Advisors must be vigilant in avoiding conflicts of interest.

A recent enforcement proceeding by the Securities and Exchange Commission (SEC) against a federally registered investment advisor should serve as notice to advisors of the seriousness with which the SEC views certain activities of advisors and their duty to clients. This case and other recent SEC actions and statements also provide a road map to advisors of the kinds of preventative measures an advisor should undertake in order to avoid a similar fate and the obstacles that advisors face when considering partnering arrangements.

Advisor Conduct

Jamison Eaton & Woods is a New Jersey based investment advisor with about 180 individual clients. It has more than $600 million under management and nondiscretionary assets of about $17 billion. Jamison has been providing investment advice in its present form since 1972 and has referral arrangements, in some cases going back 25 years, with various registered representatives of full service broker-dealers, among others. Pursuant to these arrangements, the broker reps referred their clients to Jamison for advisory services, with the quid pro quo that Jamison would continue to execute transactions through the full-service broker-dealer that had provided the referral. An SEC examination of Jamison found that clients who came to Jamison through the broker rep referral arrangement paid commissions of about $0.35 per share, while Jamison's other clients paid a commission rate of $0.08 per share through a lower-cost bank clearing service.

In what appeared to be a recognition of the conflict-of-interest issue and an attempt to address it incrementally, Jamison's disclosure to clients evolved over time. Prior to 1999, Jamison's one-page client agreement made no reference to any actual or potential conflict of interest regarding broker rep referrals, nor did its Form ADV. Between 1999 and 2002, Jamison used various vague references in an attempt to disclose away the issue. It was not until January 2002 that Jamison boldly informed clients that a potential conflict of interest could arise in situations where a client is referred from a broker rep. At no point did Jamison mention that this conflict would result in the client paying more for brokerage transactions.

SEC Action

Not surprisingly, the SEC found that Jamison failed to disclose a material arrangement to clients, and did not review the direction and placement of its client brokerage in light of its fiduciary duty to seek to obtain best execution in the evolving market for custody and execution services. By failing to disclose its potential conflict of interest and other brokerage options, and by failing to seek best execution, Jamison violated various provisions of the Investment Advisers Act of 1940 and incurred a fine of $100,000. In addition to paying a fine of $100,000, Jamison also entered into a settlement order with the SEC that obligates it to:

Maintain a director of compliance who has unrestricted access to the board of Jamison and is instructed to meet with legal counsel annually to review compliance procedures.

Disclose in its Form ADV that a conflict of interest may exist in obtaining best execution between the client and the advisor in situations where the client is referred by a broker rep.

Maintain a standard investment contract that has a separate paragraph entitled "Placement of Brokerage" and permits clients to direct brokerage to a particular broker.

Maintain a revised procedures manual that includes policies and procedures to ensure adequate disclosures to clients relating to broker referrals and conflicts of interest.

Mail Form ADV to all advisory clients who use a full-service broker and are not in an asset-based-fee program along with an explanatory letter that has been approved by the SEC.

Conduct periodic and systematic evaluations of its brokerage arrangements and the alternatives available for analyzing best execution.

Clearly, this advisor can now look forward to a long and close relationship with the SEC.

What The Law Requires

Although the terms of the order entered in the Jamison case may seem harsh, this case hardly breaks new ground. In 1988, the SEC settled a case with Mark Bailey that received widespread attention in the financial press in a "failure to disclose" case with facts very similar to the Jamison situation. In the Bailey case, the SEC stated that Bailey had breached its fiduciary duty to clients because it failed to disclose to clients that it had a potential conflict of interest between clients' interest in obtaining best execution and Bailey's interest in receiving future referrals, and that Bailey did not seek to obtain best execution because it did not negotiate commission discounts. The SEC stated that clients might have paid lower commission rates if they had not directed their brokerage to the referring brokers. The SEC has also found in other enforcement cases regarding the trading of securities for clients the potential for a conflict of interest when an advisor sells securities it owns to a client or when an advisor receives soft-dollar services for trading commissions. In each case, the SEC has consistently delivered the message to advisors that full disclosure to clients is necessary.

Relevant portions of the Advisers Act and case law make it illegal for an advisor to engage in any transaction, practice or course of business that operates as a fraud or deceit upon any client of prospective client. The existence of a conflict or potential conflict of interest is a material fact that an investment advisor must disclose to clients because it might cause the advisor to render advice that is not disinterested. Accordingly, advisors must disclose to clients in Part II of Form ADV (or a brochure in lieu of Part II that goes to clients) any material information regarding brokerage placement practices. Additionally, advisors have a duty to seek best execution on behalf of clients and to periodically and systematically review the quality of execution services in view of market developments. Although many of these types of enforcement actions are brought under a theory of failure to disclose, it would not be sufficient for an advisor to disclose to its clients that it does not review brokerage arrangements and does not seek to obtain best execution. Therefore, an advisor has both an affirmative duty to act in the best interests of its clients and to disclose to clients those situations where a conflict to that duty could occur.

What Advisors Need To Do

In the wake of recent corporate scandals, the SEC budget has been increased to provide for additional examiners. In the next several months, it is expected that the SEC will start hiring and deploying these examiners to visit advisors and other registrants that have not been examined recently or who have never been examined. In recent speeches and public pronouncements, the SEC has indicated that investment advisor compliance is a top priority. Lori Richards, director of the SEC's Office of Compliance, Inspections and Examina-tions, has estimated that 70% of advisors that are inspected are found to be deficient in their disclosure of material information to clients. The SEC has indicated that they intend to examine advisors that have been found to have material deficiencies on a more frequent basis than advisors whose problems are less severe. In addition, the SEC has proposed a rule that would require investment advisors to adopt, implement and annually review compliance policies and procedures that must be reasonably designed to prevent violations of the Advisers Act. The rule proposal would also require advisors to designate a chief compliance officer. This person will be required to be someone who understands and appreciates investment advisor compliance, not simply a warm body that receives a new designation.

The Jamison case should serve as notice to registered investment advisors that they must prepare themselves now for their next SEC examination. Advisors should undertake a review of their current business practices to determine whether such practices have changed significantly since their Form ADV and client brochure was last revised. It is often the case that regulatory disclosure is written when the advisor first becomes registered, but simply does not keep up with the fast-paced changes in the marketplace. Often the full nature and extent of business practices is not effectively communicated to compliance staff and, therefore, is not accurately described in Form ADV updates and amendments. It does not take very many rounds of insufficient disclosure revisions before the manner in which the advisor actually conducts its business diverges materially from how the advisor's business activities are described. This is true not only of trading practices, such as best-execution and soft-dollar arrangements, but can also occur in the investment programs of the investment advisor. It is imperative, therefore, that the portfolio managers, as well as marketing, operations and compliance staff, periodically review disclosure to regulators and clients.

One way for an advisor to demonstrate that it has evaluated these matters in a "periodic and systematic" manner is to hold regularly scheduled meetings of a best-execution or trading-practices oversight committee. Minutes of these meetings should be kept, and an advisor should be able to demonstrate that the issues discussed and the resolutions adopted at such meetings were put into practice and disclosed in regulatory filings and disclosures to clients.

In addition to the compliance and legal issues discussed earlier, advisors must also review their business relationships and referral arrangements with nonadvisory entities. Obviously, the Jamison case places advisors who seek to build their businesses through referral arrangements in a difficult position. What broker-dealer or accountant will want to enter into a referral arrangement with an advisor if the advisor is obligated to inform the referred client that his broker or accountant may have been overcharging him? This point underscores the fiduciary duty that an advisor has to its client that brokers and other service provider do not have. Remember, in the Jamison case, the SEC sought enforcement action against the advisor, they did not also seek to charge the broker-dealers or broker reps for aiding and abetting a violation of the Advisers Act. Registered investment advisors are simply held to a higher standard, and adherence to this higher standard may dictate the manner in which business is developed. A likely consequence for advisors that do not adopt and adhere to a high fiduciary standard is close and continuous scrutiny by the SEC.

At the end of the day, principals of investment advisors must reconcile themselves to the new regulatory environment. Rather than wait for an SEC examination and the resulting deficiency letter, advisors should take pre-emptive action to ensure good compliance and good business practices. Resources allocated before the fact will be money well spent when the regulators walk through your door.

Jay Gould is a former attorney with the Securities and Exchange Commission and has nearly 20 years of experience representing investment advisors, broker-dealers and investment companies. He presently represents E*TRADE Group Inc. and can be contacted at [email protected] or 310-800-6500.