Spring Regulatory Update: Key developments for advisors to watch

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Get the latest on SEC examination priorities, requirements for serving senior investors, and emerging regulations that could impact your firm.

Evolving regulatory priorities and guidelines continue to keep advisors on their toes. The SEC's 2019 examination priorities reflect a growing emphasis on disclosing potential conflicts of interest and protecting senior and vulnerable investors. And, new regulations at the federal and state levels are emerging now that the DOL fiduciary rule is a thing of the past.

In our semiannual update on regulations affecting RIAs, find out what these new developments could mean for your firm and how you can prepare.

For our spring Regulatory Update, we talked with Steve Johnson, Schwab Vice President and Associate General Counsel for Schwab Advisor Services and Digital Services, to find out what regulators are focused on now, common issues arising from Securities and Exchange Commission (SEC) examinations and key lessons learned from enforcement actions. We also look at how, in the aftermath of the DOL fiduciary rule, new requirements and standards are emerging from a variety of sources. Here are some of the key developments to watch in the months to come.

1. SEC exam priorities: Disclosures and senior investor protections

In 2019, SEC examinations are mostly maintaining focus on the key themes the Office of Compliance Inspections and Examinations (OCIE) emphasized last year, with some refinements and notable shifts. Of the six areas the SEC announced as 2019 priorities, here are the four priorities with the highest potential impact for advisors:

  • Fee and expense disclosure. Advisors should confirm that their advisory fees are consistent with what's stated in client agreements and in ADV disclosures. If you have a wrap fee program, be sure to review your wrap fee disclosures to ensure they're compliant. OCIE will also be evaluating financial incentives that may influence an advisor's selection of mutual fund share classes, so be sure you're taking into account all mutual fund share class options and have good documentation explaining why any of your clients are in a higher mutual fund share class.
  • Conflict of interest disclosure. Advisors should review their disclosures of risks and conflicts of interest related to affiliated products and service providers and be sure any associated financial incentives are clearly disclosed. Examiners will also be looking closely at the practice of borrowing from clients, which presents a number of conflicts of interest for an investment advisor. In particular, examiners will be looking at whether advisors' disclosures are adequate—including disclosures about an advisor's potentially poor or failing financial condition—and whether advisors' actions have been consistent with the disclosures.
  • Portfolio management and trading. Advisors can expect increased scrutiny on portfolio recommendations as OCIE looks at practices for fair allocation of investment opportunities among clients and whether advisors' investment recommendations are consistent with client objectives. Among other things, examiners will be assessing whether their investment or training strategies are:
    • Suitable for and in the best interests of investors based on their investment objectives and risk tolerance
    • Misaligned with disclosures to investors
    • Introducing new, risky investments or products without adequate risk disclosure
    • Appropriately monitored for attendant risks
  • Protecting senior and retirement savers. SEC examinations continue to place a high priority on protecting main street investors, particularly seniors and investors saving for retirement. The OCIE is pursuing examinations of firms serving these investors, with a particular emphasis on the following:
    • Advisors' compliance programs
    • Appropriateness of recommendations to seniors
    • Supervision of employees involved with serving senior investors

2. The SEC's Share Class Selection Disclosure Initiative reveals disclosure pitfalls

The SEC's Share Class Selection Disclosure Initiative, which closed last June, was designed to protect advisory clients from undisclosed conflicts of interest. Specifically, the initiative focused on an advisor's failure to make required disclosures relating to the selection of mutual fund share classes that paid related entities or individuals a 12b-1 fee. The initiative gave advisors the opportunity to self-report potential deficiencies, offering partial amnesty to RIAs who failed to disclose receiving 12b-1 fees for recommending a retail share class when a lower class was available. 

Key focus areas that emerged in terms of what the SEC is looking for in these kinds of disclosures and what advisors should pay attention to include:

  • Conflicts that may arise for firms that are dual registrant or hybrid model RIAs, i.e., those that have both an investment advisory business and the ability to act as a broker-dealer
  • Advisor-sponsored wrap fee programs
  • Scenarios in which investment advice comes from an investment advisor, and 12b-1 fees are paid to an affiliated broker-dealer or their representative
  • The use of “may” in disclosure language, which could be problematic (e.g., “may” receive 12b-1 fees from sale of mutual fund shares, or third-party compensation “may” create a conflict of interest)

How should advisors prepare for increased SEC scrutiny into conflicts of interest?

Johnson suggests advisors review their own disclosures and best execution procedures regularly to ensure accuracy and compliance. Look for and, if appropriate, eliminate problematic uses of “may” or “potential conflict”. And consider other areas—aside from mutual fund share class disclosures—where those words could raise concerns. 

Advisors should also review their best execution procedures, consider forming a best execution committee, and document all committee meetings. Last July, the SEC issued a Risk Alert emphasizing advisors' fiduciary responsibility to seek best execution when selecting broker-dealers to execute client trades that result in the most favorable total costs or proceeds for clients under the circumstances.     

The Risk Alert notes eight common exam deficiencies in this area:

  • Not performing best execution reviews
  • Not considering materially relevant factors during reviews
  • Not seeking comparisons from other broker-dealers
  • Not fully disclosing best execution practices
  • Not disclosing soft-dollar arrangements
  • Not properly administering mixed-use allocations (relating to soft dollars)
  • Inadequate policies and procedures relating to best execution
  • Failure to follow a firm's own policies and procedures

Johnson adds that advisors should consider tools specific to share class selection, review documentation of the calculation performed to determine a specific share class for a client and compare the overall expected costs of a no-transaction fee fund versus a transaction fee fund. Factors to look for include:

  • Commission and any operating expense ratio difference
  • Size of the investment
  • Likely holding period

3. Serving senior investors: Rules and regulations for advisors 

U.S. Census Bureau data indicates the entire Baby Boomer generation will be older than age 65 by 2030, which means one in every five American residents will be of retirement age. According to the Securities Industry and Financial Markets Association, U.S. seniors lose an estimated $2.9 billion every year in cases of financial exploitation, with only 1 in 44 cases reported to authorities. This has particular importance for advisors, as seniors are a fiduciary issue for advisors under the Adviser's Act and state law. 

While the SEC does not have specific rules regarding seniors, it is an important area of focus for examiners. Sample questions that have arisen in recent exams include:

  • How do you address diminished capacity and changes in power of attorney and trustees?
  • What happens when your client transitions to retirement?
  • How are you dealing with communications to senior clients? What happens upon the death of a client?

Here's a look at some of the existing and developing regulatory frameworks advisors should be aware of.

Federal regulations for serving seniors

In the past, concerns about lawsuits resulting from false fraud claims may have discouraged financial institutions or advisors from reporting that an older adult may be the victim of fraud. In May 2018, President Trump signed a bipartisan reform package that included The Senior Safe Act, a measure that allows banks, credit unions, investment advisors, brokers, etc., to report suspected fraud to law enforcement without the fear of being sued as long as they have been trained in how to identify and report suspicious activity.

Two FINRA rules that went into effect last February impact broker-dealers and, indirectly, the investment advisors who transact through broker-dealer custodians:

  • FINRA Rule 4512 requires member firms, including Schwab, to make a reasonable effort to obtain the name and contact information of a trusted contact person for each client. 
  • FINRA Rule 2165 provides member firms, including Schwab, with a safe harbor to place temporary holds on the disbursement of funds or securities if a member reasonably believes their client is being exploited financially. 

State legislation on senior financial protections

Several states have proposed or adopted legislation to protect senior investors, including provisions regarding self-reporting and training. For example, under California law, financial institutions are considered “mandated reporters of financial abuse,” and more states are likely to follow suit. New Mexico, Connecticut, and Washington currently have mandatory training laws in place.

Red flags to look for when serving senior investors

As advisors' client bases skew toward senior investors, there are some critical warning signs to watch for clients who may be experiencing diminished mental or physical capacity or—even more concerning—who may be the victim of potential elder abuse. Issues to look out for and potentially reflect in your policies and procedures include: 

  • Sudden changes in habits, such as uncharacteristic cash withdrawals or wire transfers
  • Reliance on a new friend or relative who shows excessive interest in the account
  • Changes to authorization, power of attorney, beneficiaries, or trusts
  • Memory loss, confusion, or difficulty speaking or communicating

How can advisors take action to protect senior investors?

To proactively protect senior clients from being victimized by fraud or foul play, here are some actions you can take:

  • Create senior and vulnerable investor risk assessment tools.
  • Develop communications and reporting lists, including trusted contacts for your clients and the appropriate entities to report suspected fraud to (e.g., Adult Protective Services).
  • Establish a protocol for how to deal with suspected impairment, including when to stop a disbursement, when to report to authorities, and when it may be time to terminate your relationship with the client.

Schwab has a Senior and Vulnerable Investors Investigations team to help advisors navigate concerns with senior clients. Contact your Schwab service team if you suspect exploitation or elder abuse and would like to help.

4. Life after the fiduciary rule: What's next? 

2019 and 2020 are likely to be big years as states and multiple federal regulators weigh in on standards of conduct for broker-dealers and investment advisors who provide retail investment advice. On April 18, 2018, the SEC proposed a comprehensive set of reforms that would do the following:

  • Establish a broker-dealer best interest standard of conduct, also known as the Regulation Best Interest (or “Reg BI”)
  • Require broker-dealers and investment advisors to create a client relationship summary (Form CRS) detailing their relationship to retail investors
  • Clarify an investment advisor's fiduciary duty to clients

Although there is no date set for the SEC Final Rule, a 2019 rollout appears possible.

The Certified Financial Planner (CFP) Board enacts new standards

Last year, the CFP Board approved an expansive definition of financial planning. Under the new CFP standards, all CFPs, including brokers, must act in the best interest of their clients when providing financial advice. Previously, the CFP Board's rule only applied to CFPs when they were involved with financial planning. 

Under the new standard, CFPs must fully disclose all material conflicts of interest and follow business practices reasonably designed to prevent material conflicts of interest from compromising the CFP professional's ability to act in their clients' best interests. The new standard goes into effect on October 1, 2019, giving CFP professionals and their firms time to review the standard and implement it in their policies and procedures.

The states establish new rules for advisors

Several states have also moved to regulate the provision of financial advice. Nevada, for example, is proposing a rule to apply fiduciary duties and disclosure requirements to broker-dealers and investment advisors.

Although the proposal does not include a specific definition of fiduciary duty, it does use best interest and prohibits putting a firm's interest ahead of the client's.

This complicates compliance questions for advisors—particularly in the event that states are inconsistent in their regulations and individual state regulations include broader requirements than the SEC. Be sure to consult with your compliance resources and legal counsel to stay abreast of your own state and federal obligations.

How Schwab is advocating for advisors

Schwab is actively working with the Investment Adviser Association (IAA) on advocacy efforts to mitigate the risk of multiple fiduciary standards for advisors. Specifically, Schwab is advocating for harmonizing the different standards. Schwab and the IAA agree that state regulations are preempted for SEC-registered advisors and only apply to state-registered advisors, and that imposing ongoing fiduciary duty on the broker-dealer model undermines client choice.

5. Cybersecurity update

Cybersecurity continues to be a hot topic, as data breaches make headlines. OCIE recently announced a third cybersecurity sweep exam focusing on branch offices and firms that have been through a merger or acquisition. The Cybersecurity Sweep Document request letter has included requests for items including:

  • Lists of employees and onsite contractors
  • Lists of terminated employees
  • Policies around penetration testing
  • Vulnerability scans
  • Patch management
  • Policies related to data classification
  • Policies related to verification of the authenticity of a client request to transfer funds

Phishing scams and credential harvesting

At both the advisor and the end client level, reports of email or computer intrusion and then exploitation through wire transfers is a primary area of concern, and fraudsters are getting increasingly more sophisticated. The typical situation involves an employee or client clicking on a link or opening an attachment in a phishing email. This simple mistake can give a fraudster account access to set up auto-forwarding to send copies of all received messages to an alternate account they control. To combat this threat, consider these steps:

  • Continuously train your employees on phishing.
  • Conduct phishing simulations with your staff.
  • Routinely check all email accounts for unauthorized auto-forwarding rules.
  • Don't allow work email to be used for personal use.

What advisors need to know now about cybersecurity and the SEC

Recurring deficiencies found in recent enforcement actions, including failure to supervise and failure to implement policies and procedures reasonably designed to prevent fraud, revealed potential risks to end clients. Here are a few key takeaways for advisors from recent examinations and enforcement actions:

  • The responsibility for cybersecurity is not limited to your IT team—business leaders and management need to be informed and engaged.
  • Expanding mobile technology and outsourcing options are leading to increased supervision. While vendor due diligence is important, financial professionals also need to maintain ongoing oversight and visibility into any changes on the vendor side that could impact your clients' data.
  • Firms should have an inventory of all technology used for firm business, including personal devices.
  • It's likely unnecessary for all employees to have access to client's nonpublic personal information (NPI). Client NPI should not be stored in an unencrypted database with broad internal access, and you should have the ability to turn off access for individuals and groups.

Mobile devices in particular pose a growing cybersecurity risk. A December 2018 OCIE Risk Alert regarding advisors' use of electronic messaging made multiple references to third-party technologies. The Risk Alert explicitly reminded advisors about the SEC's annual review requirement, which states that each year, advisors should consider any compliance issues that emerged in the previous year, changes in business activities of an advisor and its affiliates, and any changes in the Adviser Act or other regulations that may require an update to a firm's policies and procedures. 

Insights to help you stay informed and prepared

As these and other regulatory issues continue to unfold, keep reaching out to your own compliance contacts and legal counsel for guidance. Schwab Advisor Services™ also provides access to current news, analysis, and an extensive library of resources on our Legislative & Regulatory Affairs page.

We hope these tips help you guide your firm and clients as regulatory issues continue to evolve. 

What you can do next

  • Scroll to the “Compliance and Legal” section of On-Demand Webcasts to view the replay
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