Golden RuleThus far, our review of the necessary components of your compliance program has focused on discrete areas. This post focuses on another equally important aspect of your compliance program that touches all of those other areas; ensuring the accuracy of your disclosures. After all, what’s the point of putting in all of the hours to build a robust compliance program only to raise the ire of a regulator or a client because of inaccurate or leading disclosure?

At first, this may seem intuitive. You may say, for example, of course if we change a product or service we offer we will update our compliance program accordingly. In practice, however, this may be a case of easier said than done. Especially in the context of a robo-advisory firm, things tend to move quickly, and your firm needs to ensure that your compliance program changes just as quickly when needed.

When setting up your firm’s compliance procedures for ensuring accurate disclosure, the first step is to identify the areas or items necessary for review. This should include all marketing materials, your firm’s website (including any client intake documents or portals), its social media accounts, client account statements, and your firm’s Form ADV (including any brochures).

Once you have identified all areas for review, the next step is to establish a reviewer and a consistent and appropriate review period. Your firm’s Chief Compliance Officer (“CCO”) should be the individual tasked in your compliance program with oversight of the periodic review of all necessary materials to ensure accuracy of disclosure. The CCO should ensure that the review is done and may be involved in each review, but it is equally important that a qualified expert review the materials. The next question is timing of review. Regular and periodic review is key. But the timing of review may change depending on the item in question. For example, a quarterly investor letter should obviously be reviewed quarterly prior to being distributed. But perhaps your procedures call for a monthly review of the accuracy of your website disclosure. Marketing materials require ad hoc review whenever a new piece is produced. Other items are tied specifically to regulatory timelines, for example, material inaccuracies in your brochure must be updated promptly. Your compliance review schedule must account for all of these timelines.

Training is also an important component of accurate disclosure review. Your firm may establish a strong compliance review program effectively executed by the CCO, but unless other employees know certain items, such as marketing materials, need to be reviewed before a new piece is issued potential problems can occur. This may be especially important in the case of your firm launching a new product or service. Your firm’s product development team is rightfully focused on bring new services to the market, and without proper involvement from your compliance team, may not fully contemplate potential regulatory pitfalls. Regular training to involve your firm’s CCO in these types of situations can save your firm from headaches down the road. As you can see, with many moving parts and different time periods, it’s important to establish a strong infrastructure for your compliance procedures to ensure there are no gaps in the timing or consistency of your review.

Next time, we’ll continue our compliance 101 thread when Marc discusses safeguarding client assets from conversion or inappropriate use by advisory personnel. As always, thank you for your continued readership!

When it comes to trading in your firm’s own investment accounts (proprietary trading), it’s never cherry-picking season.  Instead, when allocating investment opportunities, you should follow the golden rule – treat your clients like you want to be treated.

What does this mean?  As an investment adviser, your fiduciary duty requires you to allocate securities and advisory recommendations among clients in a fair and equitable manner, with no particular group of clients or the adviser’s proprietary account being favored or disfavored over any other clients.

What happens if you don’t?  The SEC has brought a number of enforcement actions against investment advisers that have been found to cherry-pick profitable investments.  For example, in one case, the SEC alleged that an investment adviser purchased blocks of securities in an omnibus account that included both proprietary and client accounts and did not allocate the securities purchased until later in the day after the adviser had determined whether the securities had appreciated. The SEC further alleged that the adviser allocated more of the profitable trades to proprietary accounts than to client accounts.  As a result, the agency barred the adviser from the securities industry and ordered the adviser to pay a civil penalty and “disgorge” (pay back) the ill-gotten gains.

Adopting and following fair and equitable trade allocation policies and procedures can help protect you and your firm from a similar fate.  And for robo-advisers, which automate many of their trading and allocation processes, those policies and procedures must be built in to the trading programs and algorithms used to build client portfolios.  In building out such a policy, consider including the following elements:

  • Adopt a policy flatly prohibiting proprietary and employee accounts, or any group of client accounts, from profiting from trade allocations at the expense of other accounts
  • Permit the blocking of trades to allow for increased efficiency and reduction of overall commission costs to clients
  • Prepare allocation statements that specify how securities from an aggregated transaction will be allocated before the order is placed
  • Require that participants participating in an aggregated order receive an average share price and share in transaction costs equally and on a pro rata basis
  • Adopt procedures to handle fairly allocations of only partially filled orders
  • Require and document periodic review of allocations to determine whether any accounts are systematically disadvantaged

Robust allocation policies and procedures, when followed, will significantly reduce the risk of intentional or inadvertent disfavoring of accounts and help you continue to meet your fiduciary obligations to clients.   We hope you’ll join us next time, when Josh will discuss the practical ways you can ensure the accuracy of the disclosures you make to clients and regulators.

ledgerOur blog recently discussed how soft dollar arrangements can impact the bottom line for both advisers and investors, and therefore require adequate disclosure. Other compliance requirements involve non-client facing operations, but are equally important to monitoring and protecting against conflicts of interest. The Personal Trading Policy is one such requirement.

The Investment Advisers Act and the Code of Ethics rules adopted thereunder mandate that advisers have a personal trading policy to protect against misuse of material non-public information, such as timing trades to disadvantage clients, or the market itself- both breaches of fiduciary duty. The rule requires employees with access to such information to report personal securities holdings and transactions for the adviser to maintain and periodically review.

The Adviser must, first, determine which employees are “access persons”. Generally, an employee will be an “access person” if that person: a) has access to nonpublic information regarding clients’ transactions or portfolio holdings, and/or b) makes, or has access to, securities recommendations to clients. This includes not only those making the recommendations or accessing client information, but their supervisors, and company partners, officers and directors as well.

Advisers should be requesting access persons to report holdings within 10 days of assuming an “access” role, and seeking annually certification of holdings and interests (these may include others in their household). The Adviser’s Code should also require access persons to report personal trading of reportable securities on a quarterly basis, thereafter. Finally, Adviser’s are obligated to keep adequate books and records to show compliance with these requirements, and efforts to monitor trading. Many access persons meet reporting requirements by having duplicate trading statements sent directly to the adviser, while other firms require that employee trading accounts be held by an affiliate of the firm (where existing). Careful manual or automated surveillance will look for both trading in securities in common with clients, or impacted thereby (ie. options trades), or other peculiar transactions that precede market movements.

There are also classes of securities, such as money market funds or government securities, which represent a low risk for trading abuses and, therefore, are exempted from the reporting requirement. Though the Code must also require pre-clearance for access persons to participate in IPOs or certain private offerings, many firms have broader restrictions.

In our next blog post installment, we will be exploring the topic of proprietary trading.

IcebergIn our last post, Craig began our discussion of trading practices by examining an adviser’s duty to obtain best execution. This post continues our trading practice discussion with a focus on soft dollar arrangements.

Soft dollar arrangements generally arise when an adviser receives research or brokerage products or services from a broker-dealer in exchange for placing securities transactions with that broker-dealer. Soft dollars arrangements can potentially provide significant benefits to your firm’s clients by generating access to a greater variety of investment research or services than would otherwise be available without them.

So, what’s the potential issue? In order to receive the research or services, your firm may pay more than the lowest possible commission rate to a broker-dealer. If it does so, because the research and brokerage services are provided in exchange for client commission dollars (i.e., soft dollars), which are client assets, your firm could be viewed as breaching its fiduciary duty to its clients by using client assets to pay for products or services that should be paid for by your firm directly.

While the potential for conflict is inherent in utilizing soft dollar arrangements, your firm does not have to avoid them as a general prohibition. Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor for advisers that enter into soft dollar arrangements, provided certain conditions of the safe harbor are satisfied. In other words, by adhering to the conditions contained in Section 28(e), your firm will not have breached its fiduciary duties under state or federal law solely because it paid a brokerage commission to a broker-dealer for effecting securities transactions in excess of the amount another broker-dealer would have charged.

Generally, a particular product or service falls within the safe harbor if an adviser can demonstrate that the research or brokerage service obtained with soft dollars: (i) is an eligible research or brokerage service within the specific limits of the safe harbor, (ii) provides lawful and appropriate assistance in the performance of an adviser’s investment decision-making responsibilities, including the appropriate treatment of “mixed-use” items (i.e., certain products and services may have mixed use and could be allocated between hard and soft dollars depending on the way in which the adviser uses the products or services), and (iii) the amount of client commissions paid is reasonable in light of the value of the products or services provided by the broker-dealer.

It’s important to note that while the three prongs listed above comprise the conditions of the safe harbor in its entirety, each prong requires additional individual analysis and application to the particular arrangement proposed. As stated above, soft dollar arrangements have the potential to provide significant benefits to your clients. However, you should enter them with care, consulting with a compliance professional as necessary, so that you can be sure that any proposed arrangement is not likely to violate your firm’s fiduciary obligations. If you have any questions about your firm’s soft dollar arrangements, please don’t hesitate to reach out to us.

Check back in next post, when our colleague Marc Minor debuts on the blog with his discussion of a firm’s duties with respect to the personal trading activities of its supervised persons. Thank you for your continued support!

So, let’s say your robo-adviser firm has created a brand new strategy that you think would be attractive to investors.  You’ve registered your firm, licensed your personnel, built and tested the algorithm, and now you’re ready to bring your strategy to market.  Now, all you need to do is find a broker who can help buy and sell the securities your algorithm recommends.  Does it matter who you pick?  You bet it does.

All investment advisers owe a fiduciary duty to clients to seek “best execution” of their securities transactions.  The SEC has described this requirement generally as a duty to execute securities transactions so that a client’s total costs or proceeds in each transaction are the most favorable under the circumstances.  To fulfill this duty, an adviser should consider the full range and quality of a broker-dealer’s services in placing trades. Critically, the SEC has explained that best execution is not determined by the lowest possible commission costs, but by the best qualitative execution.  Otherwise stated, you needn’t necessarily pick the cheapest firm – instead, you’re looking for the best value.

So what does this mean practically?  It means that before you pick a broker to execute client trades, you will need to determine (and document) how that broker will fulfill your best execution obligation.  You should consider a number of quantitative and qualitative factors in selecting a broker, such as execution capability, commission rates, financial responsibility, confidentiality, frequency and correction of trading errors, expertise in specific securities, credit quality, the value of research provided, and responsiveness to your firm.

Moreover, best execution is not a once-and-done thing.  The SEC expects advisers to periodically and systematically evaluate the performance of brokers executing client transactions.  As a result, over time, you may have to consider whether a change in broker is warranted.

Worried about how to get this all done and documented?  Just create and implement best execution policies and procedures and train your personnel on how they work.  Such policies and procedures should contain guidelines and factors used to select brokers, formalize the frequency and process for ongoing evaluations, appoint specific individuals or teams responsible for action items, and require documentation of steps taken.

However, that’s not the end of the story when it comes to brokerage practices.  Part and parcel of the best execution obligation is understanding and addressing conflicts created when a broker provides your firm with research products and services under what is commonly known as a “soft dollar” arrangement.  We hope you’ll return for our next post, when Josh will explain how such arrangements work and how to use them effectively.

portfolioIn a previous blog post, we discussed an adviser’s fiduciary duty to provide advice based on the client’s financial situation and investment objectives. In today’s post, we’ll examine the practical implications of this requirement from a compliance prospective.

Craig noted in our last entry that Advisers Act Rule 206(4)-7 (the “Compliance Rule”) requires that every investment adviser adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules. The adopting release for the Compliance Rule includes a list of the critical compliance policies that the SEC expects each adviser to address. The first of these critical policies relates to an adviser’s portfolio management processes.

The most important consideration in developing your portfolio management compliance policy is developing procedures that ensure adherence to the investment profile of each of your clients, including each client’s investment objective, restrictions, and risk tolerance. Moreover, your firm must address how your firm allocates investment opportunities among its clients.

As a robo-advisory firm, you likely have little to no in-person contact with your clients and your firm also likely utilizes a proprietary algorithm for portfolio selection. Given this scenario, your portfolio management compliance policy should focus on:

  1. ensuring that your client intake process is adequately designed to capture each client’s investment profile, including the client’s investment objective and risk tolerance (see our fiduciary duty post on this topic above for more information on this process);
  2. that investment opportunities are allocated equitably among all clients (this not typically an issue for robo-advisory firms given the general availability of offerings, e.g., ETFs, mutual funds, etc.), and
  3. developing procedures for a periodic review of your algorithm to ensure that its security selections remain consistent with each client’s investment profile, as well as any applicable regulatory disclosures or restrictions, especially in light of any relevant market or profile changes that may have incurred since the client’s initial intake.

At minimum, your portfolio management compliance policy should clearly articulate your understanding of the duty to only select securities that are suitable for each client’s specific investment needs, which is accompanied by procedures that detail a regular review and documentation of your investment methodology to ensure compliance with your policy. A best practice would be to conduct periodic sampling tests on the results produced by your algorithm to ensure that they are consistent with each client’s investment profile.

It’s important to note that the compliance procedures designed for any policies related to your portfolio management process need not be rigid. Instead, consider designing your policies and procedures in a manner that allows for necessary flexibility. Market conditions are ever changing. Designing a policy that mandates a yearly review of your algorithm to ensure that it is producing portfolios consistent with client expectations may be adequate in periods of less volatility.  However, in a less stable market environment a more frequent review process to ensure consistency may be required. Your compliance policy should account for such a contingency.

We hope you’re finding our examination of critical compliance policies helpful. Please don’t hesitate to reach out if you have any questions. We continue with this topic series in our next post when Craig discusses trading practices. As always, we thank you for your continued readership!

To date, we have covered a myriad of topics designed to help you get your firm off the ground, focusing primarily on issues like registration, licensing, advertising, disclosure, and communicating and contracting with clients.  These critical issues have one thing in common – they all involve working with folks outside your firm. Today, we kick off a new chapter of our blog, inviting you to turn your gaze inward and examine the key pieces of your compliance program.

So, let’s start at the very beginning. Advisers Act Rule 206(4)-7 (the “Compliance Rule”) requires that all advisers registered with the SEC:

  • adopt and implement written policies and procedures reasonably designed to prevent the adviser and its personnel from violating the Advisers Act and rules adopted under the act;
  • review, at least annually, the adequacy of those policies and procedures and the effectiveness of their implementation; and
  • designate a chief compliance officer to administer its compliance program.

Interestingly, the Compliance Rule doesn’t indicate what operational issues those policies and procedures should cover.  To find out, we need to look at the Compliance Rule’s adopting release.  In that release, the SEC stated its expectation that an adviser’s policies and procedures, at a minimum, address the following areas to the extent they are relevant to the adviser:

  • Portfolio management processes
  • Trading practices
  • Proprietary trading of the adviser and personal trading activities of supervised persons
  • The accuracy of disclosures made to investors, clients and regulators
  • Safeguarding of client assets from conversion or inappropriate use by advisory personnel
  • Recordkeeping
  • Marketing of advisory services
  • Valuation and fee assessment
  • Privacy and information security
  • Business continuity

Granted, depending on the particularities of an adviser’s business, a firm is likely to need policies and procedures that cover additional compliance areas.  Nevertheless, the list above serves as a good baseline to start from when building or initially assessing your program.  As such, our next series of blog posts will walk you through these key compliance areas so that you can meet your regulatory obligations effectively and efficiently.   We hope you’ll return for our next post, when Josh will discuss critical aspects of your portfolio management processes, including policies and procedures for maintaining the algorithm driving your investment decisions.

Business Continuity PlanTo our readers, we hope this entry to our blog finds you and your family safe and healthy. As we all begin to envision a path forward following the unprecedented events caused by the COVID-19 pandemic, a focus on compliance for your firm should not be an overlooked task.

For robo-advisers, this is an opportunity to analyze your compliance program with specific attention on policies that may have been trigged as a result of the pandemic. Given the need for social distancing and the stay-at-home restrictions imposed by many states, it is likely that your firm operated at some point, and perhaps for the entirety, of the past few months pursuant to its business continuity plan (“BCP”).

Barring some unexpected previous need, this is likely the first time that your firm had to rely on its BCP. Like all compliance polices, periodic review and testing for effectiveness is always a best practice. In essence, the last few months have served as a live test of your BCP. What makes a review of your BCP so important at this juncture is that it presents an obvious target for potential regulatory review. During your next examination, your firm should anticipate scrutiny by the SEC staff of any compliance policy likely to have been relied upon during the pandemic. In preparation for such an exam, it would be prudent to evaluate your BCP as presently drafted and compare it against the practicalities of how your business operated for the past few months while the plan was in effect. Identify and reconcile any divergences from the plan. That is, analyze how your business operated during this period and ensure that the policy and procedures laid out in your compliance program accurately and appropriately match those business operations. Additionally, your firm should also work to identify any potential gaps in your BCP. Even if your firm operated in line with its current policy, consider if there were any lessons or best practices that could be adopted to improve your compliance procedures.

Staying ahead of regulatory scrutiny involves anticipating issues before they become problems. Regular review and testing of a compliance program are critical to the success of all robo-advisory firms. If we can be of assistance in reviewing your BCP or any aspect of your compliance program, please don’t hesitate to reach out. We thank you, as always, for your continued support of the blog and hope you’ll check back soon for our next entry.

If you can believe it, May 1, 2020 is almost upon us.  And if you don’t remember from our February post, that is the day when advisory firms serving retail investors may start filing client relationship summaries on Form CRS.  As a reminder, Form CRS gives clients a quick summary of the key things they need to know about working with your firm, as it discusses types of services offered, fees charged, conflicts of interest, and disciplinary history.  While it cannot exceed two pages, Form CRS still manages to cover many of the same topics that are discussed in detail in Form ADV Parts 1 and 2.

On April 7, 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a risk alert announcing that regulatory exams occurring after the compliance date for Form CRS (June 30, 2020) will assess how well firms have implemented policies and procedures to ensure compliance with the new requirements. In that alert, OCIE confirmed that examinations of advisers occurring after the compliance date will:

  • assess whether firms have filed, delivered and posted Form CRS as required;
  • determine whether the content and format requirements of Form CRS have been met; and
  • evaluate whether Form CRS recordkeeping processes have been implemented.

Importantly, in the risk alert, OCIE discussed with some particularity how the staff anticipated assessing compliance with Form CRS.  OCIE noted specific questions the staff may ask, what documents may be requested, and what disclosures the staff might expect to see.  For example, the staff may review records of the dates that Form CRS was delivered, advisory contracts to confirm consistency with disclosed fees, or copies of the adviser’s recordkeeping policies and procedures.  Firms tasked with compliance with Form CRS should review the guidance provided in the risk alert and evaluate whether any updates to their compliance program should be made.

We will continue to follow guidance released by the staff on Form CRS and keep you informed.  And please be sure to check back next time, when Josh will discuss a challenge you’re probably facing right now – ensuring that your business continuity plan is effective or gets the upgrades it needs so that you can continue to operate in this time of adversity.  Until then, we hope you are staying safe and healthy.

As Josh discussed earlier this week, the annual update to Form ADV is generally due at the end of March for most robo-advisers.  However, we are interrupting our current discussion thread to make sure you were aware that on March 13, 2020, the SEC extended Form ADV filing and delivery deadlines for investment advisers whose operations may be affected by the coronavirus.  The agency acknowledged that the impacts of the pandemic may delay or prevent advisers operating in affected areas from meeting certain regulatory obligations due to restrictions on travel, access to facilities, the potential limited availability of personnel and similar disruptions.

To enable advisers to meet those obligations and to continue their operations, while recognizing that there may be temporary disruptions outside of their control, the SEC issued an order (“Order”), effective through April 30, 2020, exempting advisers from the requirements to (i) file an amendment to Form ADV and (ii) deliver amended brochures, brochure supplements or summaries of material changes to clients.

The exemptions are available provided that the firm:

  • is not able to meet a filing deadline or delivery requirement due to circumstances related to the coronavirus;
  • promptly notifies the SEC via email and the public via its website that it’s relying on the Order, why it’s relying on the Order and when it expects to be able to meet the filing or delivery deadline; and
  • meets the filing or delivery deadline by no later than 45 days after the original due date.

Please don’t hesitate to reach out to us with questions on how the Order may affect your firm.  We will continue to monitor regulatory events related to coronavirus and keep you updated.   And be sure to check back soon, as we plan to return to our regularly scheduled discussion topic – how to ensure that your algorithm continues to work for clients the way that you intend.