Securities Regulators Reveal Widespread Compliance Deficiencies On the Part of Investment Advisers

By James Eccleston

he North American Securities Administrators Association ("NASAA") has released a report that details significant compliance deficiencies among investment advisers nationwide and in Canada, and outlines a set of recommended best practices to avoid those compliance deficiencies. Let's highlight the key compliance deficiencies and the recommended best practices.

As background, securities regulators from 43 state and Canadian jurisdictions conducted 418 examinations of investment advisers between January and May of 2007. The examinations revealed that 41% of all advisers had at least one compliance deficiency. Moreover, the examinations found 2,135 deficiencies in 13 compliance areas. That equates to an average of more than 5 compliance deficiencies for each investment adviser!

Let's examine the five more significant findings among the 41% of advisers found to have compliance deficiencies. First, 71% of those advisers had deficiencies related to registration issues. This percentage represents a 12% increase from the examination report issued in 2005. The major deficiencies were failing to amend Form ADV — the disclosure document filed with the regulators — as well as inconsistencies in parts 1 and II of Form ADV, failing to provide or offering to provide the Form ADV to clients on an annual basis and failing to accurately report assets under management.

Second, 47% of investment advisers were found to have unethical business practices. These included advisory contract deficiencies, unsuitable recommendations made in violation of the adviser's duties to clients, excessive fees, and misrepresenting qualifications, services or fees.

Third, 46% of advisers had deficiencies in the area of preparing and maintaining current and accurate books and records. This percentage represents a 19% increase from the examination report issued in 2005. The top two deficiencies in this area were not maintaining data relating to clients in order to make suitability determinations, as well as the adviser's not maintaining financial statements.

Fourth, 36% of advisers were found to have supervisory deficiencies. This percentage represents a 25% increase from the examination report issued in 2003. The most common deficiency was the failure to have any written supervisory/compliance procedures.

Fifth, 28% of advisers had issues relating to client privacy. The most common was the failure to create a privacy policy and failure to provide privacy notices to clients both initially and annually.

While these were the top five deficiencies, other areas of deficiencies included the failure to prepare and maintain financial records, advertising violations, custody violations, inappropriate investment activities, violations associated with the adviser's use of solicitors, performance-related violations, and hedge fund-specific violations.

Based upon the deficiencies found, NASAA has recommended the following "Best Practices" as a guide for investment advisers:

Review and revise the Form ADV and disclosure brochure annually to reflect current and accurate information;
Review and update all contracts;
Prepare and maintain all required records including financial records;
Prepare and maintain client profiles which show suitability information;
Prepare a written compliance and supervisory procedures manual relevant to the type of business;
Prepare and distribute a privacy policy initially and annually;
Keep accurate financials, file them timely, and maintain a surety bond if required;
Calculate and document fees correctly in accordance with the contracts and Form ADV;
Review and revise all advertisements, including website and performance advertising, for accuracy;
Implement appropriate custody safeguards, if applicable; and
Review solicitor agreements, disclosure and delivery procedures.

By adopting these best practices, and by having qualified legal counsel conduct an annual review or "audit" of operations, investment advisers hopefully will score better on their next exam!

_______________________________________________________________________
James Eccleston, an attorney specializing in adviser and broker-dealer issues, is a partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston in Chicago.