As an attorney and a compliance consultant, I realize the difference between RIA compliance and RIA risk management. I also realize the importance of both. Unfortunately, I see far too many cases where RIA firms have unnecessary liability risk exposure due to the failure to implement appropriate risk management strategies.
Whenever I do a mock audit for an RIA firm, I always include a risk management assessment as well. An RIA firm may have all of the files and manuals required under the ’40 Act and still find itself on the losing end of an investor’s claim of breach of fiduciary duty. Even thought RIA firms and their members are not expected to be attorneys, there are a number of key decisions, such as In re James B. Chase, Levy v. Bessemer Trust and LaRue v. DeWolff to name just a few, that investment advisers should be aware of given their potential impact on their practices. Compliance errors usually end in fines and suspensions, while risk management errors may threaten your RIA firm’s very survival, both from the resulting monetary damage and the regulatory investigation that is sure to follow.
This distinction between compliance and risk management is something broker-dealers rarely mention with registered representatives who own their own RIA firms since there is no requirement that broker-dealers do so. Broker-dealers are only required to monitor trading activity of RIA firms independently owned by their registered representatives.
As a former director of RIA compliance for one of the nation’s largest independent broker-dealers, I was not allowed to warn the registered representatives with their own RIA firms about these issues due to the concern about providing legal advice. When I open my legal/ compliance practice, I was finally able to prepare a fiduciary investing manual for my clients, covering approximately thirty key decisions, with ongoing updates. There are plenty of excellent firms providing compliance services to RIA firms, but unless they are also attorneys, they cannot legally provide RIA firms with the legal services necessary to properly address the issue of RIA liability risk management.
If you own an RIA firm, it is your responsibility to educate yourself about potential legal issues and establish the necessary risk management strategies and procedures to protect both the firm and the firm’s individual advisory representatives. Two of the most common RIA risk management mistakes that I see involve the use of IPS statements and “black box” financial planning.
Far too many RIA firms fail to use IPS statements. A properly drafted IPS statement allows a client to see a commitment by both parties as to the services to be provided and the expectations of both parties. A properly drafted IPS statement can also be an important tool for an RIA firm in case a dispute or claim does arise. In many cases, an IPS statement can help summarily resolve a dispute or claim, saving the RIA firm both money, mental distress and unwanted negative publicity.
“Black box” financial claims can be relatively easy to win if the client’s attorney knows what he or she is doing. Many such claims eventually settle prior to arbitration since few advisors ever take the time to actually research the theories and other writings of Dr. Harry Markowitz and Dr. William Sharpe to see what they actually said and what they warned about in using their theories. It is very easy to make a case against an adviser who claims that they were acting in accordance with the Prudent Investor Act when the adviser has never actually taken the time to read the Act, including all of the relevant notes. The use of Modern Portfolio Theory and the Prudent Investor Act without studying and truly understanding the theories and writings of those behind such theories and laws is not only ill-advised and negligent, but arguably grounds for malpractice.
If you are ever involved in a claim, a good securities attorney is going to ask you how you arrived at your recommendations and whether you relied on MPT and/or MPT-based software. Since most commercial asset allocation/portfolio optimization software programs are based on MPT or CAPM, Dr. Sharpe’s variation of MPT, an adviser should be prepared to answer detailed questions about both theories, followed by detailed questions regarding the adviser’s understanding of the Prudent Investor Act.
The plaintiff’s securities bar is well aware of these issues and the questions to ask to make their case. I realize that most investment advisers will continue to ignore their Achilles’ heel, their lack of effective liability risk management policies and procedures. The proactive Prudent Investment Adviser, on the other hand, will take steps to protect their firm from unnecessary liability risk exposure and provide better service to their clients.