As fiduciaries, Registered Investment Advisors (RIAs) must, at all times, serve the best interest of their clients and cannot place their own interests ahead of the interests of their clients. These obligations generally fall into two broad categories commonly referred to as the duty of care and duty of loyalty.

The Duty of Care requires an investment adviser to provide investment advice in the best interest of its client, based on the client’s objectives. The Duty of Loyalty requires RIAs to eliminate or disclose any possible conflict of interest involving themselves, their advice or their client.

In one way or another, most legal claims against RIAs stem from these two duties that serve as the underpinning of the profession. The Securities and Exchange Commission (SEC) recovered its largest amount of damages in fiscal year 2022 with RIAs and investment companies targeted for the most actions taken.

Clear communications and concise policies can help your firm prevent and mitigate the five most common legal claims against RIAs:

Breach of Fiduciary Duty

This is what happens when RIAs fail to exercise their responsibility to safeguard a client’s best interests. And it can be career-ending. It could come at the cost of a professional license in addition to financial damages.

The easiest way to mitigate any potential exposure is to be transparent. Make sure you disclose any possible conflicts of interest. Be crystal clear with your investment advice. Translate industry jargon into layman’s terms so your clients understand what is being said.

Working with an attorney on a new policy that prohibits self-dealing would be a good start.

Last year, the SEC ordered a dually registered RIA and broker-dealer to repay more than $800,000 to harmed clients for breach of fiduciary duty.

The SEC found the RIA did not adequately disclose conflicts regarding compensation that it received from the client investments, as well as a breach of its duty to provide best execution when it opted for a more expensive class of mutual funds when classes of more favorable value were available. In addition, the RIA failed to implement compliance policies and procedures designed to prevent such violations.

Negligence

Simply put, negligence means carelessness, while gross negligence means recklessness on a bigger scale of damages.

As a fiduciary, you have responsibilities. In other words, your clients expect you to perform your duties in a manner that doesn’t harm their financial interests.

Last year, a federal court in Massachusetts ruled against an investment advisor who defrauded two advisory clients when he recommended that they invest in a scam investment abroad. The SEC’s complaint alleged that the investment advisor ignored and failed to disclose warnings from two banks in Turkey that the opportunity was probably a scam. The court ordered the advisor to pay more than $500,000 in damages.

RIAs should work with an attorney to draft disclaimers that can help mitigate errors. Each state has differing laws on negligence and award amounts, so make sure your disclaimers comply with your state’s laws to ensure they are enforceable.

Cyber Security Failures

Protecting your clients from cyber security breaches means being proactive.

The SEC continues to add more consumer protections, which will make your research and planning more valuable to your business. In March, for example, the SEC proposed amending Regulation S-P to require “covered institutions”—including RIAs—to provide notice within 30 days to investors affected by certain types of data breaches. The original regulation, which was adopted in 2000, simply required investment professionals to notify their clients about how they use their financial information.

Creating policies and procedures is the best way to start building the framework for a program that will better protect all stakeholders. Written policies and procedures will ensure your IT team is protected because they will know how to safeguard the data, prepare for possible cyber attacks and how to best respond. Because technology connects all of us, the same standard should be used with all your vendors’ IT programs. Do they have similar polices in place? Ultimately, you will be responsible.

Ongoing stress-testing your systems will provide another layer of protection to your firm. Hire a company that will send fake “scam” emails to your employees and turn it into a teachable moment.

Remember when your bosses sent you emails asking you to buy them gift cards on behalf of the company—with the promise of being reimbursed? (They really didn’t.)

Failure to Disclose

Be transparent with your clients about matters that involve your financial relationships with vendors and investments. More specifically, make sure you state the details about how you are compensated when it involves your client recommendations.

In 2020, the SEC sued an investment advisory firm for defrauding its clients by failing to disclose financial conflicts of interest when recommending investments. The agency alleged the advisory firm recommended their client invest $16 million in four private real estate investment funds without disclosing their fund managers received $1 million from the funds, as well as incentives to keep their money invested. For two of the four funds, the undisclosed financial arrangement resulted in reduced returns.

Any client grievance—written or verbal—should be taken seriously, which would reduce the odds of the complaint becoming a docket item. The matter should be taken directly to your in-house compliance officer or attorney if you have outside counsel. Acknowledge receipt of the complaint to your client and provide a timetable for an outcome.

If the investigation has merit, the compliance officer should immediately contact an attorney, who can draft a legally binding agreement for resolution.

Making Up Unsubstantiated Claims

When it comes to attracting new clients, the truth is your friend.

Research your own investment history to ensure that you can substantiate every claim. If a specific fund has yielded 50% annual returns in the past, then that is something you can talk about—but stay away from what is possible in a perfect world.

Last year, the SEC filed a civil action against former investment advisors for alleged participation in a Ponzi scheme that raised more than $110 million from more than 400 advisors. The defendants received undisclosed compensation from the investment fund, which was recommended based on unsubstantiated claims.

When it comes to the five most common legal claims against RIAs, say what you mean and mean what you say. It will go a long way toward protecting your book of business.

(Paul Fenaroli is an Associate Attorney at Pastore admitted in Connecticut and the District of Connecticut. He provides private companies with a full range of business law services covering formations, mergers, acquisitions, corporate governance, securities offerings and litigation)

 

Tags: Joseph Pastore, Registered Investment Advisors