Mitigating Registered Investment Advisor Liability Exposures

Working as a registered investment advisor (RIA) has its rewards. But heavy compliance requirements can be a downside. Here are some of the major issues RIAs must contend with.

One way to limit your registered investment advisor (RIA) liability exposure is to effectively handle your compliance obligations. Fully discussing these would require writing a novel. But for our immediate purposes, let’s focus on two key topics:

• Documentation (books and records requirement).
• The investigation process (after clients file complaints about the investment advice they receive).

General Compliance Requirements

As an RIA member, you work in one of the most highly regulated professions in America. Based on your assets under management (AUM), you’ll either come under the purview of the Securities Exchange Commission (SEC) or a state-level investment advisor regulator. If you don’t register your business entity with the appropriate authority and/or never become properly licensed as an investment advisor representative (IAR), you may find yourself at risk.

At the highest level, RIAs must comply with Rule 206(4)-7 of the Investment Advisers Act of 1940. This requires them to:

• Develop and implement written policies and procedures to prevent violations of U.S. securities law.
• Annually review those policies and procedures.
• Designate a Chief Compliance Officer (CCO).

The SEC has imposed many additional requirements underneath the “policies and procedures” requirement just mentioned. They address matters such as:

• Portfolio management.
• Trading practices
• Proprietary and personal trading
• Accuracy of disclosures to key stakeholders
• Protection of client assets
• Marketing strategies
• Valuation of client assets
• Client privacy
• Business continuity plans

RIAs must also operate as fiduciaries when providing investment advice and disclose information about their backgrounds, prior disciplinary sanctions and business practices. Acting as a fiduciary is perhaps the bedrock of RIA compliance. It rests on two highly significant duties:

• The Duty of Care, which requires providing advice that serves a client’s best interests. This duty also requires RIAs to continually seek to provide best execution of a client’s transactions and to provide ongoing advice and monitoring during the entirety of the client relationship.
• The Duty of Loyalty, which requires RIAs not placing their own interests ahead of their client’s. The Duty of Loyalty also mandates full and fair disclosure of all material facts about the advisory relationship, including conflicts of interest.

The Books and Records Requirement

When you provide investment advice as an RIA, you must document in writing every action you take during the course of your client engagement. Based on Rule 204-2 of the Investment Advisers Act, RIAs must make and keep records regarding their investment advisory businesses.  Here are just some of the items you must store for five years, with the first two years being in an appropriate business location:

• Your firm’s compliance manual (all versions).
• Policy and procedure reviews.
• Lists of current and former clients (with contact information).
• Cash inflows and disbursements.
• Financial statements.
• Internal working documents.
• Paperwork relating to your firm’s bank accounts: check registers, monthly statements, cancelled checks and cash reconciliations.
• Copies of signed client agreements.
• Documentation of client authorization of trading authority.
• Archive of client correspondence, both print and electronic.
• Copies of client complaints and their resolution.
• Proof that Form ADV Parts 1, 2 and 3 were given to clients.
• Documentation that all clients received your privacy notice.
• Copies of reports mandated by your Code of Ethics.
• Copies of all marketing materials, including web pages, blogs, social media posts and trade ads.
• Copies of all client communications.
• Documents relating to RIA registration.
• Other records that may be required based on your business model and place of registration.
• Records pertaining to political contributions.
• Records regarding custody of client assets.

Finally, if you advertise your firm’s investment performance, you must retain records relating to how you calculated your performance or rate of return.

Complaint Handling Process

Since RIAs work with clients about something they care a lot about—their investments—it’s inevitable some will be unhappy with the results delivered. When an RIA’s investment strategy produces losses instead of gains, it’s common for clients to file complaints with an advisor’s regulator. If this doesn’t provide satisfaction, many will take their concerns to court.

According to RIA Compliance Group, advisors should first define “complaint.” Then, when a client disagreement falls within the definition, it should trigger a formal complaint handling procedures. Typically this process involves escalation in which a dispute moves to progressively higher levels in an RIA firm. It’s important to define this process in advance and to disclose it to clients. You can be certain if the SEC or a state regulator audits you, it will ask to see a copy of your complaint-handling process, along with details of recent complaints filed and resolved.

Step one typically involves informing your chief compliance officer that a client complaint is “on the table.” Formal notice should occur either at the outset or soon after submission of all relevant documents relating to the dispute. Involved parties in the firm should also submit their accounts of what triggered the dispute.

Once all files and explanations have been filed, the chief compliance officer should fully investigate the matter and then attempt to resolve it to the satisfaction of all parties. At the same time, the COO should notify the firm’s E&O insurance carrier of a potential claim.

After the COO decides how to resolve the complaint, he or she should formally notify the client and all involved parties within the firm.

As part of overall firm supervision, the COO should keep detailed records of all complaints and firm responses. The rationale for all complaint resolutions should be documented in writing.

Why E&O insurance is essential for Registered Investment Advisors

Complying with RIA regulations is essential. Also essential is mitigating your RIA liability exposures with errors and omissions (E&O) insurance. Most RIAs will be required to carry E&O insurance by the firm’s broker dealer. Without it, you’ll leave yourself unprotected against client lawsuits. Here’s why this is unwise (especially during your initial years in the business):

• Clients who seek investment-advisory services are typically demanding investors. They will not be tolerant of investment professionals who lose their money through incompetence or negligence.
• As client assets under management (AUM) have grown, plaintiff’s attorneys have become more aggressive and savvy. Today they target RIAs who have received federal or state regulatory sanctions by running social-media campaigns targeting their current or former clients. This has made the RIA industry even more legally precarious than before.
• New RIAs are busy. This sometimes leads them to postpone mitigating their business risks. However, reality has a way of intervening. All it takes is one investment planning or execution error to turn a long-term satisfied client into a legal nightmare.

Bottom line: If you’re planning to establish an RIA, take immediate steps to mitigate your legal exposures. With so many challenges ahead, you don’t want an uninsured E&O settlement or judgment to drain your personal assets. Solution? Secure E&O insurance coverage or if you’ve already purchased it, review your policy’s limits of liability to make sure they’re still sufficient.

Paying too much for your RIA E&O insurance? Then compare your current policy with those available from NAPA. Our insurance for RIAs, investment advisor representatives, registered representatives and financial planners starts at $72.08 per month. To learn more, visit our website.