Module 9- Fiduciary, Ethical And Regualtory Issues For Advisors

Question 1

Chapter 1: History of US Financial Regulation

Trust in Financial Services

Answer 1

Trust in financial services industry remains low

Increasing trust gap between elites and mass population

State Regulations are not able to regulate across borders

Question 2

Regulated Environment of Modern Investing

Answer 2

SEC- Created in the 1934 Act

• Requires public companies to disclose material information to the public
• Overseas stock-exchanges, BD’s, IA’s
• IA’s managing over 100MM register with the SEC and must retain records for 5 years

1933 Act- Regulates IPOs by requiring a registration statement and prospectus
-Preparers of prospectus can be sued if there is material information wrong or left out

1934 Act- Created SEC and regulates existing issues

• Forbids market manipulation, deception, and fraud
• Requires filing of quarterly, annual reports and 10ks

Investment Advisers Act of 1940- Wrote into law fiduciary duty of investors

• Requires IAs to register with the SEC by filing form ADV
• ADV discloses background, business affiliations and compensation charged
• Over 100MM SEC, under with states

Investment Company Act of 1940-
Regards the structuring of Mutual Funds
-75% of assets must be diversified
-OF the 75, no more than 5% in a single stock, no more than 10% of voting securities
-Unable to buy from IA, restricted from buying underwritings when an affiliate is a principal underwriter
-Must use a custodian and send semiannual and annual reports to SEC and shareholders

Question 3

Acts from 1970 forward

Answer 3

1. Securities Investor Protection Act of 1970:
   - Created SIPC to oversee liquidation of brokerage firms, ensuring accounts up to 500k (250k cash)
   - Commodity futures, LPs and fixed annuities not registered are not covered
2. Employee Retirement Income Security Act of 1974 (ERISA)
   -Set minimum standards for pensions and health plans for private industry
   -Eliminated impossible to meet vesting requirements
   -Title I (fiduciary standard) is administered by DOL
   Fiduciary Standard met if:
   A. Makes recommendations
   B. Regular Basis
   C. Pursuant a mutual agreement
   D. Advice is primary basis for invest
   E. Based of need of plan or ORA
3. Securities Acts Ammendments of 1975 and May Day:
   - SEC to supervise national securities market, and a national system for clearing and settling trades
   - Created Municipal Securities Rule making Board
   - Also led to the abolishment of fixed rate trading
4. Gramm-Leach-Bliley Act of 1999 and Commodity Futures Modernization Act of 2000
   - Dealt with handling of private info
   - Repealed prohibition of commercial banking mixing with investment banking and insurance
   - Exempted derivatives from regulation which led to sub-prime debt
   - Before these two acts, private partnerships were converting to corporations which also led to more risk taking due to repeal of Glass Steagall

Question 4

Acts from 2000 Forward

Answer 4

USA Patriots Act of 2001:

• Required know your customer policies
• Should look for random transactions, multiple accounts for no reason, lack of concern for risk

SOX of 2002: -Set up Public Company Accounting Oversight Board

• 5 Member board, 2 must be CPAs
• Lead auditor and reviewing partner must rotate every 5 years
• CEO and CFO must certify info is valid
• No credit extensions to directors

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

• Required banks to hold more capital and liquid assets
• SIFI= Significantly important financial intermediaries
• SIFI’s required to participate in a Federal Reserve annual comprehensive capital assessment
• Allowed for multilateral netting at clearing houses to reduce systematic risk of multiple investors trying to close their accounts
• Required Hedge Funds with AUM over 100MM to register with SEC

-IAs are held to fiduciary responsibility while BDs are held to suitability

Question 5

FINRA and NYSE

Answer 5

FINRA is a self-regulatory organization created by the securities industry, not the government

Main roles of FINRA:
1. Market Regulation- Regulates all markets and conducts on-site inspections of the largest market-making and trading firm in US

2. Member Regulation: Makes available information through FINRA BrokerCheck
   - Also requires members to pass examinations and requires formal training programs for employees
3. Enforcement of rules
4. Dispute resolution- Handles 90% of security arbitrations and mediations
5. Advertising regulation/investment companies- Marketing material for funds

NYSE Rule 405- Requires investment professionals to understand every essential fact of a customer (net worth, income, investment objective etc.)

Also outlines supervision and approval requirements of new accounts

Question 6

Doing business in a litigious world

Answer 6

Keep logs and notes of meetings and conversations with clients

First thing analyzed in arbitration is the new account form

Suitability rule: The investment professional must have reasonable grounds for believing that a particular investment recommendation is suitable based on client’s overall financial situation, tax status, risk threshold, and investment objectives

Question 7

Chapter 1 Review

Answer 7

1. Main provisions in federal regulations
   A. Securities Act of 1933
   -New issues, required to register with SEC. Must have a prospectus
   B. 1934 Act
   -Established SEC, requires registrations, ongoing information of companies required, insider trading
   C. IA Act of 1940
   -Fiduciary duty of IAs to clients, Requires form ADV, 100MM to register with SEC
   D. Investment Company Act 1940
   -Mutual fund regulation, requires a custodian to be used, proceeds of redeemed shares send in 7 days
   E. Investor Protection Act of 1970
   -SIPC creation to oversea liquidtion of investment firms, does not cover market losses while securities are untouchable
   F. ERISA of 1974
   -Monitor private retirement plans, must be a fiduciary if giving advice to a company retirement plan
   G. Securities Act Amendments of 1975 and May Day
   -SEC supervise national market… May Day is name five to day in 1975 when commision rates became unfixed
   H. Gramm-Leach-Biley Act of 1999
   -Dealt with private information of clients. Also repealed rule that commercial banks and investment banks could not mix.
   I. Commodity Futures Modernization Act- Exempted derivatives from regulation
   J: USA Patriots Act of 2001
   -Required know your customer rules and for advisers to look for red flags in illegal activity
   K. SOX 2002- Founded Public Accounting Board. Stricter inspections into accounting firms. CFO and CEO sign off on reporting to 1934 act
   L. Dodd Frank Wall Street Reform/Consumer Protection Act:
   -Required big banks to submit to stress tests, regulation of derivatieves
2. Rule 405 for NYSE: Must learn essential facts of each client, including net worth, income, invest objectives
3. FINRA’s role in regulating securities industry?
   - Self regulation of financial industry, continuing education to members, and looks into advertising of mutual funds

Question 8

Chapter 2: Forces Changing Financial Services

Answer 8

1. Changes in Structure of Individual Firms:
   - Small to mid size firms are non-existent

• Challenge is to manage ethical and compliance standards by means of training, closer supervision, specialized staffs and clearer articulation of rules due to higher turnover
• Use to tie pay of investment analysts to investment banking opportunities brought in. Now fined and stopped by regulation.
• When IBanks were private, would tie risk to profit/losses. Now public and took excessive risk.

2. Increasing Emphasis on Price and Transactions vs Relationships
   - Deregulation has caused clients to be more willing to shop around

-Long term relationships that allow NYSE Rule 405 to be followed are less prevalent

3. Increased Competition, Complexity, Pace
   - Complexity of assets has crowded out the time required to reflect on client needs
4. Difficulty of Supervising Technical Specialists
   - Technical activities of strategies has made supervising more difficulty
   - Risk arbitrage, programmed trading can go unmonitored and cost brokerage firms millions
5. The Landmark RAND Study
   - SEC commissioned study of financial landscape
   - Many customers are confused on what individuals do
6. Challenge of Language and Terminology
   - CFP not established until 1985
   - Titles are not regulated
7. Credentials Can be Misleading
   - CFP and CFA are massive
   - Others are weekend designations
   - Seniors make up 30% of fraud victims

Question 9

Common Sources of Ethical Conflict

Answer 9

1. Monthly Production Expectations
   - Most advisers have a goal to meet on a weekly basis
2. The Client with Unrealistic Expectations
   - High return expectations but high commissions
3. Mismatch of Client and Investment Professional
   - Client is afraid of the stock market but reluctantly agrees to invest

Question 10

Chapter 2 Review

Answer 10

1. ID forces changing and how each impacts ethics of securities business
   - Changes in structure of firms (large organizations can only manage ethics, analysts comp is tied to deals, less risk averse)
   - Emphasis on price and transactions vs relationships (clients more focused on cost to them than relationships with advisors, leads to breaking NYSE rule 405)
   - Complexity in securities
   - Difficulty of supervising technical specialists
2. Identify three sources of ethical conflict
   - Mismatch of client and investment professional, high expectation of return and monthly performance expectations
3. Major findings in the RAND study
   - Most investors are confused by the titles of investment professionals and their designations
   - 30% of fraud is related to seniors
4. Three main standards for advisers providing investment and retirement advise?
   - Fiduciary standard by DOL for company retirement plans
   - Fiduciary standard of 1940 Investment Advisers act for registered IAs
   - Suitability standard for registered reps and insurance agents
5. Rules based vs principle based fiduciary standard
   - Rules= more enforcement and loopholes
   - Principle= aspirational, generally role of RIAs and CFP

Question 11

Chapter 3: The Fiduciary Standard

Answer 11

Investment Advisers Act of 1940 clearly establishe RIA’s as having a fiduciary standard for advice given to clients

Act did not establish education or qualification standards for becoming an RIA, merely it required registration

Question 12

Three Different Standards

Answer 12

1. Department of Labor (DOL) Fiduciary Standard (highest)
2. Registered investment adviser (RIA) fiduciary standard:
   - Required to provide Form ADV Part 2, and explain it to the client
   - Conflicts of interest must be in writing and a contract is required
3. Registered Representatives and agents suitability standard
   - Must be suitable but possibly not in clients best interest

Question 13

Suitability vs Fiduciary

Answer 13

Suitability

• Only need a verbal disclosure and will go to arbitration
• Typically registered reps, agents
• Regulated by FINRA and States
• Product driven

Fiduciary

• Written disclosure
• Legal action is in public courts
• Must be in best interest of clients considering all factors
• RIAs, trustees, ERISA
• Regulated by SEC/states/DOL

Question 14

Rules Based vs Principal Based Approach

Answer 14

Rules

• Lots of guidelines or do’s and dont’s
• Complex, leads to loopholes and litigation

Principle Based- Aspirational in nature

Question 15

Who is currently a fiduciary

Answer 15

• Annuity Sales Person
• Bank Reps
• CFP
• CPA
• Financial Planner, Adviser, Wealth Manager
• Insurance Agents
• Mortgage Broker
• Registered IA (under 1940 Act)
• Stockbroker
• ERISA adviser

Call center employees are not either way

Before DOL these were not fiduciaries:

• Annuity salesperson
• Bank rep
• CFP in some instances
• Wealth mangers mostly
• Insurance Agent
• Mortgage brokers
• stock brokers

Question 16

Major Changes to Determining a Fiduciary under DOL

Answer 16

1. If dealing with retirement assets (including IRAs), then adviser is considered a fiduciary
2. Moving or rolling over retirement assets is a fiduciary activity

Extremely concerned with rollovers from defined benefit plans and low cost 401k plans

Any distribution from a retirement account you are a fiduciary

Question 17

Highlights of New DOL Standard

Answer 17

• Not based on product but rather if dealing with a retirement investor
• Firms failing to set up regulations would cause advisory compensation to fall under a prohibited transaction
• Clients retain the right to join class action lawsuits
• Advice must be prudent (based on IO, risk tolerance, financial circumstances and needs of investor)
• Signed contract must be developed before first transaction, but all advice is subject
• Allowed to charge a level fee on retirement assets, but still required to go through BIC rules

Question 18

Best Interest Contract Exemption

Answer 18

These transaction would require a prohibited transaction exemptions
1. Transfer of 401 (k) or IRA assets into a higher fee IRA

2. Rollover to an IRA where adviser would begin receiving comp
3. Commission based account to a wrap fee account

To receive the exception must:

1. Acknowledge fiduciary status
2. Adhere to impartial conduct standards (advice, reasonable fee, no misleading statements)
3. Implement policies and procedures
4. Refrain from incentives for advisers to act against client best interest
5. Disclose fees and conflict of interest

Question 19

Limited benefits of disclosure

Answer 19

What information is delivered, how it is delivered and how it is utilized is very different

Disclosure of conflicts of interests is not understood by investors which made it important that advisers were fiduciaries

Question 20

Impact of DOL Rule financially

Answer 20

23. 5 Trillion Retirement Assets
24. 3 Trillion Financial assets in personal sector (a/o 15Q3)
25. 3 Trillion in IRAs

.1% fee would be 23.5 Trillion

Question 21

The Fiduciary Duty

Answer 21

Fiduciary= When one person trusts in or relies upon another

The duty of loyalty

Pension managers, investment managers, custodian of a child’s account, trustee of a college endowment all have clear fiduciary duties

Follow the Prudent man rule: Managee not in regard to speculation, but in regard to permanent disposition of their funds, considering probable income, and safety of capital

Knut Rostad’s reasons why advisers should be fiduciaries:

• Separation of sales from advice is blurred
• investors dont know difference
• harm due to misunderstanding is significant
• new standard would possibly water standard down
• distrust of Wall Street is deepening
• conflicts due to opaqueness

Question 22

The Prudent Investor Rule

Answer 22

Uniform Prudent Investor Act established in 1994

-Establishes a list of assets that are prudent for a trustee to invest in but could be not prudent if incorrect mix

5 Standards

1. Total portfolio risk is considered
2. Risk vs Return is primary consideration
3. Can invest in anything as long as it meets risk return
4. Diversify investments
5. Delegation of investment management is allowable

Question 23

Duties of Investment professionals

Answer 23

1. Duty to Disclose all material facts and conflicts
   - Conflicts of interest are only illegal if not disclosed
2. Duty to Diagnose
   - Obligation to know your customer (NYSE Rule 405) and investigate suitability of investment products

-Must be aware of economic environment and changes in client’s financial picture

3. Duty to Consult
   - Required to consult with specialists if unclear of specifics of a plan
4. Duty to Keep Current
   - Keep current with tax laws, product offerings, fortunes of security issuers
   - Investors have a responsibility to disclose information about themselves

Question 24

Chapter 3 Review

Answer 24

1. Key concepts of fiduciary DOL rule
   - All retirement asset recommendations are a fiduciary responsibility
2. Best interest contract exception:
   - Gives an exception to those participating in a prohibited transaction. To avoid, must acknowledge fiduciary status and adhere to impartial conduct standards.
3. Disclosure always effective?
   No, because it may not be fully comprehended by the client
4. What is “conflicted investment advice”
   - Advice that is given that would result in a higher fee being paid for lesser quality
5. Prudent investor rule
   - A prudent investor must take into account the risk reward characteristics of the entire portfolio, and diversify the assets within it. May delegate management functions if subject to safeguards
6. Describe these duties:
   A. Fiduciary Duty- Duty to lookout for best interest of client
   B. Duty to disclose- Disclose important information and conflicts of interest
   C. Duty to diagnose- Requirement to understand the clients situation
   D. Duty to consult- Talk to specialists if unaware of best answer
   E. Duty to keep current- Keep up to date on laws and current issues
7. Duty to keep current and disclose
8. Duty to disclose
9. Fiduciary duty

Question 25

Chapter 4: Formal Ethical Codes and the Investment Professional

Determining whether CFP member is a financial planner

Answer 25

CFP Professionals who practice material elements of financial planning are considered fiduciaries

Four areas CRP board looks at to determine if practicing:

1. Clients understanding and intent in engaging CFP professional
2. Degree to which multiple financial planning subjects are discussed
3. Comprehensiveness of data gathering
4. Breadth and depth of recommendations

CFPs acting are subject to a written disclosure requirement and enter into a written agreement governing financial planning services

Question 26

CFP Board Code of Ethics and Professional Responsibility

Answer 26

Seven principles of conduct

1. Integrity: honesty and condor not subordinated to personal gain and advantage
   - Following letter and spirit of law
   - Understanding difference between right and wrong in respect to client
2. Objectivity: intellectual honesty and impartiality
   - making decisions based on merit, not personal relationships
3. Competence: Maintaining an adequate level of knowledge and skill
   - Also understanding when you need consultation
4. Fairness: Disclosure of material facts and avoiding material conflicts of interest
   - More based on financials than relationships
5. Confidentiality: Ensuring information is accessible only to those authorized
6. Professionalism: Cooperate with fellow professionals to maintain public image and improve services
7. Diligence: Prompt and thoroughness in planning or rendering of services, supervising recommendations

Question 27

The Asset Management Process

Answer 27

1. Gather Data
   - Required to gather data (NYSE rule 405) and keep info up to date
   - fulfills the duty to act with diligence, confidentiality and professionalism
2. Establish financial goals
   - Fulfills duty to act with diligence and to diagnose
3. Analyze Information
   - Duty to diagnose
4. Make recommendations
   - Be fair and objective
   - Fulfill duty to disclose risk, diagnose and keep current
5. Monitor Asset Performance
   - Ethical requirement of diligence and duty to diagnose

Question 28

Chapter 4 Review

Answer 28

1. Diligence (acting in a prompt an thorough manner)
2. Competence (attaining an acceptable level of knowledge)
3. Integrity (honesty and condor which must not be subordinated to personal gain/advantage)
4. ID regulatory issues, ethical duties or principals of conduct in the following steps of asset management process

A. Data Gathering: NYSE 405, diligence, confidentiality, professionalism

B. Establishing goals: know customer, dilligence and duty to diagnose

C. Analyzing information: Duty to diagnose, principles of professionalism, competence and confidentiality

D. Making recommendations: fiduciary duty and duties to diagnose, disclose and keep current; principles of objectivity, fairness, integrity and competency

E. Monitoring performance: Duty to diagnose and principle of diligence