The majority of financial advisors use tactical and alternative investments and 84% are likely to recommend them to clients in 2013, according to a survey conducted at the Financial Planning Association’s annual conference this fall by CMG, a Philadelphia-area registered investment advisor. Investor exposure to alternative investments is also expected to grow as advertising restrictions loosen next year under the Jumpstart our Business Startups Act (JOBS Act).
But the U.S. Securities and Exchange Commission isn’t giving much guidance on how to comply with the regulations in this space, which center on suitability concerns and disclosures. So how can advisors try to avoid stepping on potential land mines?
Your best bet for now is to follow the guidelines the Financial Industry Regulatory Authority has provided to broker-dealers, says Robert Schlangen, co-founder/partner of 3010 Enterprises LLP of Katy, Texas. The compliance and consulting company helps broker-dealers, RIA firms and financial advisors understand and interpret rules and regulations, and assists in customizing the implications into their practices.
At a minimum, advisors should understand products before offering them to clients, conduct due diligence and ensure the suitability of client participation, says Schlangen, who began his career as a financial advisor with Merrill Lynch before transitioning into compliance.
Finra expectations “should be mimicked on the investment advisory side as a best practice to make sure the best interests of clients are being met,” says Schlangen. The SEC has even told some RIAs that they can follow Finra steps to make sure products are suitable, he says.
In addition to getting acquainted with the new Suitability Rule (Finra Rule 2111) and Know-Your-Customer Rule (Finra 2090), which both took effect in July, Schlangen says RIAs should familiarize themselves with a couple of Finra Regulatory Notices.
• Regulatory Notice 09-09—Customer Account Statements and Due Diligence Requirements for Unlisted Real Estate Investment Trusts (REITs) and Direct Participation Programs (DPPs)—reminds broker-dealers of their ongoing due diligence obligations and the need to consider how distributions can be impacted. For example, it says to find out if there have been unscheduled cancellations of existing leases that impair or materially affect a real estate investment program’s cash flow. Programs with cash flow trouble may lower dividend distributions.
• Regulatory Notice 10-22—Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings—says that at a minimum a broker-dealers should conduct a reasonable investigation concerning the issuer and its management, the business prospects of the issuer, the assets held by or to be acquired by the issuer, the claims being made and the intended use of the proceeds of the offering.
Schlangen says advisors should be on the lookout for pertinent red flags such as an issuer’s financial position (and whether they’re providing unaudited or audited returns); unwillingness of an issuer to divulge information; criminal and regulatory events of principals of the issuer; poor or anemic past performance of previous offerings; any pending litigation; and use of unsubstantiated financial models to generate projections or targeted returns.
Schlangen also suggests looking at notices and enforcement cases on the SEC website. “Sometimes how you learn what to do is when you learn what not to do,” he says.