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.

He points to Provident Royalties LLC, a private placement company which sold oil and gas interests and was accused by the SEC of running Ponzi schemes. Both RIAs and broker-dealers were told they should’ve seen the red flags, and more than 20 independent broker-dealers had to close their doors because of associated legal costs, he says.

Schlangen also cites Behringer Harvard REIT I, which was sued in September by an investor seeking class action status. The complaint alleges the large nontraded REIT masked poor performance by paying investors back with their own money. “Financial advisors should be aware and communicate to clients the difference between return of capital and return on capital,” he says.

Financial advisors should also get more attuned with the regulations because the JOBS Act will create a whole different category of alternative investments, he says. “This could unfortunately open the door for some rotten apples out there,” Schlangen says.
Schlangen notes that the Financial Services Institute and the National Society of Compliance Professionals are places to go to learn more about regulatory or compliance requirements.

Marina Lewin, head of sales for BNY Mellon’s Asset Servicing business in the Americas and leader of global sales for the company’s Alternative Investment Services (AIS) group, agrees that advisors should get to know the growing number of alternative investment regulations—many of which came out of the Dodd-Frank Act. “There’s a broad cross-section of change,” she says.

For example, managers of many hedge funds and private investment funds are now required to register with the SEC and file a quarterly “Form PF.” The 42-page document must include disclosures on strategy, liquidity, ownership and asset performance.  “The industry is not nearly as opaque as it was 10 years ago,” Lewin says.

She suggests that advisors select platforms only after rigorous due diligence that includes examining their structure to ensure they have separation of duties and knowing who the trading partner, prime broker and service providers are.

“The regulations may appear to be burdensome but the real driver is investment protection,” Lewin says. “Understand the risks of who you’re investing with.”