Suitable Sanctions Await Advisers Recommending Unsuitable Investments

In their 2016 examination priorities letters, the SEC and FINRA stressed that suitability will be a major focus during examinations. State securities examiners are also on the lookout for situations where Registered Investment Advisers (“RIAs”) fail to recommend suitable investments. The North American Securities Administrators Association (“NASAA”) reported that one of the top books and records violations found by state examiners was a failure to document suitability.

Suitability and fiduciary duty

The duty to recommend suitable investments is just one element of an RIA’s fiduciary obligations. Firms must possess books and records demonstrating that all investment recommendations were suitable using documentation such as:

• Investment Policy Statements (IPSs);
• Client questionnaires and responses;
• Risk tolerance evaluations;
• Correspondence and memos to confirm the results of a suitability analysis; and
• Fact sheets that verify a client’s investment objectives and other important information.

Suitability documentation, including IPSs, must be updated periodically. Furthermore, RIAs should make it clear to clients that they must notify the firm if their financial circumstances change.

During a firm’s annual review of its compliance manual, the Chief Compliance Officer (“CCO”) should make certain that policies and procedures are designed to ensure that recommendations made to clients are suitable. The CCO should also make certain that policies and procedures are being followed to the letter.

It is helpful for an RIA to test whether clients’ suitability documentation is current and consistent with the composition of their portfolios. As part of its testing, an RIA should consider comparing clients’ portfolios with others who have similar investment objectives, risk temperaments, and financial situations. If reviews show these investments are unsuitable, RIAs should make the appropriate changes, identify the root cause of the discrepancy, and revise policies and procedures to prevent a recurrence of the mistake.

State regulators’ views on suitability

Alaska has spelled out what its examiners look for during examinations of state-registered investment advisers:

Examiners review accounts for suitability issues by comparing account information with the services contracted for under the investment advisory agreement and with the advice given to the customer. State investment advisers need to maintain adequate information on their customers to document the suitability of the recommendations made. At a minimum, the investment adviser should maintain information on the customer’s annual income, net worth, and investment objectives. If the customer has specific objectives, for example, to retire in the year 2020 with a certain level of investment income, or to have funds available for their children’s future education, those objectives should be reflected in the customer’s file.

The examiner will pay special attention to the suitability of recommendations where the investment adviser has discretion over the customer’s account. However, the suitability of investment recommendations is an issue relating to all investment advisory customers, not only those who have given the investment adviser discretion over his or her account.

The guidance from Alaska is helpful to all RIAs, whether they are SEC or state-registered. It can be found athttps://www.commerce.alaska.gov/web/dbs/Securities/ComplianceforStateInvestmentAdvisers.aspx#SUITABILITY.

The failure to recommend suitable investments is more than just a breach of an RIA’s fiduciary duty. It might also be a violation of a state’s unethical and/or dishonest business practices statute.

The New Hampshire Bureau of Securities Regulation issued an Order barring an RIA and its owner from securities licensure in the state. The Order alleged that the owner and his firm engaged in an investment strategy that was unsuitable for their clients. The strategy involved leveraged and inverse exchange traded funds (“ETFs”), which were deemed unsuitable for their clients. The RIA also misrepresented the owner’s qualifications and the fees to be charged. These activities were found to violate New Hampshire’s unethical business practices law. Aside from a cease-and-desist order, the RIA and its owner were ordered to pay a fine and to make restitution to clients.

In addition, the SEC imposed sanctions on the owner who was barred from association with any broker-dealer, investment adviser, and other entities. The SEC’s order can be found athttps://www.sec.gov/litigation/admin/2016/ia-4332a.pdf.

In a recent deficiency letter sent to an RIA, the Securities Division of North Carolina criticized a firm for engaging in a dishonest and unethical business practice by recommending the purchase, sale or exchange of a security without reasonable grounds for believing that the recommendation was suitable for a client. The deficiency letter alleged that the adviser did not make a reasonable inquiry concerning the client’s investment objectives, financial situation, time horizon, and risk tolerance. Examiners for the state did not find current suitability documentation in clients’ files, even though the RIA stated that these documents were updated yearly.

The deficiency letter offered suitability guidance that applies to all RIAs. The Securities Division encouraged advisers to retain a dated IPS in each client’s file. They should also document in their files whenever clients change their time horizon, risk tolerance, and/or investment objectives.

Certain investments are more likely to be unsuitable

Analyzing and documenting suitability is particularly important when RIAs recommend high-risk investments to their clients. As the Office of Compliance Inspections and Examinations said in its 2016 examination priorities letter, “We will focus on detecting the promotion of new, complex, and high risk products and related sales practice issues to identify potential suitability issues and potential breaches of fiduciary obligations.”

Investing clients’ funds in alternative investments is likely to raise suitability issues, especially if they perform poorly. An article published in the Ohio Securities Bulletin in the fourth quarter of 2015, suggested that advisers should always be mindful of clients’ suitability considerations when determining their potential exposure to alternative investments. Advisers should also make certain that they follow their firms’ policies and procedures, if any, regarding the maximum amount of a client’s portfolio that can be allocated to alternative investments.

In December 2015, the SEC filed a complaint against an RIA that invested $43 million of its clients’ money in illiquid bonds without disclosing a serious conflict of interest. After learning about the bond investments, several of the firm’s clients expressed concern over the bonds’ valuation and suitability.

Conclusion

Examiners are even more likely to scrutinize the portfolios of older clients to ensure that the RIA has recommended suitable investments. In particular, examiners will look closely at IRA rollovers to verify that the recommendations made were in the best interest of the client. Documentation is especially important when recommendations are made to senior investors. All of these documents must be retained for a minimum of five years.

RIAs should retain robust documentation to support their recommendation of alternative investments to older clients. These books and records should thoroughly document the adviser’s rationale for using alternative investments, such as increased diversification or the firm’s quest to produce better risk-adjusted returns for the senior investor.

Les Abromovitz can be reached at NCS Regulatory Compliance by calling 561-570-1813 or by e-mailing him at labromovitz@ncsregcomp.com. Les is the author of THE INVESTMENT ADVISOR’S COMPLIANCE GUIDE, which was published by the National Underwriter Company, a division of ALM.