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.