. All such advisers should qualify any such claim by indicating that: (1) it should not be construed by any existing or prospective client as a guarantee that they will experience a certain level of results if they engage or continue to engage the adviser s services; (2) it should not be construed as a current or past endorsement of the adviser by any of its clients; and (3) lists or rankings published by magazines and other sources are generally based exclusively on information prepared and submitted by the recognized adviser. In addition, the use of investment-performance data in advertising and marketing materials is highly complex and carefully scrutinized by the SEC. The reason for the complexity of this subject is that the SEC has not established any fixed formulas for the calculation of investment adviser performance. Over the years, however, the SEC has issued numerous no-action letters setting forth required practices for performance advertising. Particular care must be taken to ensure that materials promoting the adviser s performance contain required disclaimers and legends. Finally, the contents of an adviser s website constitute advertising materials. Advisers who maintain a website should include appropriate disclosures so the site s content is not misleading. Moreover, additional substantive website disclosures should be included, depending upon specific website content and links to third-party sites. Properly Calculate Your Assets Under Management for SEC Registration Must an investment adviser with $30 million in assets under management register with the SEC? It depends on whether or not the adviser has qualifying assets under management. The Advisers Act sets the threshold amount for SEC registration at $25 million, but provides for $5 million in leeway, permitting an adviser with $25 million to defer registering with the SEC until he or she reaches $30 million in assets under management. Thus, an adviser with between $25 million and $30 million in assets under management is permitted, but not required, to register with the SEC. Reaching the $25 million (permissible) or $30 million threshold, however, is only part of the determination. The second, and most overlooked, factor is whether the adviser provides continuous and regular supervision or management services (i.e., the adviser has discretionary authority or has ongoing responsibility to recommend and arrange purchases and sales of securities for a client). Generally, those assets actively managed by an investment adviser on a discretionary basis qualify for SEC registration purposes. What about non-discretionary advisers and advisers allocating assets among separate account managers who actively manage the adviser s client s assets on a discretionary basis? Fortunately, the SEC has provided the following specific examples of whether or not an adviser provides continuous and regular supervisory or management services:

9 1. Qualifying Assets: You do not have discretionary authority over the account, but you have ongoing responsibility to select or make recommendations, based upon the needs of the client, as to specific securities or other investments the account may purchase or sell. If such recommendations are accepted by the client, you are responsible for arranging or effecting the purchase or sale. 2. Assets That May Qualify: You allocate assets among other managers (a manager of managers ), but only if you have discretionary authority to hire and fire managers and reallocate assets among them. 3. Assets That Most Likely Do Not Qualify: You provide qualifying non-discretionary advisory services referred to in (1) above, but you review the accounts only on an intermittent or periodic basis (e.g., the account is reviewed and adjusted quarterly). Why is this important? It has bearing on whether you should be, or remain, registered with the SEC or with the state. Many SEC-registered advisers may learn during an SEC exam that they do not have sufficient (at least $25 million) qualifying assets under management to remain registered. Thus, an SEC-registered adviser who has transitioned a substantial portion of his or her assets to separate account managers should make sure that either: (1) he or she retains discretionary authority to hire or fire the separate account managers without first obtaining client consent; or (2) he or she has retained at least $25 million in qualifying assets under his or her management (i.e., assets for which he or she provides continuous and regular supervision or management services ). Conversely, a non-discretionary state-registered investment adviser does not need to transition to SEC registration solely because he or she advises on $30 million or more in assets. However, that state-registered adviser should make clear on his or her written disclosure statement that (absent mitigating circumstances) he or she reviews accounts no more frequently than quarterly (if this is a true statement). A caveat: The understanding and application of the above criteria have been uneven recently. Some states have been referring advisers with considerably more than $30 million under management to the SEC, without first ascertaining whether the assets qualify for SEC-registration purposes. Moreover, and most surprising, is that the SEC, upon its subsequent review of the adviser, is sometimes disregarding its own registration guidelines and requiring stateregistered advisers who do not seem to provide continuous and regular supervision or management services to transition to SEC registration exclusively based upon the dollar amount of assets under management. Thus, it is all the more important for a non-discretionary adviser desiring to maintain his or her state-registration status to make clear on his or her written disclosure statement that (absent mitigating circumstances) he or she reviews accounts no more frequently than quarterly. Use Arbitration Provisions? Misinformation about arbitration clauses abounds. They are strictly prohibited, right? Wrong! In 1986, the SEC staff took the position that a contractual provision that is likely to lead a client to believe he or she has waived any available right of action against an investment adviser may violate the Advisers Act s antifraud provisions. As such, the staff believed that mandatory arbitration provisions (an advisory agreement that requires arbitration as the only dispute-resolution forum) and/or hedge clauses (contractual provisions seeking to limit an adviser s liability) generally may not be included in an advisory contract if they could reasonably lead a client to believe that he or she has waived any rights he or she may have under federal securities laws. However, the operative word is mandatory. We continue to strongly recommend arbitration as the optimal forum to resolve client disputes, including disputes between industry professionals. It was once erroneously believed that arbitration consistently favored the investment industry. Data over the past two decades belie such a compliance review 9

10 contention. Moreover, arbitration provides a much more expedient and cost-effective dispute-resolution forum. When drafting adviser liability and arbitration provisions to be included in advisory agreements, it is strongly recommended that the adviser include qualifying language such as To the extent not inconsistent with applicable law and The federal and state securities laws impose liabilities under certain circumstances on persons who act in good faith, and therefore, nothing herein shall in any way constitute a waiver or limitation of rights which the client may have under federal and state securities laws. Moreover, the 1986 SEC staff position on arbitration should be viewed in light of subsequent U.S. Supreme Court cases. The staff position was based on a 1953 Supreme Court case that was overturned by the Court in two cases after 1986 (McMahon and Rodriguez). In the post-1986 cases, the Court held that: (1) a predispute agreement to arbitrate claims under the Securities Act of 1933 is enforceable, and a resolution of the claim in a judicial forum is not required; and (2) predispute arbitration agreements between brokerage firms and their customers to be conducted before self-regulatory organizations (e.g., NASD, NYSE) are enforceable in the context of a claim under the Securities Exchange Act of Based upon these subsequent Supreme Court cases, especially if the adviser includes in his or her advisory agreements the qualifying language referred to above, it is reasonable to conclude that an arbitration provision in the context of the Advisers Act is as enforceable as a similar clause in the context of the 1933 Act or the 1934 Act. Caveat: In both McMahon and Rodriguez, the Court noted that arbitration would be conducted by a selfregulatory organization (SRO) subject to SEC oversight. Investment advisers (unlike broker-dealers) are not SRO members. Accordingly, arbitration may be conducted by organizations not subject to SEC oversight, such as the American Arbitration Association, the forum we generally recommend for dispute resolution between advisers and clients. Therefore, a challenge could be made that McMahon and Rodriguez may be distinguishable from arbitration between investment advisers and clients. We believe that such a challenge would fail, especially if the adviser included the qualifying language referred to above in his or her advisory agreements. Regardless, as discussed above, we strongly recommend that advisers include arbitration provisions in their advisory agreements. Get Errors and Omissions Insurance Are you really covered? When was the last time you reviewed your errors and omissions policy? Does your policy provide coverage for all of your advisory operations? Have you reviewed the exclusions section of the policy? Have you increased the amount of coverage as your practice has grown? An adviser should substantively review policy coverages and exclusions no less than annually. Most policies now exclude coverage relating to the purchase of private investment funds. The private investment fund offering memorandum and subscription documents serves to protect the fund sponsor, not the investment adviser who is recommending the purchase to his or her clients or reviewing the prospective investment at the request of a client. As a result, we are now strongly recommending that an adviser have his or her clients execute a Private Investment Acknowledgment, pursuant to which the client acknowledges the risks associated with such an investment, including principal risks and liquidity constraints. Protect Your Client Relationships and Plan for Firm Succession Many principals of investment advisory firms think about the day when they may sell their largest asset the firm. Unfortunately, too many firms inadequately protect their most important asset client relationships. It is imperative for each firm to make sure it has taken appropriate steps to protect its client relationships relative to firm employees (generally, the firm s investment adviser representatives) who may service those relationships. Without doing so, the firm is exposed to the unfortunate consequence of losing client relationships 10

11 to departing employees. How does the firm avoid this? It requires each employee who is responsible for establishing or serving clients to execute a restrictive covenant agreement. Although it is a relatively simple process, too many firms either have not done it or have agreements in place that do not protect the firm (for a variety of reasons, including poor drafting or lack of consideration). Because of the graying of the investment advisory industry, it is becoming increasingly important for firms to consider succession planning issues, whether by prospective internal succession or by an external acquisition or sale. Critical to any successful succession is having the appropriate underlying documents in place. These include: (1) appropriate restrictive covenant agreements protecting the firm s proprietary interests in its client relationships; (2) for an internal succession, 1 a well-drafted shareholders agreement or operating agreement addressing the terms and conditions for the disposition or succession of ownership interests (i.e., stock, membership interests, etc.) upon the occurrence of various events, including admitting new owners, regulatory disqualification, death, disability, retirement and termination of employment; and (3) for an external transition, 2 a welldrafted purchase/sale/merger/joint-venture agreement that adequately protects the respective parties interest before and after the transaction. By addressing the regulatory and legal issues discussed above, and by periodically updating those considerations, advisers will not only comply with regulatory requirements but will also protect their firm from liability to clients and preserve the firm s value for its owners. About the Author Thomas D. Giachetti, Esq., is chairman of the Securities Practice Group of Stark & Stark, a law firm with more than 100 attorneys, located in Princeton, New Jersey; New York City; and Philadelphia. The firm represents investment advisers, financial planners, broker-dealers, CPA firms, registered representatives, and public and private investment companies (e.g., mutual funds, hedge funds) throughout the United States. (Visit or tgiachetti@stark-stark.com.) Compliance Resources on Visit the compliance site on for compliance and regulatory information and solutions. Schwab works with third-party firms to provide select resources to help keep you informed of certain regulatory and compliance developments. The site features Compliance Hot Topics, Customizable Templates and Guideline Documents, a Rulemaking Calendar, archived issues of, Third-Party Resources and Discounts. As a unique resource, this single-destination compliance site is complimentary and exclusive to advisors who work with Schwab Institutional. Visit > Resource Center > Compliance today! compliance review 11

12 1 See An Overview of Internal Succession Planning for the Registered Investment Adviser, Schwab Institutional, October See An Overview of External Transition Planning for the Registered Investment Adviser, Schwab Institutional, September The information available through the compliance resources page of the Schwab Institutional website is for general information only, and is not intended to provide specific compliance, regulatory or legal advice. For further information, contact your legal or compliance advisors. The services and opinions of the author are independent of Charles Schwab & Co., Inc. The articles and opinions in this publication are for general information only, and are not intended to provide specific compliance, regulatory or legal advice. Schwab makes no representations about the accuracy of the information in the publication or its appropriateness for any given situation. For further information, please contact your legal and/or compliance counsel Charles Schwab & Co., Inc. All rights reserved. Member SIPC. Schwab Institutional is a division of Charles Schwab & Co., Inc. FTA ( ) NWS15120JUN06 (06/06) 12