Articles About Regulation & Compliance

Financial advisors at RIAs have a fiduciary obligation to their clients, which includes both a Duty of Loyalty (to avoid – or at least disclose and take steps to mitigate – any conflicts of interest) and a Duty of Care (to act with prudence when making investment recommendations, considering both their investment opportunity and benefits along with the associated costs). However, while certain costs (e.g., fund expense ratios or ticket charges on trades) are relatively transparent, RIA custodians also earn revenue in various ways from client portfolios in exchange for the custodian's services. Which means RIAs that place clients at a particular RIA custodial platform also have a fiduciary obligation to ensure that their clients are paying reasonable expenses to the platform in exchange for the services they receive. That said, when it comes to RIA custodians, there is no explicit fee for services – nor really any way to determine the total costs clients actually pay (i.e., that their RIA custodian earns) for custodial-related services – making it difficult for firms to determine whether their current custodial relationships are truly aligned with their fiduciary obligation to their clients.

Notably, RIAs aren't necessarily required to choose the lowest-cost custodial option for their clients. Nonetheless, if an RIA did choose a more expensive one, the firm would, at a minimum, have a fiduciary obligation to justify why that option was chosen and how it would benefit the client (e.g., a particular custodian might offer superior technology to execute trades and better service to resolve client issues). Though, given the lack of price transparency amongst custodians, such a calculation is again nearly impossible to make!

With the current RIA custody model creating challenges for advisory firms to fulfill their fiduciary responsibilities to their clients – and putting their interests at odds with those of the custodians they work with (with a firm trying to minimize custodian-related client costs and the custodian having an interest in generating more revenue from each RIA client) – both RIA firms and custodians have an interest in finding an alternative.

One possible option would be for the RIA custodian to charge a basis-point fee to each client of RIAs on its platform, equal to the average fees they're earning under the current model (so the custodian continues to earn the revenue it needs to provide its services), and then apply a credit to the client's statement for any other revenue the custodian is earning. In many cases, this might fully offset the custodial fee anyway, but it would be done at the client's discretion as to how they wish to pay! In turn, custodians would be incentivized to better 'stock the shelves' of their custodial platform with unique offerings (e.g., highest-yielding cash sweeps, lower-cost investment products) to attract advisors and their clients to the platform to pay the fee (and thus grow their own assets).

While the concept of such an 'upside-down' fiduciary model for RIA custody is relatively straightforward to re-align the interests of the custodian, the advisor, and their client, doing so would come with non-trivial complexities and questions – not only in terms of systems but also in determining fairness to RIAs and their clients. For example, a custodian would have to determine whether the statement credit would be allocated across all clients on their platform at the client, account, or individual holding level. Also, such a move could lead to uncomfortable conversations for advisors (e.g., if they choose a more expensive custodian that provides them with practice management support or client referrals, which benefit the advisory firm but don't actually benefit the client that incurred the cost).

Though, arguably the biggest challenge of instituting a basis-point fee and statement credit system is behavioral. Simply put, clients (and their advisors) aren't used to paying an outright fee for custody. And when something has been provided for 'free' for so long, any fee – no matter how reasonable – can induce sticker shock (even if much, or even all, of the fee is being rebated through the statement credits)! Though notably, the entire evolution of the RIA movement for the past 20 years has been the transition from opaque commissions (on investment products) to transparent advisory fees, which consumers have ultimately come to prefer because of the better alignment with their advisor… suggesting that, in the long run, custodians stand to benefit from a more fiduciary pricing model for RIA custody in the same manner that RIAs themselves have benefited in the marketplace.

Ultimately, the key point is that the current RIA custody model presents fiduciary challenges for advisors, who have no feasible way to compare the costs for their clients of different custodians they might work with to ensure clients are receiving benefits commensurate with their cost (as custodial revenue yield, and thus pricing, can vary significantly from one platform to another). Which suggests that an alternative approach – pairing a clear basis-point fee for the client with statement credits for revenue generated by their use of custodial services – not only offers greater transparency in the costs for custodial services but also better aligns the interests of clients, advisors, and the custodians they work with. And, in the end, that alignment would allow advisors to more effectively fulfill their fiduciary obligations to clients!

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When a financial advisor transitions from one firm to another, they're often offered incentives by the new firm based on how much client revenue they bring with them. The challenge, however, is that advisors generally don't have the legal authority to simply transfer clients to a new firm. Because client relationships are technically "owned" by the firm – not the individual advisor – any transition requires clients to take action to shift from one firm to the other. This creates a host of challenges tied to client privacy laws and the advisor's contractual obligations to their former firms.

In this guest post, Isaac Mamaysky, Partner of Potomac Law Group and Cofounder of QuantStreet Capital, discusses the legal and compliance issues that arise when an advisor tries to bring clients with them to a new firm and the key considerations – including data privacy restrictions under SEC Regulation S-P and non-solicit clauses in employment agreements – that create complex dynamics and potentially conflicting obligations advisors must navigate to avoid violating privacy laws or breaching contractual obligations.

From a privacy standpoint, client data held by an RIA or broker-dealer is considered Nonpublic Personal Information (NPI) under Regulation S-P and generally cannot be shared with an unaffiliated third party without the client's consent – unless the firm's privacy policy explicitly allows it and the client has not opted out. Which means that if an advisor leaves a firm whose privacy policies don't permit such sharing, they can't take any client data with them, including names, contact details, or even knowledge that an individual was a client of the old firm. Furthermore, in states with stricter rules, such as California's "opt-in" privacy requirements, clients must affirmatively authorize information sharing at all times, adding another layer of complexity.

Although the Broker Protocol allows for the sharing of limited client contact information between firms, advisors and their firms are still required to comply with Regulation S-P. Advisors may only take information if their firm's privacy policies allow it and clients haven't opted out. In other words, participation in the Broker Protocol doesn't override privacy laws.

Further complicating matters, advisors may be bound by contractual non-compete or non-solicit clauses in their employment contracts with their old firm. These clauses typically prohibit advisors from encouraging clients to move with them to a new firm. So if an advisor is required to obtain client consent before transferring information to their new firm, they may be contractually prohibited from even asking for that consent. In other words, when privacy laws prohibit sharing information without consent, and contractual obligations prohibit asking for that consent, advisors risk violating either privacy law or their agreement with their previous employer!

Ultimately, the key point is that moving clients from one firm to another requires careful coordination across three fronts: Federal and state privacy laws, firm privacy policies, and employment agreements. While obtaining client consent is generally the safest approach, advisors must understand whether asking for that consent could violate their employment contract. While the rules can be complex, a thoughtful evaluation of the advisor's legal and contractual obligations, along with careful planning, can help manage their risk and increase the likelihood of a successful transition!

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Maintaining adequate books and records is a cornerstone of compliance for all investment advisers. While state and Federal regulations clearly outline recordkeeping requirements for areas like financials, advertisements, and trading records, there is a notable gap when it comes to documenting the delivery of services – especially financial planning services – necessary to justify the fees charged for those services. This lack of specificity can result in regulatory deficiencies or scrutiny, even for firms providing substantial financial planning value to clients, if records fail to consistently demonstrate that fees are 'reasonable' in relation to the services provided.

To minimize regulatory concerns regarding the reasonableness of advisory fees, firms can establish internal standards for service-related recordkeeping. For investment management services, documenting the entire client engagement – such as onboarding, reviewing and recommending portfolio adjustments in line with collected suitability information, opening and funding accounts, conducting periodic reviews, and rebalancing – can help clearly evidence the services provided.

For financial planning services, a similar approach to documentation can be applied to support regulatory compliance from the start of client engagement through all the steps that follow. This includes tracking the information-gathering process during the client discovery phase, followed by the research and development of a financial plan. Next, firms can document the delivery of the plan, check-ins throughout the year to support plan implementation, periodic meetings to work on or execute various aspects of the plan, and the annual review of the client's situation. The review should also include updating the plan to account for significant changes and seasonal "to-dos", assessing any advised assets that aren't under the firm's direct management, and responding to other financial planning questions that arise throughout the year. NASAA's Fee Guidance highlights the importance of detailed recordkeeping for emerging fee models and provides practical context for advisers navigating these challenges.

A client service calendar can be an excellent tool to illustrate these services. It provides a structured outline of the firm's service delivery, sets client expectations, and serves as a framework for systematizing processes as the firm grows. It also helps demonstrate to regulators what the firm's ongoing financial planning services entail (though advisers will want to be certain that client files reflect that the adviser did everything the firm committed to in the client service calendar!).

Ultimately, the key point is that while the books and records requirements for financial planning services are less prescriptive than for investment management, advisers can take proactive steps to systematically document the services they provide to clients. This reduces the risk of regulatory scrutiny during examinations and helps regulators better understand what strong service delivery and comprehensive documentation for financial planning should look like!

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In the competitive market for financial advice, advisory firms often seek to find ways to differentiate themselves from one another. For firms with high-net-worth clientele, one way to do this is to offer alternative investments, such as private equity, private debt, or hedge funds, which may offer clients the ability to invest in a more diverse range of assets. In many cases, advisors place clients into funds run by third-party managers, which allows the advisor to rely on the manager's expertise in that particular investment area as well as their back-office resources to handle the administrative, legal, and regulatory hurdles of running a private investment fund. However, it's also possible for advisors to launch and manage their own private funds, which can allow them to further tailor their investment strategy to their clients' needs and to grow their business by attracting more high-net-worth clientele, while potentially cutting out some of the cost layers that clients face when using third-party alts distribution platforms.

At a high level, private funds work by pooling capital together from multiple investors, which can be deployed in a variety of ways – from traditional investments like public stocks and mutual funds to stock in private corporations, private debt lending, commodities, real estate, and even more exotic investments like art, wine, or collectibles. Additionally, private funds can employ leverage, short selling, derivative strategies, and other methods to further manage the portfolio's risk and return characteristics. The end result is that private funds may offer investors more diversification by investing in a broader range of assets than what's found in the public markets; on the other hand, they can be riskier and less liquid than other investments, which is why generally only accredited investors (i.e., generally those with over $200,000 of income or $1 million in net worth) are allowed to invest in private funds.

For advisors who launch private funds, it can be costly to navigate the legal and regulatory complexities involved in getting the fund off the ground. Attorneys are needed to draft the fund's offering documents, and if the advisor wants to avoid the need to register the securities or the investment company with the SEC, the firm will need to implement policies and procedures to ensure the fund meets the exemptions for those requirements. In addition, most RIAs will likely want to engage the services of a third-party fund administrator to facilitate many of the documentation, tracking, and recordkeeping requirements. All of which can make a private fund expensive to launch, with the typical cost for launching a small fund ranging from $40,000 to $70,000 (costs that are typically borne by fund investors) – although given that many of these costs are upfront when launching the fund, costs to manage the fund on an ongoing basis can be substantially less, depending on the costs of the third-party administrator being used and the complexity of the strategy being employed. However, advisers may also realize the operational cost benefits of launching a private fund since they would not need to execute many individual trades for clients through separate accounts.

The key point is that although private funds might not be appropriate for all advisors – since they require having clients who qualify as accredited investors, and having enough of those clients who can benefit from investing in the fund to provide enough capital to run the private fund cost-effectively given the overhead expenses involved to start and run one – they can still be worth exploring for advisors seeking to differentiate themselves and expand their service offerings for high-net-worth clients. And while the complexity and upfront cost of launching a private fund may be high, doing so may ultimately be worth it for the ability to unlock new business growth and deliver more value for clients, at least for firms that want to further differentiate themselves on the basis of their (private) investment offerings to clients!

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As fiduciaries, financial advisors are required to disclose any conflicts of interest that exist between themselves and their current and potential clients. The conflicts themselves can range from compensation models that impact how much money an advisor might earn as the result of a recommendation (such as specific product recommendations for advisors compensated on commission and 401(k) plan rollover recommendations for AUM-based advisors) to less direct conflicts such as 'soft dollar' benefits provided by custodial platforms that could incentivize advisors to recommend one platform over another.

But no matter the size or directness of the conflict, it still needs to be disclosed to clients, at a minimum on the advisor's Form ADV Part 2A brochure. And given the sheer number and scope of potential conflicts that do exist in the advisory industry (where a wide range of providers seek to incentivize advisors to recommend their products and services to clients), there's a vanishingly small number of RIAs that don't have at least some form of actual or potential conflict to disclose.

However, despite the large number of potential conflicts that exist for advisory firms, much of the financial media and the general public tend to focus specifically on the conflicts caused by commission-based fee models. Which, in turn, has led a small but growing number of RIA firms to describe themselves as "conflict-free" on their websites and advertising materials as a way to distinguish themselves from other firms that may have more directly conflicted business models.

But the downside to using the "conflict-free" label was put into sharp focus recently, when the SEC announced that it had fined several RIA firms for violating its Marketing Rule. Specifically, the firms had all used some form of "conflict-free" to describe themselves on their website, while at the same time, each firm's Form ADV Part 2A described multiple conflicts of interest – or in other words, the firms' claims of being "conflict-free" were directly contradicted by their own required conflict of interest disclosures!

At a high level, the SEC's cases illustrate that it can be highly problematic for an advisory firm to call itself "conflict-free", since doing so violates the Marketing Rule's prohibition on making any material statements that the advisor can't substantiate when the firm really does have conflicts that it discloses in its own regulatory filings. And given that almost every firm has at least one conflict to disclose, there are almost no firms that could accurately (or compliantly) describe themselves as "conflict-free" – meaning it really might be best for advisory firms to avoid the label altogether.

If an advisory firm wanted to highlight its distinction from the commission-based compensation model, it could, in theory, use a more technically accurate term like "commission-free". However, in a landscape where the number of fee-only, fiduciary advisory firms has grown – making "commission-free" less of a differentiator for any one firm – it's worth questioning whether it makes sense for firms to describe themselves in terms of their relative lack of conflicts of interest at all. Because doing so shifts the client's focus away from the advisor's expertise and the value they provide, and instead draws attention to how their conflicts of interest compare with those of other advisors.

The key point is that with the sheer number of potential conflicts of interest in the advisory business, it's better for advisors to be transparent about their own conflicts (and how they work to minimize them) than to downplay their conflicts in comparison to others in the advisory industry. Not only does this help them stay compliant from a regulatory perspective (as the recent SEC cases showed for firms that called themselves "conflict-free") but it also helps build a foundation of trust with their clients – who are ultimately more interested in how their advisor can solve their financial problems than in questioning which practices pose more of a conflict of interest than others!

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For SEC-registered financial advisors, the prospect of an upcoming examination by the SEC can be a source of high anxiety. This is especially the case with newly registered advisors or formerly state-registered advisors who recently became SEC-registered since they may be uncertain about how the examination process will work, what elements of the firm the SEC will dig into, or what information the advisor will need to provide to the examiners. Even firms with robust compliance programs that do a good job following their required policies and procedures can struggle with examinations if they don't have the information that examiners will ask for readily available.

Thankfully, the SEC has published guidance that details the information typically requested during a first-time examination, as well as the questions examiners are most likely to ask the advisory firm, in the form of a Risk Alert titled "Observations from Examinations of Newly-Registered Advisors". Effectively, then, they've given out a 'cheat sheet' for the exam, from which advisors can glean information that can help them prepare for the inevitable phone call from the SEC initiating their next examination.

At a high level, the exam process typically kicks off with a phone call from the SEC examiner, followed by a secure email detailing the information being requested from the advisor. Advisors generally have about 2 weeks to collect the information for the specified examination period (which, for newly registered advisors, typically stretches back to the effective date of their initial SEC registration). Next, as detailed in the Risk Alert, the list of requested information tends to be similar for most advisors undergoing their first SEC examination and comprises various types of information.

First, the SEC will request information on the firm itself, including organizational charts, employee roles and responsibilities, financial statements, and/or any legal action against the firm that is pending or settled. Next, they'll want information on the firm's clients (including the number and types of clients served), client accounts (including Regulatory Assets Under Management and other assets managed such as "Assets Under Advisement"), and services (including the types of advisory services provided, authority to trade in client accounts, and use of third-party providers like custodians and subadvisors).

At the core of the examination, though, is a review of the firm's compliance policies and procedures and code of ethics, including not just a copy of the 'paper' compliance manual but also how the practices and controls the firm puts into place ensure it adheres to its compliance program. Which means the firm will need to provide records of holdings and transactions for each of its clients (which may require some training and practice for employees to be able to quickly pull the needed data from the firm's custodian), as well as archived client communications and any advertisements produced by the firm.

The key point is that even though the volume of information requested for an SEC examination may be large, advisors will be able to predict a large proportion of what that requested information will be since the SEC has given those details in its Risk Alert. Which ultimately helps advisors better prepare for an eventual examination by putting the systems in place to easily archive and submit information to examiners – and to reduce the chances of extended back-and-forth questions with regulators, so the firm and its advisors can get back to normal business!

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