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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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Fiduciary Rule for the Modern World

On April 6, the U.S. Department of Labor unveiled the fiduciary rule that has been six years in the making.

Department of Labor Secretary Thomas Perez said that the new rule ensures that financial advisers will act in the best interest of their clients. Gone is the suitability standard and replacing it is a fiduciary standard.

“A consumer’s best interest must now come before the adviser’s financial interest,” Perez said.

The Financial Planning Association will be there for its members throughout the process of compliance, said FPA President Pamela Sandy, CFP®. Firms are required to comply by Jan. 1, 2018.

Sandy said the organization is working with the Financial Planning Coalition—which includes CFP Board and NAPFA—to analyze the rule and figure out exactly what it means for FPA members.

“FPA, as your professional home, will be helping you understand the rule and assisting you in adjusting to the impact the rule will have on your clients and your business,” Sandy writes to FPA members.

Members now have access to the organization’s newest Knowledge Circle on Public Policy and Regulation, which is now available to help members navigate the new law and discuss information with peers. The Knowledge Circle will temporarily be headed by FPA Chair Edward W. Gjertsen, II, CFP®.

Perez said the change in regulation is long overdue.

“The regulatory structure that protects people’s investments has not kept up with the changing landscape,” Perez said at a press conference. The rules that were in place were sufficient for days when pensions dominated the retirement field and Leave it to Beaver was popular on television, he added.

But we live in a Modern Family world now, IRAs and 401(k)s rule the roost, and people are losing $17 billion annually in fees for bad products and advice, according to a 2015 White House report.

Perez said the streamlined rule addresses concerns that many opponents had with the first versions of it, which were proposed in 2010, withdrawn, then re-proposed in 2015. The new rule has some flexibility for firms that sell proprietary products, has extended the deadline for compliance four months, and streamlined the mechanics of the contract, among other things.

“Today’s rule ensures that putting clients first is no longer simply a marketing slogan, it’s now the law,” Perez said.

Proponents of the new rule are expecting a fight from the rule’s opponents, New Jersey Senator Cory Booker (D-N.J.) said at the press conference on April 6.

But Senator Elizabeth Warren (D-Mass.) said, “We are not going back. This rule is too important for seniors, it is too critical for workers, and it is one more step to making sure our economy can grow from the middle out, not from the top down.”

Join the discussion on FPA Connect, and see below for a list of helpful links to help you arm yourself with the most current information.

 

AnaHeadshot

Ana Trujillo
Associate Editor
Journal of Financial Planning
Denver, Colo.

 

Helpful Links for More Information