How to keep the SEC happy without going out of business.

Regulations. The SEC has spawned a bunch of them lately. Some are new, some are revised, some are highlighted by current events and some merely on the horizon-for now. In the last 12 months, the SEC has pushed to the forefront of every advisor's consciousness its policies on proxy voting, best execution and client asset custody.

"These regulations don't really affect nondiscretionary advisors," says Carol Wilson, a fee-only planner in Salt Lake City, Utah. In other words, we could avoid the burdens these regulations pose if we just stopped managing money. But for most of us, that's not realistic.

As you might imagine, advisors' responses to these regs vary from denial to full compliance. And, while full compliance may sound painful, you might be surprised at how simple it can be once you create the right documentation and procedures.

Warren Mackensen, owner of Mackensen & Company Inc. and ProTracker Software Inc. (www.protracker.com) in Hampton, N.H., is someone who's thought long and hard about regulatory compliance. His ProTracker software, used by hundreds of financial advisors to manage client contacts and workflow, is written with the same meticulous devotion he brings to the Compliance Manual he also has designed for the profession's use. Mackensen's manual contains sections for the files SEC auditors traditionally want to see when they conduct an audit, such as Bank Statements, Advertisements, and Complaints and Litigation, as well as sections for the kinds of regulations that are the subject of this article: Proxy Voting, Best Execution, and List of Discretionary Accounts and Powers of Attorney.

Mackensen, as well as many attorneys who specialize in regulatory compliance, will tell you the documentation of procedures is almost as important as the compliance itself. In some cases, auditors won't go beyond examining the regulated entity's written policy-hence, the importance of a compliance manual.

Best execution is a prime example. Tom Giachetti, with Stark & Stark, a Princeton, N.J. law firm that works with advisors on issues of compliance with the SEC and other regulatory bodies, says, "We strongly recommend that every advisor have appropriate, written best execution and trading procedures, and corresponding investment advisory agreement and Form ADV disclosures regarding its execution and trading practices, including disclosure relative to potential conflicts of interest."

Which is precisely what is covered in Mackensen's Compliance Manual section on regulations pertaining to Best Execution, for example. The process of what an advisor needs to do to comply with best execution requirements is laid out in Mackensen's Manual as follows:

"Periodic Assessment: The Investment Committee, which comprises the Registered Investment Advisers of the firm, meets quarterly to assess whether clients are receiving the best execution. The assessment includes an examination of the firm's practices with regard to:

Selection of custodians

Best execution reports from these custodians

Selection of trade away firms for bonds and other securities

Best execution reports from these trade away firms

Service quality received from these firms

Trade prices received

Liquidity

Alternative means of execution

Information Evaluation: Both qualitative and quantitative factors are considered, as well as technological developments. Consider-ation is given to:

Speed of execution

Reliability of execution

Commission or spread

Experience of the vendor

Conflicts of interest are explored. Correction of trading errors and paperwork mistakes at custodians are evaluated. Considerations given to selection of custodians are reviewed."

Must you actually carry out the procedures defined in this page from Mackensen's Compliance Manual, or is just having the page ready for the auditors enough? If your procedures say you meet quarterly to assess best execution, then you must meet quarterly, and you should file your minutes in your compliance manual for auditors to review. Easy? Perhaps not, but at least you don't have to re-invent the wheel.

Best execution is one of the more nebulous regulations, though. But it's not the only one.

How about compliance with the new proxy voting regs that went into effect March 10, 2003, wherein the SEC requires advisors to document their fiduciary efforts to vote proxies in the best interests of their clients, and to disclose to clients how they've voted? Deena Katz of Evensky, Brown & Katz in Coral Gables, Fla., has a well-developed procedure for compliance: "We vote client proxies for those assets we manage, and we put a record of how we voted up on our Web site, more for the SEC than for clients [who are less interested]."

In fact, Katz spells out her firm's proxy voting policy in the firm's compliance manual, saying:

"At the client's request, Evensky, Brown & Katz will vote security proxies in managed accounts. Permission may be withdrawn at any time. The firm policy is to vote proxies in favor of shareholder (i.e., our clients') interests. The following is a summary of guidelines used by the firm."

The firm's manual goes on to detail what its vote will typically be for routine proposals, non-routine proposals, corporate governance proposals, shareholder proposals and material conflicts of interest. The manual also states the firm's policy with respect to proxy voting disclosure.

Evensky, Brown & Katz goes one step further, though: "We have a compliance officer, which a lot of firms don't have," says Katz. "Our officer constantly reviews [regulations] that come out, and either incorporates them into our compliance manual or we meet and discuss them. She also uses a service-I think it's NRC-to keep updated on compliance issues that must be addressed and/or included in our compliance book."

We all might like to have a compliance officer keeping track of our compliance responsibilities, but what about smaller firms or sole practitioners for whom the cost of a compliance officer might be prohibitive? Jeff Schafer, of Schafer Financial Management Inc. in Englewood, Colo., operates alone and handles compliance duties himself. He is an SEC-registered advisor who's well aware of his regulatory duties. Schafer echoes a concern common among smaller practitioners: "These regulatory trends are unfortunate. It seems to me many regulations are just solutions in search of problems. It's ironic that SEC examiners want to see our advertising file and, meanwhile, mutual funds are raping and pillaging right under the SEC's nose."

To comply with the new proxy voting regs, Schafer says, "I chose to get one of the templates from one of the compliance consultants, an off-the-shelf product, that I could customize and format for my needs. It represents an additional cost and paperwork burden. I still just vote proxies in clients' best interests, but it seems there's now more emphasis on process than end result. The template enables me to demonstrate that I've got a policy, and that I am sending notifications to clients annually to show them I'm in compliance."

While advisors frequently discuss best execution and proxy voting, the regulation attracting the most attention of late is the SEC's new ruling on custody of client assets. Effective November 5, 2003, the SEC adopted long-awaited amendments to Rule 206(4)-2 intended to modernize the Investment Adviser Act of 1940 custody rule to enhance protections for advisory clients' assets, harmonize the rule with current custodial practices, and clarify when advisers have custody.

What many advisors don't realize is that, for most of us, the new rule is a liberalization of the rule previously in effect. Essentially, if you keep your clients' assets at an "approved custodian" (e.g., a bank or broker-dealer) that provides at least a quarterly statement to your client, if you send the client an invoice showing how his fee was calculated, if you turn over to custodians within three days any stock certificates a client may give you, if you don't receive client payments of more than $500 more than six months in advance of service, and if you don't hold power of attorney to sign checks on a client's behalf, then you probably don't have custody. That means you aren't subject to the requirement that you give clients audited financial statements, you don't have to pay for surprise CPA audits, and you won't incur SEC scrutiny for crimes such as embezzlement.

One exception-an exception that applies to many advisors-is that the SEC deems an advisor to have custody if he has the ability to debit his client's account for payment of advisory fees. However, he will not be required to undergo an annual surprise CPA examination, nor provide an audited financial statement based upon this one factor.

So what's the bottom line to the custody rule? Things will be easier for most advisors because they now have the option of declining to send clients quarterly investment reports if their custodian is already doing it. All you really need to do is have a page in your compliance manual that spells out where you custody client funds, when and what kind of investment report your clients receive, how and when you charge client fees, and that you do not directly hold client funds or securities.

Advisors who have been avoiding the need to develop procedures and documentation of their regulatory compliance should have a better idea of what to do now, knowing what other industry participants recommend and do. But, even with this roadmap, these new regulations will still seem to most advisors-and the sole practitioners who make up a huge percentage of our industry-to be an added burden.

To satisfy that burden, is it enough for the small firm or practitioner to follow Schafer's procedure of leaning on templates to communicate his compliance policies?

Matt Bienfang, a senior analyst in the retail brokerage and investing area TowerGroup, a Needham, Mass., research and advisory firm to the global financial services industry, isn't so sure. "The SEC is going to frown on the sole practitioner wearing all hats," he says. "It's the fox guarding the chicken house thing. I believe they'll look for a third-party relationship with an attorney or consultant specializing in compliance issues."

So, if you haven't yet implemented a set of regulatory policies, you might want to study what others in the industry are doingæbut take to heart Bienfang's advice as well.David J. Drucker, MBA, CFP ([email protected]), a fee-only financial advisor since 1981, is editor of the Virtual Office News monthly newsletter, and co-author of the book Virtual Office Tools for a High-Margin Practice (Bloomberg Press, 2002), both available at www.virtualofficetools.net.