1. 1 Web Chapter C Regulation

2. 2 Chapter Goals Discuss the role regulation plays in the financial services industry. Describe the key regulatory items that must be satisfied in dealing with clients. Explain the responsibilities of a fiduciary. Illustrate who regulates what in the financial services industry. Identify the range of financial planner compliance factors. Target selected regulatory issues of special importance.

3. 3 Overview Regulation in the financial services industry, whether by federal state or professional association, is principally concerned with providing appropriate information and beneficial advice to clients. Efficient markets mean that accurate and up to date information is supplied to all investors with buys and sells done at low transaction costs. – Assumes that people have the time and ability to understand and act on that information in the investments area. – It assumes, then, that all investors act logically and are highly knowledgeable and that our free market system ensures that they receive the information they need to make appropriate decisions.

4. 4 Overview, cont. Regulators assume that people often make incorrect choices and can be exposed to unscrupulous advice that is motivated by self-interest. – Regulators endeavor to represent and protect the average household. – They establish rules and regulations that constitute acceptable and unacceptable behavior. – The goal of financial regulation in our system, however, is to bring about an efficient marketplace with fairness for all participants. – There are a number of factors that are intended to ensure that a financial planner and other financial services individuals will provide appropriate advice. – They include competency, suitability, due care, compliance, ethical behavior, and documentation.

5. 5 General Standards of Proper Professional Behavior Competency: The ability to handle a given task with the expertise necessary to provide a satisfactory outcome. – Arises from a minimum level of general education, a specialized knowledge of finance received through education and testing of that knowledge, and a prescribed amount of practical experience. Suitability: Refers to ensuring that the advice and products provided fit the circumstances and preferences of the client. – Incorporates such variables as yearly income and net worth, tolerance for risk, age, health status, goals, and other assets owned that have a similar use. – Having an attractive product is not good enough. The product must benefit the client.

6. 6 General Standards of Proper Professional Behavior, cont. Reporting: Presentation of material facts. – Should be undertaken for two groups: clients and regulatory bodies. – Client reporting should include information about the advantages and disadvantages of any recommendation. – Clients should also be given up to date and accurate information about results. – When there is a potential or real conflict of interest between the advisor and the client, the advisor should disclose it. – Reporting as it pertains to regulatory bodies should be prompt and accurate. – It may consist of filing the characteristics of ownership and operations every twelve months. – Material changes in those factors may have to be reported within a certain period of time after they occur.

7. 7 General Standards of Proper Professional Behavior, cont. Due Diligence: Making an adequate investigation of the merits of an investment or other recommendation. – The effort must be broad enough in scope to provide appropriate recommendations. – It is important that you are careful and knowledgeable about the specific advice given. Compliance: Deals with observing all rules and conditions set up by established laws and regulatory bodies. – Compliance should mean not only following all regulations already set up but also observing the intent of those regulations in contrast to the narrower approach of doing what you can “get away with.”

8. 8 General Standards of Proper Professional Behavior, cont. Documentation: Written support for business practices and information provided for clients. – A powerful support for advisors should differences with clients enter the legal arena. Ethical Behavior: Refers to maintaining standards of correct conduct and practice. – It is sometimes difficult to specify what constitutes ethical behavior because individual circumstances can mandate differing behavior. – However, adhering to many of the items in practice we have already listed including competency, reporting, suitability, dilligence, and compliance helps underpin ethical behavior. – What constitutes ethical behavior depends on the nature of the relationship you have with your client.

9. 9 General Standards of Proper Professional Behavior, cont. The investment advisor has a fiduciary duty to clients, perhaps the highest type of trust. A fiduciary has a responsibility to a client that often involves power over assets, obviously a crucial area. Such a relationship mandates, among other things, integrity and fidelity in actions. Conflicts of interest are to be avoided in a fiduciary relationship, and when they cannot be prevented they are to be fully disclosed to clients. You owe a duty of confidentiality of information to clients.

10. 10 Regulation of Investment Advisors The Investment Advisor Act of 1940 was established to protect the investment public against fraudulent and deceitful practices on the part of investment people who provide them with advice. A key part of the act mandates that the advisor provide full disclosure of any conflicts of interest. Our discussion will include modifications to the original act and SEC jurisdiction under it.

11. 11 Terms of the Investment Advisors Act To be considered an investment advisor there are three criteria that must be met: 1. The person gives advice or analysis in regard to securities. 2. The person is in the business of presenting investment advice. 3. The person must be compensated for the services rendered. Any economic benefit received, whether direct or indirect, would meet the terms of compensation under this standard.

12. 12 Terms of the Investment Advisors Act, cont. The following are exempt from the Advisors Act: 1. A bank or bank holding company that is not an investment company. 2. Accountants, lawyers, engineers, teachers whose rendering of advisory services is incidental to their profession. If they represent themselves as providing financial planning services to the public the service is not incidental and they fall under the provisions of the Advisor’s Act. 3. Brokers or dealers whose advice is incidental to their business and do not receive special compensation for this service. However, these people cannot maintain they are financial planners or investment advisors. They can refer to themselves as financial service professionals, insurance agents, or stockbrokers. 4. Publishers of general circulation and business newspapers and magazines who render advice.

13. 13 Terms of the Investment Advisors Act, cont. 5. People whose advice is limited to U.S. government securities. 6. Those involved in statistical ratings services such as Standard & Poor’s and Moody’s bond and other ratings. 7. Other people designated by the (SEC) 8. People all of whose clients are within one state where the advisors have their business and do not render advice on securities traded on a national securities exchange. 9. People who have less than 15 clients and represent themselves as advisors to the general public. 10. Those who provide services only to the insurance industry.

14. 14 Obligations of an Investment Advisor Under The National Securities Market Improvement Act of 1996: – Advisors actively managing more than $30 million in assets will register with the SEC. – Those managing under $25 million will register with the state in which they do business. – Those who manage assets between $25 and $30 million have a choice of either. To register with the SEC the advisor must file form ADV, which has two parts. – Part I provides information about the firm and the backgrounds of its key employees. It also includes the type of clients the firm works with. – Part II gives types of services offered, methods of compensation, and other information.

15. 15 Obligations of an Investment Advisor, cont. The SEC has requirements and restrictions on practices, as follows: – The advisor must keep a set of books and records, in hard copy or online, that provide sufficient information to protect clients. – Each year the form must be modified annually, giving updated information and disclosing any material changes in operations. Those who register with the SEC and are accepted are called Registered Investment Advisors (RIAs) – As a restriction on compensation, the advisor cannot share in the profits of the client unless the client has assets of over $1 million or is a registered investment company. – The advisor cannot assign the contract with the client without the consent of the client.

16. 16 Obligations of an Investment Advisor, cont. – Advisors cannot call themselves an “investment counsel” unless they qualify as an investment advisor under the Investment Advisor Act. – Under the “brochure rule” an advisor must give each new client a copy of Part II of the ADV form, or its equivalent and offer to provide one annually for all existing clients. – Record keeping Indicates the way records are to be filed. For example, maintaining clients’ acknowledgment of receipt of the brochure – typically, ADV form, Part II. Records must be kept for a minimum of five years. Records may be kept in electronic files as long as they are safe and accessible. Common records are an income statement, a balance sheet along with supporting transaction records, a list of securities purchased and their cost, and others.

17. 17 Obligations of an Investment Advisor, cont. – Anti-Fraud Provision: Fraud is deliberately intending to deceive in order to obtain something of value. An advisor cannot defraud any current or prospective client. An advisor cannot act as a principal to sell or purchase a security from a client without disclosing your acting as a principal and getting approval to do so. As a fiduciary, an advisor cannot do anything fraudulent, manipulative, or deceptive. An advisor must disclose any conflict of interest or potential conflict of interest to the client. – Performance Fees Not allowed except for clients who have a net worth of $1,500,000 or $750,000.00 under the management of the RIA.

18. 18 Obligations of an Investment Advisor, cont. – An advisor cannot assign a contract to someone else without the approval of the client. – Amendments to form ADV for material changes in people, practices, etc. must be filed within 90 days of the end of the advisor’s year. The SEC pays particular attention to certain areas. – One is advertising. Selected presentation of past performance is not permitted; full and fair presentation must be made. Advisors are not allowed to use testimonials by clients. Disciplinary actions against advisors must be disclosed. You cannot use the term Registered Investment Advisor or RIA as if it implied that you had a professional credential. You must have your own compliance manual.

19. 19 Obligations of an Investment Advisor, cont. In 2004, the SEC promulgated Rule 204A-1, a new Investment Advisor Code of Ethics under the Investment Advisors Act of 1940. – Provided new standards of conduct and addressed new conflicts of interest, particularly as they pertained to personal trading by advisory personnel. Among the changes are that firms must keep copies of their own code of ethics which includes: Protection of material that is not public information. Reporting securities transaction and establishing policies to be reviewed by a compliance officer established by each firm. Preapproval for securities transactions by the firm’s employees is required. Advisors should describe the code of ethics to clients.

20. 20 Obligations of an Investment Advisor, cont. Under the National Securities Markets Improvement Act (NSMIA) of 1996, the supervisory role of the SEC was eased by assigning investment advisors who manage $25 million and under to the states. – Thus, many financial planners who do not have large investment management practices are regulated by the states. Four kinds of advisors are permitted to register with the SEC under NSMIA: – consultants; – nationally known statistical organizations; – certain affiliated investment advisors who are also in other types of business; and – those who reasonably expect to manage over $30 million and will register with the SEC.

21. 21 Obligations of an Investment Advisor, cont. Although not bound by the entire Investment Advisors Act, most states follow many of its principles in registration and regulation. – They act against illegal, fraudulent, or deceptive acts and record procedures against insider trading. – Advisors must notify clients about a material change in ownership and cannot assign the client contract to a third party without client approval. – Advisors cannot act as principal and sell a security to a client without prior notification to that client. All states use the ADV form, and most states require exams with the National Association of Securities Dealers (NASD). The definition of a financial planner can vary by state.

22. 22 The NASD The National Association of Securities Dealers (NASD) is a self-regulatory body for the securities industry. – Those who sell products and receive compensation for doing so must register with the NASD. – Fee-only or fee and commission planners register with the states or the SEC. Under NASD regulations, those who sell investment products must associate with a broker-dealer. The two principal NASD exams are: – Series 6: A limited registration. – Series 7: A full securities exam. A Series 65 exam is required for people who represent themselves as financial planners.

23. 23 Broker-Dealer Regulation When a person sells products and receives commissions as a commission-only or fee and commission financial planners do, he or she must register as a representative of a broker- dealer. – The broker-dealer is regulated by the NASD and federal and state authorities. Those planners must offer only products that have been screened and approved by that broker-dealer. The registered representative (RR), who may also be an RIA and perform financial planning services, must notify the broker-dealer of transactions and the broker-dealer supervises the RR’s RIA actions.

24. 24 Insurance Regulation Insurance generally falls under state regulation. – State regulation is made more uniform through the National Association of Insurance Commissioners (NAIC). The NAIC’s Model Insurance Act covers appropriate actions. – The Model Insurance Act prohibits certain practices. One is twisting, getting a client to switch insurance policies without a strong reason for doing so. The second prohibited practice is selling products that are not suitable for a client. In some states another is calling insurance an investment. – Insurance agents should disclose certain information as to commissions, the fact that they are agents, and reasonable assumptions on policy illustrations including current results.

25. 25 Other Professionals A registered representative is a broker who represents a broker-dealer in securities transactions for clients. – Regulated by the broker-dealer and by the NASD with whom they register. Accountants and lawyers may provide financial planning advice. – If that advice is incidental to their operations, they need not register as RIAs. – However, their actions are regulated by the states they practice in and by their industry associations, the American Institute of Certified Public Accountants and the American Bar Association, respectively.

26. 26 Other Professionals, cont. Insurance Agents provides products for individuals using industry products but he or she is not employed by any one company. – A person who renders advice for a fee with or without selling products is considered an insurance consultant. – Thus, a financial planner who provides advice on insurance matters can be deemed an insurance consultant and must register. Investment advisors need not be financial planners, although a growing number are offering specialized or general planning advice. – Regulated as RIAs and if they are Chartered Financial Analysts (CFA Charterholders) by the industry’s CFA Institute.

27. 27 Targeted Areas Some of the areas of particular interest to the SEC or regulatory authorities are as follows:

28. 28 The CFP Code of Ethics and Practice Standards The CFP Code of Ethics and Professional Responsibility, and Practice Standards are promulgated by the CFP Board. – Meant for all people who are practicing CFP® certificants or engaged in related activities or professions or who intend to become CFP® professionals. The CFP Board calls these people Board certificants; we will refer to them as certificants. The Code of Ethics consists of Part I Principles and Part II Rules. – The principles are ideals, and the rules are a more practical implementation of the principles. – For some planners certain rules may not be applicable in some cases.

29. 29 The CFP Code of Ethics and Practice Standards, cont. Part I – Principles – Integrity. – Objectivity. – Competence. – Fairness. – Confidentiality. – Professionalism. – Diligence. Part II – Rules – The rules are practical applications of the ethical principles. – A detailed specification of the rules is provided in the text of the chapter.

30. 30 Practice Standards Practice standards are the ways in which you operate. – Standards for CFP® professionals are developed and implemented by the CFP Board of Standards. – The practice standards follow the six-step financial planning process: Establishing and defining the relationship with a client. Gathering client data. Analyzing and evaluating the client’s financial status. Developing and presenting the financial planning recommendations. Implementing the financial planning recommendation Monitoring. – A detailed specification of the practice standards is provided in the text of the chapter.

31. 31 Chapter Summary Regulation has as its intent providing proper information and advice to clients. General standards of appropriate professional behavior include: competency, suitability reporting, due diligence, compliance, documentation and ethical behavior. The Investment Advisors Act protects the investments public against fraudulent and deceitful practices by people who provide them with advice. Under the Act all people who provide investment advice not incidental to another activity must register with the SEC or their state and adhere to the Act’s requirement. All people who call themselves financial planners or who perform comprehensive financial planning services or as part of their planning services make investment recommendations must register with the SEC or with their state.

32. 32 Chapter Summary, cont. The SEC ADV parts I and II provide detailed information about a firm to that regulatory body and to the public. The NASD and the broker dealer they are enrolled with supervise people who sell products to clients. A financial planner who does so may be NASD registered and be a Registered Investment Advisor under SEC or state regulation. Other financial service professions are regulated under Federal, State or individual professional regulatory body requirements. The CFP Code of Ethics provides seven principles and rules which follow them that must be adhered to. The CFP Practice Standards provide norms for planner activities. They follow the six step financial planning process.