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How Can Financial Advisors Navigate the Compliance Maze?

Kate Stalter

Advisors must adhere to stringent demands of state and federal regulators. Regulations, too, are constantly evolving, adding layers of complexity for advisors.

For example, last year's passage of the SECURE Act, which stands for "Setting Every Community Up for Retirement Enhancement," affected Americans' retirement savings. It sent advisors scrambling to make clients aware of the changes and help them implement new approaches to savings and withdrawals.

Adding an extra layer, there were broader tax law changes in 2018. While most advisors don't prepare client tax returns, the changes impacted many financial strategies, including plans for charitable donations.

Here's what advisors need to know when it comes to navigating the maze of meeting compliance regulations.

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Why It's Important

That's not to say that advisors intend to flout regulations. On the contrary, the majority want to sail through their federal or state audits with flying colors. But compliance mistakes do occur, even at the most well-intentioned advisory firms.

While regulators do their best to answer advisor questions and clarify gray areas, there's no simple checklist of rules that would make it easy for advisors to toe the line in every imaginable situation.

"We had an issue with a registered investment advisor [firm] that was taking inadvertent custody of client funds or securities because one of the investment advisor representatives of the firm was acting as a trustee over client trusts and had never reported this fact to his compliance officer," says Ara Jabrayan, a managing member at RIA Compliance Group in Delray Beach, Florida.

Investment advisors with custody of client assets have a much higher compliance burden than those who don't. A majority of advisors avoid custody of funds for that reason.

"During a routine audit, the Securities and Exchange Commission discovered this issue and required the RIA to hire an unaffiliated public accountant to undergo a custody examination for the previous five years," Jabrayan says. "Although the firm was not fined, the custody exams cost the firm close to $50,000 and caused a massive disruption to the firm's day-to-day operations."

Mark Alcaide, senior managing director at compliance consultant Foreside in Boston, says the most common compliance mistakes revolve around conflicts of interest within an advisor's business.

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Disclosure Is Key

"Most situations we see a result from an advisor's failure to recognize, or failure to fully disclose, the existence of a conflict of interest," Alcaide says.

It's a common conflict for advisors and it's prompted a heightened review by regulators in the past 24 months when it comes to undisclosed revenue-sharing arrangements, he says.

That arrangement means that a firm may be entitled to compensation from a third party for actions such as recommending a product issued by the third party.

An advisor might sell a particular mutual fund to a client and receive compensation from the fund issuer. This provides an incentive for the advisor to recommend the revenue-generating product over other products.

That may seem, on the surface, to be underhanded, but it doesn't necessarily mean the fund in question is inappropriate for the client. Fee-only fiduciaries, who have a responsibility to act in their clients' best interests, can't enter into such arrangements, but advisors with broker-dealer affiliations may. It becomes a compliance problem when advisors fail to tell clients about these transactions.

"While many revenue-sharing arrangements are acceptable in the advisory world, they must be disclosed so that clients and prospective clients can make an informed decision when considering whether to engage the advisor," Alcaide says.

He adds that other common conflicts of interest relate to incentives an advisor may give to a prospective or existing client to entice new business. Political contributions may also be conflicts of interest, as an advisory firm's staff may make campaign donations with the hope of receiving the business of managing pension funds for states or municipalities.

[Read: Tax Deductions for Financial Advisor Fees Without IRC 212.]

Steps to Take

While it's not easy to stay apace with changes to compliance rules and regulations, advisors have options for making sure their procedures are up-to-date.

Alcaide notes that the SEC's Office of Compliance Inspections and Examinations, known as the OCIE, issues risk alerts for advisors periodically. These sometimes highlight common compliance deficiencies identified by the SEC during examinations of advisory firms.

Speaking at the Investment Adviser Association's compliance conference in March, Peter Driscoll, director of OCIE, said the SEC expects to release numerous risk alerts in 2020. Although advisors often tend to view regulators as adversaries, that's not necessarily the case.

Driscoll told conference attendees, "We're really trying to get more information out to you all to help you do your jobs."

In particular, Driscoll referenced Regulation Best Interest (BI), which implements a best interest conduct standard for broker-dealers and affiliated individuals. The regulation, commonly known as Reg BI, applies when a registered representative recommends securities to retail clients.

Regulation Best Interest and Fiduciaries

The regulation includes changes to securities recommendations, sales incentives, and disclosures of fees and potential conflicts of interest. These apply mainly to broker-dealers, who receive commissions for product sales. However, RIAs should also familiarize themselves with the rule changes, as they are held to the higher fiduciary standard.

"RIAs are held to the fiduciary standard, while broker-dealers have to comply with the suitability standard," Jabrayan explains. "As such, RIAs must make sure all advice provided to the client is in the client's best interest without regard to any incentives that the investment adviser may have."

He adds: "A broker-dealer just has to make sure the recommendation given to the client was suitable for the client at the time the recommendation was given."

Jabrayan suggests some tips for advisors hoping to streamline their compliance processes.

"Try to simplify your business model. Provide adequate resources to your compliance officer," he says. "If you cannot afford a dedicated compliance officer, hire a consultant or work with a securities attorney. Make sure you are well-versed in regulatory requirements, including SEC and/or state securities laws and regulations."

Alcaide also offers some guidance: "Advisors can avoid common compliance mishaps by periodically conducting a risk assessment of the firm's compliance risks by identifying, mitigating, and disclosing conflicts of interest, and paying attention to the issues raised by the SEC in its risk alerts and other communications."



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