Bridgewater’s Caution Highlights Vendor Risks

One of the world’s largest global hedge funds, Bridgewater Associates, has taken an unusual step to address their operational risk. They have hired a second fund administrator, Northern Trust, to verify the accuracy of their primary fund administrator’s work on an ongoing basis. While Bridgewater’s move is unusual and much too expensive for smaller advisers, it does show just how much pressure there is on advisers to validate and supervise all areas of operations. For the complete story please click here.

Amended Custody Rule

Rule 206(4)-2’s adopting release regarding custody provides a definition of “custody” and interpretative guidance by providing discussion and clarification of the most common examples of what is, and what is not, custody. Under the amended Rule, an adviser has custody (and thus must comply with the above new amended Rule requirements) if it holds client funds or securities directly or indirectly, or if it has any authority to obtain possession of them.

Ability to Debit Account for Fees: An adviser has custody if it has the ability to debit the client’s account for payment of advisory fees. However, per the above, this type of custody will not require the adviser to indicate that it has custody on Form ADV, undergo an annual surprise CPA examination, nor provide an audited financial statement if assets are held by a qualified custodian who sends quarterly statements directly to the client.

Ability to Sign Checks or Withdraw Funds: An adviser has custody if it has a power of attorney to sign checks on a client’s behalf, to withdraw funds or securities from a client’s account, and/or to dispose of client funds for any purpose other than authorized trading would be deemed to have custody and subject to the above referenced annual surprise CPA examination.

Possession of Bank Account or Credit Card Information: An adviser who maintains possession of client bank account or credit card information for the purpose of the adviser debiting/charging said accounts to pay the adviser’s fee, would be deemed to have custody and be subject to the annual CPA surprise examination.

Possession of Stock Certificates: An adviser has possession of client funds or securities if it holds client stock certificates, even temporarily, because such possession puts those assets at risk of misuse or loss. However, the Rule specifically excludes inadvertent receipt by the adviser of client funds or securities, so long as the adviser returns them to the sender within three (3) business days of receiving them. An adviser may continue to meet with clients to prepare or compile documents, including stock certificates, for forwarding by the client to a custodian or third party, without the adviser having custody. However, if the client were to leave the stock certificate in the possession of the adviser thereafter, such possession would most likely not be inadvertent, and would result in custody of client assets.

Possession of Signed Checks: An adviser’s possession of a check drawn by the client and made payable to a third party does not amount to custody of client funds by the adviser. However, an adviser would have custody of client funds if it holds a check drawn by the client and made payable to the adviser with instructions to pass the funds through a custodian or to a third party.

Trustee Service: The adviser would be deemed to have custody when it (or a related person as defined under the Adviser Act, including any access person) acts as both trustee and investment adviser of a trust. In these situations, the adviser shall be subject to the above referenced annual surprise CPA examination. However, the adopting release did clarify that it would not view an adviser to have custody of the funds or securities of an estate, conservatorship, or trust solely because the supervised person has been appointed in these capacities as a result of a family or personal relationship with the decedent, beneficiary or grantor (and not a result of employment with the adviser). If the adviser or its related person is a Co-Trustee, the adviser shall be relieved of the surprise examination requirement if the co-Trustee is a qualified custodian or the trust Grantor (which will not be applicable for irrevocable trusts).

Adviser’s 401k Plan: If any member of the Adviser serves as a trustee to the Firm’s qualified retirement plan, and the Adviser also serves as the investment adviser to the plan, the Adviser would be deemed to have custody and be subject to the annual CPA surprise examination. This adverse custody determination also applies if the qualified plan is self-directed but the Adviser manages certain assets allocation models from which the participants may choose.

Possession of Client 401k Passwords: An adviser who maintains possession of client 401k passwords for the purpose of allocating the client’s retirement account among the investment options provided under the plan shall be deemed to have custody and correspondingly be subject to the annual CPA surprise examination if the plan web site permit’s the adviser (regardless of whether the adviser has any intention to do so) to electronically (via the web site) to compromise the integrity for the underlying assets or beneficiaries (i.e., the ability to make account distributions and/or change account beneficiaries).

Investment Partnerships: An adviser has custody if it acts in any capacity that gives the adviser legal ownership of, or access to, client funds or securities. An advisory firm that acts as both general partner and investment adviser to a limited partnership, by virtue of its position as general partner, generally has authority to dispose of funds and securities in the limited partnership’s account and thus has custody of client assets. The SEC also indicated that this example applies equally to an adviser that acts as both managing member and investment adviser of a limited liability company or another type of investment vehicle. See discussion above and below relative to annual audited financial statement exception from surprise examination and custody control review

If you have any questions regarding custody or any other compliance questions or concerns, Red Oak is always here to help you.

How to Calculate Regulatory Assets Under Management

There seems to be a lot of confusion surrounding the issue of how to calculate regulatory assets under management. There is some good guidance surrounding this in the IARD training manual under Section 5.

First you must determine whether each client’s account satisfies the definition of a securities portfolio. An account will be treated as a securities portfolio if at least fifty percent of its total value is made up of securities. Cash and cash equivalents, including bank deposits and certificates of deposit, are viewed as securities. If fifty percent or more of the account value is comprised of securities, the entire account value is counted when calculating the adviser’s regulatory assets under management. A securities portfolio includes:

• Assets of foreign clients;
• Family or proprietary assets; and
• Assets managed without any kind of compensation.

If you have advised any of your clients to invest in a private fund, all of the assets are treated as a securities portfolio. You are required to determine the private fund’s current market value or fair value in order to calculate regulatory assets under management.

For all accounts that meet the definition of a securities portfolio you must determine if the accounts receive continuous and regular supervisory or management services. This is the case if you have discretion over the account or if you are responsible for evaluating specific securities or other investments based upon the client’s financial situation and make recommendations. You must be also be responsible for arranging or placing the purchase or sale of those investments. If you use third party money managers you must have the authority to hire or fire the managers.

The following should not be considered assets under management: (1) assets reviewed as part of a financial plan; (2) assets managed by a third party money manager where you do not have discretion to hire or fire the money manager; (3) assets held in an account where you are paid a commission and are not responsible for ongoing management services; (4) assets reviewed or consulted only at the specific request of the client and the final implementation decision is left to the client.

You should not deduct the following from your AUM calculation:

• Unpaid accrued liabilities;
• Outstanding loans; or
• Securities purchased on margin.

FINRA Exam Priorities

It’s that time of year again and FINRA has published its Exam Priorities Letter which highlights areas of significant focus in their audit program. These priorities represent FINRA’s assessment of the key issues they will focus on in 2013. The areas highlighted in their letter include:

Under Business Conduct and Sales Practices

• Suitability and Complex Products (FINRA Rule 2111)
• Business Development Companies (BDCs)
• Leveraged Loan Products
• Commercial Mortgage Backed Securities (MBS)
• High-Yield Debt Instruments
• Structured Products
• Exchange Traded Funds and Notes (ETFs and ETNs – particularly those using leverage)
• Non-Traded REITs
• Closed-End Funds
• Municipal Securities
• Variable Annuities
• Cyber-Security and Data Integrity
• Microcap Fraud
• Private Placement Securities
• Anti-Money Laundering
• Automated Investment Advice
• Branch Office Supervision

Insider Trading

Firms must be vigilant in safeguarding material, non-public information, and should periodically assess information barriers and risk controls to ensure they are adequate. FINRA provides some examples of risk controls that firms should assess to make sure their insider trading controls are adequate.

Financial and Operational Priorities

• Guarantees and Contingencies
• Margin Lending Practices
• Leverage and Liquidity

Market Regulation Priorities

• Algorithmic trading
• High Frequency Trading Abuses
• Alternative Trading Systems (ATS)
• Options Origin Codes
• Large Options Position Reporting (LOPR)
• Fixed-income (including best execution)

For more complete information on the key issues outlined above, please read the entire letter by clicking here.

As always, if you need any help with your compliance program or have any questions, please contact us. Our team at Red Oak is always here to help guide you through the regulatory quagmire.

Social Media Risk - Negative Posts

Social Media, like many things in the financial services industry has a lot of risks that need to be handled appropriately. FINRA and the SEC have issued rules and guidance to help Advisers regulate this regulatory maze but they fail to give specific instructions. Instead they leave it up to the Adviser's Compliance Officer to create reasonable policies to monitor social media use.

There are a few risk areas we feel compelled to discuss here so that Advisers have a little better idea of how to handle certain circumstances.

One such circumstance is what an Adviser should do if someone adds a negative comment to their social media site. Human nature’s first instinct is to delete it. However, this is a very bad idea. You need to report anything that would be considered a complaint to your Compliance Officer. If you are unsure whether it rises to the level of a complaint, you should consult your Compliance Officer. You should never respond to anything that is a complaint and if it is not a complaint, remember anything you put on your site is visible to everyone. Translated that means be careful that you are projecting the image you want for yourself and your firm and never put anything negative in writing on your social media site.

This is your site and you are responsible for everything on it. So use your Compliance Officer for guidance, always follow the regulations and never forget this is a public forum, visible to just about everyone. If someone posts something that is inappropriate, remove it immediately and let your Compliance Officer know what happened. You should also let the individual know that this is unacceptable and provide guidance on what can and cannot be posted. Remember, your image and brand are at stake, so view all comments through that lens.

Mistakes do happen so if something is posted in error, either remove it or correct and repost it.

Advisers also need to carefully monitor their Privacy settings to make certain their content is only visible to those they want it to be visible to. Since social media sites make numerous updates to how their application works, Advisers need to monitor the social media vendors for updates that may require them to update their privacy and account settings.

Social media is evolving at an unbelievable rate, Advisers need to be ready to ride the wave and information is the key to controlling the ride.

Private Placements of Securities Effective Date

On December 3, 2012 the SEC Approved New FINRA Rule 5123 Regarding Private Placements. FINRA Rule 5123 requires each FINRA member that sells an issuer’s securities in a private placement, subject to certain exemptions, to file with FINRA a copy of any private placement memorandum, term sheet or other offering document the firm used, within 15 calendar days of the date of the sale, or indicate that it did not use any such offering documents.

Firms must file the required offering documents electronically through FINRA’s new private offering filing system through the FINRA Firm Gateway.

In addition, firms must submit filings regarding member firm private offerings (MPOs), as required by FINRA Rule 5122 (Private Placements of Securities Issued By Members), through the same FINRA Gateway system.

Click here for the full regulatory notice 12-40.