Tracy Pride Stoneman, JD, represents investors, stockbrokers, and financial professionals in investment related disputes. Ms. Stoneman’s experience includes time as a municipal judge and as a partner and trial lawyer in a large Dallas, Texas, law firm. She has published numerous articles in the securities field and is a frequent lecturer on securities fraud, arbitration, and investment disputes. She is active in the national organization of attorneys who represent investors in securities cases—the Public Investors Arbitration Bar Association (PIABA). She has her own firm in Colorado Springs and Westcliffe, Colorado. Feel free to email her at Tracy@InvestorFraud.com.

Since the majority of Ms. Stoneman’s work entails either defending or suing investment professionals, she is well equipped to help the investment professional navigate through the applicable rules and regulations. She can also assist in setting up and maintaining an advisory practice that minimizes the potential for problems down the road. Whether the reader is a CPA, a CFP, a Registered Investment Adviser (RIA), or an individual with a Series 7 securities license, her topics will likely touch upon a subject of interest and value.

Prudent Investment Advisory Practices

Introduction

This article addresses two aspects of an investment adviser’s practice. First, it highlights investment advisory practices the adviser should avoid because they are not prudent and could subject the adviser to liability claims. It then discusses specific “red flags” advisers should be alert to when reviewing clients’ investment records that reflect investment activity another adviser was responsible for.

Advisers should avoid these practices

The following discussion examines some of the major issues that should be addressed by Registered Investment Advisers (RIAs) to limit their liability exposure.

• Poorly documented discretionary authority — Having discretionary authority means sharing or solely possessing the authority to make decisions about what assets to buy or sell on a client’s behalf. Without this authority, the adviser would need to call each client with his recommendation and get the approval from the client to implement the transaction. This authority should be evidenced in the advisory agreement by way of a limited power of attorney that specifies the discretionary powers.
  
  Note: If the adviser does not have discretion, he still needs a limited power of attorney to execute the trades with a custodian or broker-dealer on a non-discretionary basis. Both of these powers should specify that they are “limited.” The limitations should be detailed and specific.



• Having general power of attorney over client accounts — If the adviser has a “full” or “general” power of attorney, his authority is so broad (giving him the ability to withdraw funds and securities) that he will be deemed to have custody of client assets. Advisers generally should avoid custody because of the responsibilities it entails (see the following paragraph). Accordingly, all powers of attorney over client assets should be limited specifically to discretionary investing and should not include the power to withdraw funds.



• Having custody of client assets—An adviser is considered to have custody if the adviser directly or indirectly holds client assets, has the authority to obtain
  possession of them, or has the ability to appropriate them. This broad view can lead to inadvertent custody and a full array of additional requirements. Advisers that are considered to have “custody” of client assets have additional federal record keeping and compliance requirements. Some states impose similar requirements. Most advisers try to avoid custody because of these burdens. However, some advisers have accepted the responsibility and simply take the steps to comply.



• Engaging in prohibited transactions — Section 206 of the Investment Advisers Act of 1940 makes it unlawful for any investment adviser to (1) defraud any client or prospective client, (2) engage in any activity that operates as a fraud or deceit upon any client or prospective client, (3) knowingly sell any security to or purchase any security from a client, on behalf of the adviser’s own account or acting as broker for a person other than such client, without making full disclosure to such client in writing and obtaining the consent of the client to such transaction, and (4) engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative.



• Having a soft dollar arrangement that does not qualify for the safe harbor under Section 28(e) of the Securities Exchange Act of 1934—A soft dollar arrangement is one where client commissions are used to pay for services that are received by the investment adviser. Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor that protects the investment adviser with investment discretion over an account from any allegations that the adviser violated any law or fiduciary duty by virtue of a soft dollar arrangement. To qualify for the safe harbor, the following conditions must be met:
  1. The products and services to be acquired must be either “brokerage” or “research” to be acquired by the adviser.
  2. They must be “provided by” a broker-dealer.
  3. They must be provided in return for brokerage commissions.
  4. They must be based upon the adviser’s “good faith” determination that the commissions were reasonable in relation to the services provided.



• Accepting or paying undisclosed referral fees — Referral fees are a potential source of fiduciary duty violations, especially if they are undisclosed. However, no federal law expressly prohibits an RIA from paying or receiving a referral fee. (Some states prohibit CPAs from accepting referral fees.) Advisers should be prepared to demonstrate that any referral fee arrangement in which they participate does not violate the adviser’s fiduciary obligations to his clients and that the referral fee has been disclosed to the client.

Recognizing Red Flags for Client Accounts.

What is a “red flag”?

The term “red flags” is a term of art in the brokerage industry. It was coined by the Securities and Exchange Commission to denote “indicators of misconduct”—activity that should alert management to potential wrongdoing. “Red flags” do not mean that wrongdoing has necessarily occurred, but they do warrant further inquiry into the issue.

A valuable client service

Any investment professional who has occasion to review the investments and trading activity by a third party in a client’s account—even if that activity is not the responsibility of the investment professional—should be aware of some of the more common “red flags.” CPAs, CFPs, and RIAs are among the few people who have access to clients’ account information and know the clients’ financial situations intimately. Their ability to spot red flags in a client’s accounts and relay the information to the client is a valuable client service.

Examples of red flags

The following may be “red flags”:

• Margin — Margin is the ability to borrow money from a brokerage firm using securities as collateral. It is a red flag when it is used in a client’s account without the client’s full understanding or knowledge. This scenario is not uncommon, because authority to use margin is typically embedded in the Customer Agreement and often goes unnoticed by clients.



• Churning/excessive trading— Churning occurs when an adviser or broker-dealer encourages and engages in transactions that are designed to generate commissions for the adviser rather than benefit the client’s account. A quick rule of thumb—if the value of the account (excluding margin debt) is being turned over (i.e., bought and sold) two to three times a year, the adviser may be churning. Excessive trading can also be revealed by the cost/equity ratio of an account. A red flag should be raised if the account’s annualized cost of doing business exceeds the amount of return on the investments. Another red flag would be if Schedule D of the client’s Form 1040 is more than one page for a small account or for a person who is not a confirmed speculator. Churning can occur even if the client made money on all of the transactions in the account.



• Losses — Be wary of large losses that may indicate inappropriate investments, especially in the accounts of clients who have limited assets, who are recent widows, or who recently inherited funds. Be alert to a client who expresses surprise at losses. Determine if the client’s adviser led him to believe he was making money.
  
  Be aware of disguised losses. These are losses measured not by how the actual investments did but rather how the overall markets did. The red flag is raised when a client’s investments did poorly compared to other assets in its asset class. A client can claim damages, even when the client made money on all of the transactions in the account.



• Return of principal - The client may mistakenly believe that his principal is safe and intact when, in fact, it is being depleted through distributions the client believes are from income. The client’s brokerage statements will not reflect the source of the distributions. However, you can reconcile distributions the client receives to reports such as 10Ks, and annual reports of publicly traded corporations, K-1s of partnerships, and Forms 1099.



• Mismarked order tickets/confirmations — The rules and regulations of the securities industry require that brokerage order tickets and the corresponding confirmations be marked either “Solicited” or “Unsolicited” when the adviser or broker-dealer executes a trade in a client’s account. Too frequently, orders are improperly marked as unsolicited when the adviser or broker-dealer solicited the order directly. If there is no mark, then the industry presumes the trade is solicited. There is a red flag when the client says the investment was the broker’s idea, but the confirmation reflects an unsolicited trade.



• Unauthorized trades — There are only two situations in which an adviser can make an investment for a client without obtaining the client’s permission just prior to making the investment.
  
  First, with a discretionary account the client grants authority to the adviser to make investment decisions without prior consultation. Unlike the subtle way that margin authority is slipped into the Customer Agreement, if a client grants full discretion to an adviser, the client usually knows it. Its authority is in a separate, clearly identified document.
  
  Second, in a “time and price discretion” scenario there is a general discussion about the investment with no order to buy or sell immediately, but the adviser has authority to buy “x” number of shares at “y” price in the future. However, it’s a short future—the trade must occur within a matter of hours—not days or weeks. If the client professes to not know about trades before they are made and the facts do not fall within one of these two scenarios, a red flag exists.

Conclusion

Being aware of the red flags for adviser liability can help you protect your practice from lawsuits.

Depending on your relationship with the client, you may have an obligation to spot red flags in the client’s account, such as when you are providing the client a “second opinion” on the activities of another adviser. However, even if you have properly shielded yourself from this responsibility, pointing out red flags to clients enhances their investment knowledge, helping them to be better clients. Identifying these potential problems also gives clients additional reason to value you and your services because you are helping them preserve assets—not to mention that preserving clients’ assets gives you that much more to work with!