Compliance and the IPS
Issues and Tools in Using IPS AdvisorPro®
“If there were only one tool every financial advisor must have to run their business, it would be IPS AdvisorPro™. I feel so strongly about Lubitz and Boone’s book and software that I recommend it to every one of our clients without fail. If you want to keep your clients and keep your clients happy, this is the right tool for you.”
Katherine Vessenes, JD, CFP® President of Vestment Advisors, nationally known authority on investment advisor and broker-dealer compliance issues and author of “Protecting Your Practice” and “Building Your Multimillion Dollar Practice.” Katherine, VestmentAdvisors.com
Overview
- The regulatory environment is an ever-evolving one, but the trends are clearly moving toward greater consumer protection. Broker-dealers and registered firms are subject to two primary obligations that are relevant here: the “suitability” requirement and the “fair dealing” rules. Registered advisory firms must satisfy fiduciary standards of care and client protection that go even further. Well thought-out procedures are critical to satisfying these requirements. Adequate record-keeping can serve to satisfy regulatory auditors, by documenting the appropriate implementation of these procedures.
- In addition to enhancing the trust bond between the client and the advisor/rep thus improving sales opportunities, using an IPS as part of the investment process clearly documents the relevant information about the client’s circumstances, goals, risk tolerance and other requirements. Doing so also helps to establish a transparency between client and advisor, helping to avoid future misunderstandings and establishing a basis for an improved relationship.
- IPS AdvisorPro™ provides a system through which the compliance office can control the verbiage used in IPS documents, can enforce a system of usage among the advisors or reps within the firm, can consistently measure and document each client’s risk tolerance, can guide investment decisions to encourage consistent use of appropriate investment policies (such as asset allocation), and permits the compliance officer a means of supervising the actual IPSs written by the advisors/reps to ensure on-going compliance.
Compliance Requirements
•NASD
o At minimum, NASD firms have a “suitability” requirement. When a broker recommends that you buy or sell a particular security, that broker must have a reasonable basis for believing that the recommendation is suitable for that client. In making this assessment, your broker must consider your risk tolerance, other security holdings, financial situation (income and net worth), financial needs, and investment objectives. The major securities industry self-regulatory organizations have suitability rules. The NASD’s suitability rule – Rule 2310 – and other NASD materials concerning suitability can be found in the NASD Manual on NASD’s website.
o In addition to “suitability,” NASD firms are subject to “fair dealing” rules whereby sales efforts must be judged on the basis of whether they can be reasonably said to represent fair treatment for the persons to whom the sales efforts are directed.
o The proposed rules from the NASD and the SEC for variable annuities essentially track the ideas and language of antifraud provisions of federal securities laws and rules from other self-regulatory organizations, which obligate a registered representative to recommend only securities which are “suitable” to any particular customer. That “obligation of fair dealing” means that registered representatives must have reasonable bases for believing that their securities recommendations are suitable for and appropriate to certain customers in light of the customers’ financial needs, objectives and circumstances.
o NASD Conduct Rule 2310 — Recommendations to Customers (Suitability)
- In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.
- Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:
• the customer’s financial status;
• the customer’s tax status;
• the customer’s investment objectives; and
• such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.
- For purposes of this Rule, the term “non-institutional customer” shall mean a customer that does not qualify as an “institutional account” under Rule 3110(c)(4).
- [Amended May 2, 1990 eff. for accounts opened and recommendations made after Jan. 1, 1991; amended by SR-NASD-95-39 eff. Aug. 20, 1996.]
o IM-2310-2. Fair Dealing with Customers
- Under Rule 2310-2 representatives subject to NASD regulation have an obligation to deal fairly with customers. Implicit in all member and registered representative relationships with customers and others is the fundamental responsibility for fair dealing. Sales efforts must therefore be undertaken only on a basis that can be judged as being within the ethical standards of the Association’s Rules, with particular emphasis on the requirement to deal fairly with the public.
- This does not mean that legitimate sales efforts in the securities business are to be discouraged by requirements which do not take into account the variety of circumstances which can enter into the member-customer relationship. It does mean, however, that sales efforts must be judged on the basis of whether they can be reasonably said to represent fair treatment for the persons to whom the sales efforts are directed, rather than on the argument that they result in profits to customers.
- Specific violations calling for disciplinary action extend to speculative activity, excessive or inappropriate trading, use of fictitious accounts, Transactions in discretionary accounts in excess of or without actual authority from customers, unauthorized transactions, misuse of customer funds, or recommending the purchase of securities or the continuing purchase of securities in amounts which are inconsistent with the reasonable expectation that the customer has the financial ability to meet such a commitment.
- RIA firms
o RIA firms have an even higher standard of care established by fiduciary standards under which the fiduciary owes an obligation to carry out the responsibilities with the utmost degree of “good faith, honesty, integrity, loyalty and undivided service of the beneficiary’s interest.” The good faith has been interpreted to impose an obligation to act reasonably in order to avoid negligent handling of the beneficiary’s interests as well the duty not to favor anyone else’s interest, including the fiduciary’s, over that of the client.
o Fiduciary liability is not determined by investment performance but rather by whether or not prudent investment practices and standards were followed. The preparation of the Investment Policy Statement is considered one of the most important functions of the fiduciary
o Further, if the advisor should find him/herself in a position of conflicting interests, the advisor must disclose the dual agency (acting for two parties at the same time).
o In ordinary cases the standard of care is whether or not the accused behaved as an ordinary, reasonable prudent person would have behaved under the circumstances. When acting as a professional however, the required standard of care changes. Such individual is required to use any special knowledge he may have obtained through education, training or experience. Therefore, if a person offers professional services to the general public, it is presumed that the person possesses some degree of special skill or knowledge.
o A professional negligence case imposes a certain level of skill and knowledge on the accused whether or not he actually possesses that skill or knowledge. This is a standard of minimum professionally acceptable conduct. Though the standards have not been applied until most recently to financial planners, it would appear that the essence- for them as well as brokers at least- is that the adviser put the clients interest first and acts with the best interest of the client in mind.
- When is an IPS required?
o Investment Policy Statements are required under virtually all investor circumstances with the exception of individual investors.
- ERISA (Employee Retirement Income and Security Act of 1974, as amended) requires an IPS exist for every qualified company retirement plan (e.g. 401k, profit sharing, pension, 403b, etc). “…there must exist a clear investment policy” which suggests the need for a written document, an IPS. In its audits of ERISA plans, the Department of Labor regularly asks to review the IPS as one of its initial requests. The ERISA Section 404(a)(1)(A) and (B) are the pertinent code sections. There is also an interpretive bulletin on the topic. (29 CFR 2509.94-2 – Interpretive bulletin relating to written statements of investment policy, including proxy voting policy or guidelines. (see Section Number: 2509.94-2, “Interpretive bulletin relating to written statements of investment policy, including proxy voting policy or guidelines. Also See: http://www.dol.gov/dol/allcfr/title_29/part_2509/29CFR2509.94-2.htm)
- The 2006 Uniform Prudent Management of Institutional Funds Act (addressing trustee responsibilities of trustees of non-profit monies, primarily foundations and endowments) is substantially similar to the UPIA and requires a written IPS.
- The Uniform Prudent Investor Act (UPIA) governs the investment conduct of private family trusts and serves as the hall mark of subsequent legislation (as well as how the courts now interpret such requirements relating to ERISA) requires a written investment policy for every trust in which trustees manage assets for the benefit of others. It also makes clear that if appropriate investment processes are in place and followed, the trustees will not be held responsible for the results.
- The 1997 Uniform Management Public Employee Retirement Systems Act (addressing trustee responsibilities of government-sponsored qualified employee benefit plans) is substantially similar to the UPIA and requires a written IPS.
- Question: if the regulators require that an IPS be in place for these client types, why would it be any less important for an individual client?
- Plan sponsors are responsible for acting in a prudent and deliberate way, and if they are challenged, they need to have evidence of a prudent decision-making process. If you don’t have a paper trail of what you’ve done and why, you can’t prove that you’ve had a diligent policy in place.
- Similarly for individual clients, being able to document what you’ve done and why can be critical in litigation, with an unhappy client or unhappy heirs. Having a client signature on a document which directs the advisor/rep to act in such a way and with an explanation of why, can be unassailable evidence of no wrong-doing.
Ken Ziesenheim, JD, LLM, CFP® wrote a pertinent article in Investment Advisor magazine, July 2006 in which he made the following statements:
- The IPS process can help build a successful practice because the process can become mechanism for updating and retaining clients, and even attracting new clients.
- The simple premise on which it is based provides an IPS with the flexibility that enables it to be used with individual clients to help make difficult decisions easier. Since accountability and responsibility are defined in the statement, each step becomes a small component of the overall decision-making process.
- There are other benefits to an IPS. It provides a framework for evaluating investment performance and aids in clear communication between advisor and client. Finally, it helps dispel the root causes of dysfunctional client/advisor relationships based on the old sales model of emotional transactional selling. A functional business model does not rely on psychological and emotional rationale to get someone to say yes.
- Using the IPS as a business system ensures that advisors hold rational and logical client discussions and that those clients have acknowledged an investment decision-making process in writing, adding an extra layer of compliance protection to your firm or to you as the advisor. This process ensures that both the advisor and client are in sync and serves as a guideline for managing clients’ assets and expectations. When used properly, the IPS can be a practical tool that embodies the essence of the financial planning process.
Compliance tools built into IPS AdvisorPro™
User Rights
In the online software application IPS AdvisorProTM, when a new user is added to the system under a license, as can be seen below, there are three levels of user rights: General Administrator, Compliance Moderator and General User. For confidentiality reasons, client IPS’s created by one General User cannot be viewed by any other General User, but Administrators and Compliance Moderators have access to all IPS’s created under that license. In addition, any user can be given or not given rights to:
• Create or modify IPS Templates
• Create or modify Asset Allocation Models
• Modify any Asset Allocation Model for a particular client, without affecting the models themselves.
Those with administrative rights or those general users granted rights are the only ones who can access the following screen, allowing only them to create and modify templates, asset classes, or the asset allocation models.
Template Management:
Within IPS AdvisorProTM a “template” is the basic wording and formatting of the IPS. Responses to the questionnaire and the selection of the Asset Allocation Model flow into the template to create a draft version of the IPS. Upon review, the draft IPS can be further modified so that every part of the document is customized to reflect the unique requirements of each client.
Those with administrative rights can determine which templates are available to users, whether to make it the default template for a particular kind of client (e.g. an individual or a profit sharing plan), how many alternative templates are available to choose from, if any, and whether to keep or delete each template in the list available to all users under that license. Administrators can edit existing templates or create news ones.
As an example, under the “Charitable Trust” type client, the administrator might wish to make slight modifications to the Charitable Trust template so that there are templates for a Remainder Trust, a Lead Trust, an Annuity Trust, and a Remainder Trust with a Net Income Make-up provision. Then, when the user is creating his or her IPS, they’ll have the necessary wording established for them by choosing the appropriate template affiliated with the Charitable Trust client type.
Every part of every IPS AdvisorProTM template is available to those with administrative rights to modify. At the start up “Wizard” process, the templates are reviewed and modified to fit the licensee’s processes and procedures. Once in the application, you can do the same thing. As can be seen below, for each paragraph of every templates, the user has full rights to edit, move or remove it. New paragraphs can be inserted above or below any paragraph. The administrator can also find a paragraph in another template within the system under this license and insert it above or below any paragraph. Finally, paragraphs can be “response dependent” which means that based on how any specified question in the questionnaire might be answered, then particular wording would be applied (i.e. if “yes” then use this wording…, but if “no” use that wording….)
Note that under the column “Display Options” a paragraph or section may or may not be designated as editable by others, and it may or may not be required (i.e. must always be present when this IPS template is utilized).
Further, all the verbiage in each paragraph is fully editable. Editing can be done at the template level, where only those with administrative rights can make changes or create new templates. It can also be done IPS by IPS.
In the set up process, the administrator or compliance officer has a high degree of control about what users can edit or not in their IPS’s. As shown below, the editing page is broken into two parts: 1) the editing screen, and 2) the control features for that section of the IPS.
- If, at the bottom, the administrator checks “Yes, this paragraph is required….” Then the paragraph will always appear in the IPS.
- If “Do not allow this paragraph to be edited by general users” is checked, then no user will be able to edit it at any point.
- To save time and effort, these changes can be broadcast to any or all of the IPS templates which contain this section (in the shown example “ERISA Discussion” only three templates contain the relevant section, so the broadcast can only go to those three—pension, “profit sharing” (defined contribution plans), and self-directed 401k plans (also 403b)).
Header/Footer
By clicking in the Navigation Box on “Header/Footer” you can navigate to the following screen where you have control over any of the six possible messages that can be placed in the header or footer (e.g. “Past Performance is no guarantee of future results”) that cannot be modified by general users.
Compliance Officer Supervision
Not only can the compliance officer determine what words are in the IPS and which of them will be editable by general users, the compliance officer has two ways to review every IPS under the IPS AdvisorPro™ license. The compliance officer can access every IPS created under the firm license and review it in its entirety, or more reasonably, the compliance officer has the ability to quickly review summary data on every IPS built under the license.
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