Source: http://www.journalofaccountancy.com/Issues/2012/Oct/20125817.htm
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Choose wisely: New brochures can help CPAs vet investment advisers
{articleTitle} {articleAbstract} FeaturePERSONAL FINANCIAL PLANNING
BY JULIE JASON, J.D.
Disclosures mandated in 2011 by the SEC help investors become more
informed about the financial advisers they work with or wish to
retain. CPAs can use them as part of their due-diligence process.
CPAs will be viewed as fiduciaries, according to Walter M. Primoff,
CPA/PFS, former deputy executive director of the N.Y. State Society of
CPAs and co-author of CPA Guide to Opportunity. “Like
attorneys, [CPAs] have always had more malpractice exposure than most
others in the wealth management arena,” he said. For this reason, it
is important that CPAs perform the necessary due diligence before
making a referral to a financial adviser or retaining an adviser when
acting as a trustee. To this end, reviewing an adviser’s newly
mandated SEC disclosure documents can provide a wealth of key
information. The documents serve as a road map for the CPA to follow
to unearth comparable information from advisers who are not subject to
these rules. The new rules recently were adopted by the SEC under the Investment
Advisers Act of 1940 (the Advisers Act) to provide advisory clients
with clearly written, current disclosure of the business practices,
conflicts of interest, and background of investment advisers. The
rules require registered investment advisers, including CPAs who act
as such, to provide clients with two narrative disclosures. Form ADV,
Part 2A, also called a “Brochure,” requires firms to answer 18 items
in a prescribed order. Form ADV, Part 2B, known as the “Brochure
Supplement,” (“Supplement”) with six prescribed items, focuses on the
financial adviser who interacts with the client. Most advisory firms
must have filed their Brochures with the SEC and delivered them to
clients by May 31, 2011. Brochure Supplements are not filed with the
SEC, but must have been delivered to clients by Sept. 30, 2011.
Importantly, these disclosure rules also apply to “almost all” major
broker-dealers, according to the SEC. Firms such as Merrill Lynch,
Morgan Stanley, and UBS are now “dually registered.” While conducting
their primary business activity as broker-dealers, they are regulated
under the Securities and Exchange Act of 1934 (the 1934 Act). When
their “registered representatives” sell investment advisory services
such as managed accounts, they are regulated under the Advisers Act
and their representatives are referred to as “adviser
representatives.” One dually registered firm cautions its customers in writing that
investment advisory (asset-based) and brokerage (transaction-based)
services are two distinct service models governed by different laws
and contracts with the customer. The firm explains that when it acts
as a customer’s broker-dealer, it does not enter into a fiduciary
relationship with the client and is not held to the same legal
standards as when it provides investment advisory services in a
fiduciary relationship. As a broker-dealer, the firm explains, its
legal obligation to disclose information about the nature and scope of
the business, personnel, fees, and conflicts of interest is more
limited. The firm explains further that differences in compensation
between models may create an incentive for financial advisers to
recommend products for which they receive higher compensation. The fact that a broker working for a dually registered firm may or
may not be a fiduciary is a surprise to many individuals. CPAs have
the expertise to understand this distinction and can help their
clients assess the nature of services desired. Moreover, they have the
wherewithal to understand the Brochure and Supplement to guide clients
through disclosures that can be quite complex if the firm’s business
is multifocused and conflicted. ACTING AS A TRUSTEE When a CPA acts as a trustee of a trust, the AICPA’s interpretations
on supervision apply. Ethics Ruling 8 (“Subcontractor Selection for
Management Consulting Service Engagements”) and Ruling 9 (“Supervision
of Technical Specialist on Management Consulting Services
Engagements”) in Section 291 of the AICPA Code of Professional Conduct
state that CPAs selecting subcontractors must ensure that the
subcontractors have the appropriate qualifications and technical
skills, and that the CPA must be qualified to supervise the
specialists’ work.
Many trustees delegate the investment of trust assets to financial
advisers, as permitted either under the Uniform Prudent Investor Act
(UPIA), which has been adopted in a majority of states, or under other
statutes. But the trustee must make an effective delegation. Having
these new disclosure documents will assist trustees in making an
effective delegation because they can more easily compare candidates
before making a decision on whom to choose to manage trust assets.
Trustees will want to ask candidates who are not subject to these
mandates to provide comparable information, following the road map
provided by Form ADV, Parts 2A and 2B. Instructions for those forms
can be found at tinyurl.com/c774rgw.
Trustees who already have chosen an adviser will want to determine
whether to continue the engagement depending on whether the
disclosures present surprises. For example, a trustee may want to
replace the adviser if the trustee did not realize that the adviser
earned undisclosed commissions, markups, or fees. A trustee might wish
to avoid an adviser who has complex industry-related disclosure on
principal transactions and trading, for example (see sidebar,
"How It's Done," providing a partial response to Item 11 of
Form ADV, Part 2A), unless those conflicts are addressed to the
trustee’s satisfaction. THE BROCHURE
Study the Brochure to see whether the services, as described, fit
the client’s needs. Beyond that, focus on risk, conflicts of interest,
and other red flags, such as disciplinary matters. Compare the
disclosure of advisers under consideration. The goal is to find
comfort in the disclosure that the adviser is right for the job.
The new Brochure requires firms to provide narrative responses to 18
specific, numbered items in a prescribed order. Some stand out as must
reads, namely, risk and disciplinary information. While you won’t see
“conflicts of interest” enumerated, the word “conflict” appears 37
times in the 26 pages of instructions to Form ADV, Parts 2A and 2B. The Brochure’s focus on conflicts of interest is important for one
good reason: Studies show that the average person believes all
financial advisers are conflict-free fiduciaries, which is not the
case under the law. CPAs, on the other hand, will approach this
information with professional skepticism.
The basis of the conflict disclosure information is the underlying
fiduciary duty owed by firms governed by the Advisers Act. A lesser
nonfiduciary standard of “suitability” applies to broker-dealers and
their registered representatives under the 1934 Act and Financial
Industry Regulatory Authority (FINRA) regulations. CPAs should be
aware that the SEC staff recently recommended that the standard of
care for registered representatives be raised to the fiduciary
standard; it remains to be seen whether that change in legal standard
will become law. The history of and the latest AICPA advocacy efforts
on this matter can be found at aicpa.org/pfp/advocacy. Some of the conflict disclosures require specific mention.
Compensation, the most basic potential conflict, presents conflicts of
interest if the adviser is compensated “for the sale of securities or
other investment products, including asset-based sales charges or
service fees from the sale of mutual funds,” according to Item 5E on
the instructions for Part 2A of Form ADV. The instructions to Item 4
of Part 2B of Form ADV say such compensation gives the financial
adviser “an incentive to recommend investment products based on the
compensation received, rather than on the client’s needs.” Firms that
receive such compensation must disclose that clients can purchase
investment products through other brokers and agents. They also must
disclose if more than 50% of the firm’s revenue from advisory clients
results from commissions and other compensation for the sale of
investment products that the firm recommends to its clients. If
commissions provide the firm’s primary or exclusive compensation,
additional conflicts are raised. Watch for a firm that charges advisory fees in addition to
commissions or markups. If the firm reduces its advisory fees to
offset the commissions or markups in full, the conflict may be resolved. INTEREST IN CLIENT TRANSACTIONS If the firm “recommends to clients, or buys or sells for client
accounts, securities in which [the firm] or a related person has a
material financial interest,” that’s a conflict that must be
disclosed, according to the Brochure instructions. Watch for
disclosure on: (1) buying securities from (or selling securities to)
clients when the firm is acting as principal (not agent); (2)
soliciting client investments in a partnership in which the firm is a
general partner; (3) acting as an investment adviser to an investment
company recommended to clients; (4) investing in the same securities
(or related securities, e.g., warrants, options, or futures)
recommended to clients; and (5) recommending securities to clients or
buying or selling securities for client accounts at or about the same
time that the firm buys or sells the same securities for its own
account. The sidebar, “How It’s Done,” shows an example of a well-crafted
disclosure for Item 11B of Form ADV, Part 2A. REFERRAL ARRANGEMENTS
Be alert to all referral arrangements (Item 14 of Form ADV, Part
2A), such as payments to (or from) accountants or attorneys, as the
SEC views such arrangements as potentially posing significant
conflicts; some advisory firms have policies against them. Failure by a CPA to disclose referral payments, according to
Primoff, is a commission of ethical and legal violations.
“This could give the CPA’s malpractice insurance carrier a reason to
decline coverage should the client sue. In serious cases, CPAs could
put their licenses in jeopardy,” he said. “If the CPA is acting as an
auditor of a client’s financial statements, accepting referral fees,
whether or not disclosed, is a prohibited violation of professional
ethics rules pertaining to auditor independence.” CPAs who wish to engage in disclosed referral arrangements will want
to review the AICPA’s Statement on Responsibilities in Personal
Financial Planning Practice and The CPA’s Guide to
Regulatory Issues in a PFP Practice. CPAs also should refer to
Rule 503, Commissions and Referral Fees, in the AICPA Code of
Professional Conduct, for guidance on appropriate disclosures. These
resources can be found at aicpa.org/pfp/practicecenter. Two other conflicts of note are participation by members of a firm
in client transactions (Item 11 of Form ADV, Part 2A), and material
relationships (Item 10 of Form ADV, Part 2A). Carefully assess the
potential impact when members of a firm are allowed to take part in
transactions that involve their clients. And watch for conflicts when
a firm has relationships with other financial firms, attorneys,
accountants, banks, or others that are material to the firm’s business
or clients. THE BROCHURE SUPPLEMENT AND DUE DILIGENCE
The Brochure Supplement focuses on the individual financial
adviser’s background. Following the prescribed order set out by the
SEC, the Supplement provides educational background, business
experience, disciplinary information, disclosure of other business
activities, and compensation information that includes commissions,
sales awards, and prizes.
It is too early to tell if the availability of these new disclosure
documents increases one’s duty to be informed of a financial adviser’s
business practices, conflicts, and disciplinary history. That is, does
the availability of the Brochure and Supplement raise the CPA’s
due-diligence bar? The real answer to this question is likely to be discovered in the
future in court. In the meantime, here are some issues to think about. Before you make a referral (or retain an adviser if you are acting
as a trustee) consider: Should you avoid advisers with disciplinary histories? Should you avoid advisers with conflict disclosures that are not
addressed to your satisfaction? Should you avoid advisers whose business affiliations are too
broad for the client or trustee to fully assess or whose business
models are too complex for the client or trustee to fully
comprehend? If you currently have relationships with financial advisers,
should they be audited to make sure that there are no conflicts or
disciplinary disclosures that cause concern? Should you demand comparable disclosure from nonfiduciary advisers
who aren’t required to provide Brochures and Supplements? Or should
these advisers be avoided altogether?
Given that you will want to demonstrate prudence in retaining,
referring, reviewing, or replacing an adviser—regardless of whether
the adviser is required to provide Advisers Act disclosures—here are
some steps to take. If you are called upon to retain an adviser in your role as trustee,
compare the Brochures and Supplements of a short list of advisers
under consideration. If considering an adviser who is not required to
provide these written disclosures, you should unearth conflicts, fees,
and disciplinary information on your own. Use the SEC’s instructions
to Form ADV, Parts 2A and 2B as a guide, because the instructions
clearly identify business practices that present conflicts. When
reviewing an existing relationship, do the same. But now, look for
surprises—information that doesn’t meet your expectations. For
example, if performance, which is not a disclosure item, is
acceptable, but conflicts are a concern, is continued retention
justified? Perhaps. Perhaps not. Facts and circumstances will
dictate. Given the fiduciary standard that applies to CPAs as expert
advisers, the new disclosure documents should be used as an important
tool to help ensure a sound choice when retaining or referring a
client to an investment adviser. How it’s done: Example shows how a firm addresses conflict
Here’s how one dually registered firm’s 2011 Brochure addresses the
potential conflict that could arise from its interest in client
transactions (Item 11 of Form ADV, Part 2A). The practice:
“[Our Firm] and our affiliates expect to earn a profit whenever we
engage in principal transactions with you, and depending on the type
of security, we may include a profit margin in the price we pay or
charge you, by marking up or marking down the price of the security.” The conflict: “The profits we or our affiliates earn on these transactions will be
in addition to the fees you pay us under the managed account program
for investment advice, trading, execution, custody and other program
services. As a result, principal transactions present a conflict
between your interests and our interests and those of our affiliates,
because we have a financial incentive to recommend these transactions
to you when they might not be in your best interest. When we propose a
principal transaction to you, it is possible that better prices or
other terms for the trade could be obtained from alternative sources
not known to [us]. Since there may be securities offered by other
dealers only to their clients, you may not be able to compare the
price on securities offered by these dealers to those offered by
[us].” How the disclosure addresses the conflict: “We have an obligation to provide you with best execution and
we believe we can provide best execution to you by routing certain
orders to our affiliate … for execution on a principal basis.” “We monitor our execution services and measure how we meet our
best execution obligation by taking into account many factors,
including the degree to which our affiliate … executes principal
trades in client accounts and, specifically, the pricing and service
quality that we receive in connection with principal trades versus
the costs associated with forgoing a trade (if [we are] the only
dealer in a security) or executing on an agency basis through
another dealer.” “The mark-up or mark-down on securities in [our managed accounts]
is not shared with your Financial Adviser.” “You remain in control of transactions executed through your
account and can withhold consent to specific principal trades before
each trade is executed or overall upon your notice to us.” “Although we are not required to waive or offset our compensation
under applicable rules or regulations, for certain security types
such as new issue fixed-income securities, we may waive some of the
compensation we earn in executing principal trades, or waive a
portion of the fee imposed on your account for a period of time as
an offset for other compensation we receive.” EXECUTIVE SUMMARY
CPAs can perform due diligence on registered investment
advisory firms and their representatives with the help of
brochures the SEC recently began requiring advisory firms to produce.
CPAs who refer clients to investment advisers or retain them while
acting as trustees should carefully review these brochures.
The first thing CPAs should evaluate while studying
the brochures is whether the services the investment adviser provides
fit the needs of their clients. CPAs also should focus on risk,
conflicts of interest, and other red flags, such as disciplinary
matters. CPAs who refer clients to investment advisers or retain them
while acting as trustees should carefully review these brochures.
When acting as trustees, CPAs who already have chosen
investment advisers should review the brochures to make sure they
don’t contain surprise disclosures that would cause them to
discontinue the relationship.
It’s important to thoroughly evaluate any conflicts of
interest revealed in the brochure. Studies show that the
average person does not understand that some financial advisers are
not conflict-free fiduciaries. CPAs possess the requisite professional
skepticism to determine when an investment adviser’s conflicts would
cause problems for their clients.
Julie Jason (
) is co-founder of Jackson, Grant Investment Advisers of Stamford,
Conn., an SEC-registered investment adviser.
article, contact Ken Tysiac, senior editor, at ktysiac@aicpa.org
or 919-402-2112. AICPA RESOURCES
(From) Your Clients’ Trust,” May 2012, page 38 “A
Wealth of Opportunity,” April 2012, page 22 “Fund
Advisers Face New Registration, Reporting Regs,” Sept. 2011,
AICPA Code of Professional Conduct (tinyurl.com/2cyfzcw) CPA Client Bulletin (#CB_FI12, #CB_FN12, #CBEXX12) CPA Client Tax Letter (#CTLFI12, #CTLFN12) The New Fiduciary Standard: The 27 Prudent Investment Practices
for Financial Advisers, Trustees, and Plan Sponsors (#017242) Adviser’s Guide to Retirement Plans for Small Businesses (#017260PDF)
Financial Planning: Process and Environment (#757200011) Investments, Sixth Edition (#757500011)
Personal Financial Planning site: aicpa.org/pfp AICPA’s Statement on Responsibilities in a Personal Financial
Planning Practice, The CPA’s Guide to Regulatory Issues in a PFP
Practice: aicpa.org/pfp/practicecenter
Membership in the Personal Financial Planning (PFP) Section provides
access to specialized resources in the area of personal financial
planning, including complimentary access to Forefield Advisor. Visit
the PFP Center at aicpa.org/PFP.
Members with a specialization in personal financial planning may be
interested in applying for the Personal Financial Specialist (PFS)
credential. Information about the PFS credential is available at aicpa.org/PFS.