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DOL Deconstructed: Regulations, Guidance and Suggestions on Documenting Alternative Investment Due Diligence

With phase one of the Department of Labor’s fiduciary rule having gone into effect on June 9, 2017, financial advisers must comply with “impartial conduct standards,” which require that advice be in the best interest of retirement investors.

The best interest standard has two primary components: prudence (professional standard of care), and loyalty (based on the interests of the customer rather than the adviser or firm). Advisers are also required to charge clients no more than reasonable compensation. The final phase of the rule is set to go into effect on January 1, 2018. See the DOL’s Transition Period Q&A here.

For most advisers, compliance with the impartial conduct standards is simple—most already give advice that is in the best interest of their clients. What may not be so simple is documenting adherence to the standards now that they will be more scrutinized. In this article, we will discuss the current regulation and offer guidance around alternative investment documentation.

Key Language on Documentation from the Regulation and Guidance

Here is a list of key language and documentation you should familiarize yourself with:

DOL Fiduciary Rule (client interactions): Broker dealers, financial advisers and registered investment advisers (RIAs) “must document why recommendations were in a client’s best interest,” including, but not limited to, the type of account used, the products that are recommended, and why the recommendation was in the client’s best interest at the time it was made. Read more from the Department of Labor here.

NASD Notice to Members 03-71 (non-conventional investments): In addition to establishing written procedures for supervisory and compliance personnel, “members must also document the steps they have taken to ensure adherence to these procedures.” Read the full FINRA notice here.

FINRA Regulatory Notice 10-22 (Regulation D offerings): In order to demonstrate that it has performed a reasonable investigation, a BD “should retain records documenting both the process and the results of its investigation of Reg D offerings.” Read the full FINRA notice here.

What to Document in Alternative Investments Due Diligence?

The process. Document your processes for identifying alternative investment opportunities. Keep a file of the list of any and all sectors, asset classes, products, and managers reviewed. Documentation tip: Keep a log of any screens you have run to narrow the universe of investment opportunities available to your clients, as well as a log of any training or education you have completed while conducting your research.

Fees, characteristics, risks and rewards. Ensure documentation of how you are educating yourself on the strategies considered. Most importantly, you’ll want to document your review of a product’s fees (especially in relation to other similar products), investment characteristics, key risks and rewards and how management intends to meet the product’s objectives. Keep an initial file and ensure you have a way to track the most up-to-date key documents and interviews with managers. Key documents include any fee comparison reports, the offering documents, performance information, brochures, quarterly/annual reports, ADVs, and any other available data. Documentation tip: Try to meet or speak with key decision-making personnel for the investment manager if possible and have them explain how they intend to meet their stated investment objectives.

Operational due diligence and analysis. Document your audit of a firm’s operational structure, adherence to compliance requirements, background checks and any red flags that may arise. Many advisers and broker-dealers rely on third-party due diligence providers for this step. Documentation tip: While it is common for third-party diligence firms to be utilized for this important step in the due diligence process, it is important to remember that you may not rely solely on a third party for due diligence. You must be familiar with the content of any third-party reports and any red flags highlighted in these reports. Document the follow-up on red flags and any conclusions.

Ongoing monitoring. Due diligence does not stop with an initial review. It is important to remember that a sound due diligence process means continually performing analysis on each manager, updating your key documents on a quarterly basis, conducting formal meetings and monitoring the portfolio for any changes or red flags. Documentation tip: Document any and all ongoing due diligence and ensure you are set up to receive notices of important events for alternative investment programs and managers.

Summary

Keep hard copies, use electronic storage and/or consider using a third party to track training and education, due diligence, research and compliance. Keep an easily accessible trail of your due diligence efforts, whether electronically or on paper, to easily demonstrate what you have done including not only the results of your due diligence but the process you followed. (Note: SEC Rules17a-3 and 17a-4 stat that during the first two years, records must be kept in a readily accessible place. Most documents must be kept for up to six years, depending on the document, although formation and organizational documents must be kept indefinitely). Always remember, if it isn’t documented, it didn’t happen!

Laura Sexton
Laura Sexton is senior director of program management at AI Insight. She holds her bachelor’s degree in education from Purdue and has held the FINRA Series 7, 24 and 66 securities and life insurance licenses. She resides in Massachusetts with her husband and two children. Visit her on LinkedIn.

 

Editor’s note: a version of this post first appeared on the AI Insight blog in March 2017.

 


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The 3Cs to Enhance Your Negotiation Skills

A new calendar year represents a fresh beginning and an opportunity to think anew about the adviser-client relationship. Financial advisers know that their annual planning conversations with clients may need to address sensitive topics related to the changing regulatory environment, particularly as we near the proposed timing for implementation of the Department of Labor’s Final Rule. These issues will certainly be on the agenda if you are transitioning to a fee-for-service model.

But the ability to engage clients in potentially difficult discussions is always key to building a successful business.

Central to these discussions is the ability to negotiate—a skill I have spent years cultivating through personal successes and failures, and through teaching thousands of business leaders and professionals at the University of Pennsylvania’s Wharton School. I consulted on a Janus Labs program, titled the Science of Negotiations, to prepare advisers to have better planning meetings. The core tenets of the program, and negotiating generally, are what we call the three Cs: commitment, candor and credibility.

Commitment: We know that as a financial adviser, your commitment is to serve as a trusted counselor to your clients. Working in a client’s best interest isn’t something new that rules require—it’s what you’ve always done. You need to convey this commitment clearly and consistently in order to build and maintain the kind of trust that allows for open dialogue. By reminding clients of your commitment to them, and connecting your actions to that commitment, the value of your relationship and services should always be top of mind for them. This way you can raise sensitive issues when the client can hear and process them fully, not simply because a deadline requires it of you.

Candor: We’re big proponents of the “radical candor” used at Silicon Valley companies like Facebook and Google. For advisers, this means demonstrating that you care personally about each client, while also directly addressing how DOL-related changes will affect them. Be a straight talker. Don’t beat around the bush: be clear that this is a difficult subject but the new services you offer are commensurate with what the client needs. Telling clients about the products and services you are not recommending is also important. Transparency is key. When you reveal information that’s not necessarily in your best interest, but is clearly in the best interest of the client, you build trust.

Credibility: Openly and willingly revealing information about products and fees increases your credibility, and research shows that credibility is the single most important asset of effective negotiators. Your credibility rests on expertise, competence and trustworthiness. It means that: 1) you bring your clients valuable knowledge and insights; 2) you apply your expertise to their benefit with skill and diligence; and 3) you consistently use your expertise and competence to create long-term value as a trustworthy counselor.

Strong negotiation skills will help you communicate more effectively in all your interactions. Demonstrating that you are credible, candid and committed will put you in a position to better navigate the sensitive topics that are inherent to financial advice, including fees and regulatory concerns. And this is a good time to start strengthening those skills, as you begin scheduling the conversations that will guide your client relationships throughout the new year.

For more information on how to use The Science of Negotiations for meaningful conversations with your clients, please contact your Janus Director or visit www.janus.com.

G. Richard Shell

 

G. Richard Shell
Legal studies and Business Ethics Professor
University of Pennsylvania’s Wharton School
Philadelphia, Pa.


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Educate Yourself About Complex Products

Regulators have been focusing on complex products for many years and we don’t anticipate a shift anytime soon.

Here are just a few regulatory references relating to complex products with one thing in common across all of them—education! It would be wise to familiarize yourself with them.

  • NASD Notice to Members 03-71 (Non-Conventional Investments) reminds members offering non-conventional investments of many obligations to include training advisers regarding the features, risks and suitability of these products.
  • NASD Notice to Members 05-26 (New Products) encourages firms to consider the complexity of a new product during the vetting process—whether the complexity would impair investor understanding of the product, and how complexity would affect the marketing and sale of the product. The notice highlights practices employed by some firms that NASD believed others should consider to comply with their various suitability obligations, avoid conflicts and plan for appropriate training and supervision. Every firm should ask and answer certain questions before a new product is offered for sale, including:
    • Does such complexity impact suitability considerations and/or the training requirements associated with the product?
    • Will the product necessitate the development or refinement of in-firm training programs for advisers and their supervisors? If so, how and when will the training be provided?
  • FINRA Regulatory Notice 12-03 (Heightened Supervision of Complex Products) identifies characteristics that may render a product “complex” for purposes of determining whether it should be subject to heightened supervisory and compliance procedures, and provides examples of appropriate procedures. The notice clearly states that advisers who recommend complex products must understand the features and risks associated with those products. The adviser should be adequately trained to understand how a complex product is expected to perform in normal market conditions as well as the risks associated with the product.

How Do Complex Products Impact Commission Structures and Regulatory Requirements?
Certain complex products may involve a higher commission structure than less complex products. Regulatory requirements place a heightened focus and obligation on the adviser when recommending such products and that may justify the higher commission.

As discussed within part one of the Exemption FAQs released by the DOL and preamble to the BIC Exemption of the DOL Conflict of Interest Final Rule, firms can pay different commission amounts for broad categories of investments based on neutral factors, such as the time, complexity and level of expertise associated with recommending investments within different product categories.

During a recent webinar hosted by AI Insight, Marcia Wagner of The Wagner Law Group, stated, “Providing evidence of training for the distribution of more complex investment alternatives would support a finding that level of expertise was an appropriate neutral factor.”

Regardless of the training policy you and your firm may have, if it is not adequately followed and documented, it didn’t happen.

michael-kell

 

Michael Kell
Vice President
Program Management and Business Development
AI Insight
Worthington, Ohio