How to Prevent Compliance Issues in an SEC Audit

Giachetti: You know, I did see something about that. I still don’t know exactly what they mean, but they did give us 300 pages – none of which makes any sense, in my opinion. But what’s your question?

Advisor: A month or so ago, I sent out a group message telling my clients that, if they feel inclined, they should send me an endorsement that describes how I’ve helped them over the years and describes the excellent quality of my advice. Obviously, I’m looking for a couple of nice endorsements that I can post on social media, which prospects can read so they’ll know that I’m probably their best option as an advisor.

I told my clients that they should be totally objective, and then I gave them some suggestions on what they could say about me.

Giachetti: You gave them some suggestions, you say?

Advisor: Yes. I was trying to be helpful. Otherwise, they might not know what would be the most effective testimonial for me to use in my advertising.

Giachetti: I see. I imagine that was very helpful.

Advisor: Thank you.

Giachetti: Have you already posted any of these testimonials?

Advisor: Just one from that first message. One client sent back pretty much exactly the wording that I suggested, which was great. The Facebook post practically glows. And, of course, it’s also on my website, right there on the front page so prospects can’t miss it. If somebody from the SEC happens to see that, I would expect them to ask if they can become one of my clients.

Giachetti: I think what you’re doing there is soliciting testimonials. Although that is not prohibited, did you disclose how this testimonial came about?

Advisor: Right now, it’s just the testimonial.

Giachetti: First off, I think the SEC might see that as a material omission, that you didn’t disclose how the testimonial came about.

And I know they’re going to be concerned about the fact that you made specific recommendations on what they should say, and you didn’t disclose that as well.

Advisor: Oh... How serious is this?

Giachetti: This could be a problem for you. The SEC has made it very clear that it is concerned about “omissions” in this regard, and you need to be careful not to omit material facts and conflicts that might be important for prospects and readers to know.

Advisor: And you think the fact that I asked clients for testimonials and provided them with suggestions on how to recommend me are – what was the word you used? Material?

Giachetti: I do, yes.

Advisor: Oh dear. I have two other testimonials that came from a second message I sent out.

Giachetti: Tell me about it.

Advisor: Believe it or not, my clients weren’t quite as enthusiastic about giving that testimonial as I would have expected, even though, as I think I may have mentioned, I provide great service to my clients.

Giachetti: I think you did mention that, yes.

Advisor: So wanted to motivate them a little bit, because they’re busy people.

Giachetti: Motivate them.

Advisor: Yes. So I sent out a second message, and this time I said if they gave me a positive testimonial about my great service, and if I liked what they sent, and used it on social media and on my website, I would waive their AUM fees and give them a free year of advice.

Giachetti: In other words, payola.

Advisor: That isn’t exactly how I’d characterize it. But it worked! I was able to post a couple of very persuasive testimonials as a result – and it really didn’t cost me that much, because they were relatively small clients, from an AUM standpoint. I’d call it a bargain.

Giachetti: You’re a fiduciary, right?

Advisor: I think so. Where are you going with this?

Giachetti: Fiduciary means full disclosure. Where the SEC is coming from with this new rule – and why can’t they just keep things simple? You have a rule and 117 exclusions; it’s just crazy. Anyway, what they're going to concentrate on with you, and what I’ve been telling my clients, is that the SEC is going to focus on omissions. What did you not tell the people who go to your website about the testimonial or endorsement?

Advisor: I didn’t actually tell them anything.

Giachetti: Exactly. The SEC is going to note that. You have to make very clear, in writing, conspicuously, that these were paid testimonials. I don’t know how comfortable the SEC would be with the fact that you were paying clients to provide this type of endorsement, but I’m sure they will be very interested in the fact that you solicited it, made specific recommendations on what to say, and paid people to do it for you – and didn’t make any of that information available to the person reading these glowing testimonials.

Advisor: Couldn’t I just leave that out? I don’t think people are going to find these testimonials quite as persuasive if they see all those disclosures underneath.

Giachetti: I appreciate that. Speaking purely from my self-financial interest, I would encourage you to leave that out. I can see where this whole situation might lead to some additional fees to me, your attorney.

Advisor: I’m not sure I follow you.

Giachetti: Let me be perfectly clear: You leave out those disclosures at your own peril. This is the most aggressive regulatory environment I have ever seen. Punitive like you cannot believe. When they come into your office, their biggest focus is going to be: how can we penalize these advisors who are making so much money to the detriment of their clients?

Advisor: But I’m a fee-only advisor.

Giachetti: I hate to break this to you, but they don’t really understand who you are or what you do – or what a fiduciary is. heir position is that all advisors are ripping people off until they can prove otherwise. And you’ve given them a great focus for their examination. They are going to ask: why didn’t you provide any of these disclosures? That full disclosure would have been material to a reader.

The advisor paid for this! No wonder the testimonials are glowing.

And I have to ask: Did you receive other testimonials that didn’t say such nice things about you?

Advisor: There actually were a couple I didn’t put on my website. Fourteen others, actually. Some of those clients are chronic complainers, and I didn’t think people needed to hear about every little problem with our service.

Giachetti: So you left out the testimonials that didn’t say such nice things about you?

Advisor: Of course, I did. That would have been terrible marketing.

Giachetti: I don’t know how far they’re going to go with that part of it. I’m working with a national firm that advises sports personalities who have given testimonials. Scares the hell out of me. But we have to be very careful, and we want to have as much disclosure as we can.

Advisor: And they don’t care that these testimonials are true? I provide great service for my clients.

Giachetti: This may be hard for you to understand, but the issue for the SEC is not what you did for them. It is what you omitted from the disclosures that might be material to the reader. Your choice is to take down those testimonials right away and go about it a different way or put some very specific disclosures around them.

Advisor: And if I say “I forgot,” they’re not going to forgive me?

Giachetti: Oh, sure. At our age, I guess we’re allowed to forget.

Advisor: Well, that’s a relief.

Giachetti: I’ll defend you on your ”I forgot” defense, but I might forget that I told you about it.

Is there anything else you’re worried about with this upcoming examination?

Advisor: Just a couple more things. I manage assets for my clients, and put together portfolios, and long ago, I decided that as an accommodation for my clients, I would pay the trading commissions out of my own pocket.

Giachetti: Very generous of you.

Advisor: Thank you. Then my custodian eliminated trading commissions on pretty much all of what I’m recommending today, the ETFs that I use. I’m still paying the commissions out of pocket, except that now I don’t have to pay for them anymore.

I think the SEC would probably approve of this, because I’m benefiting my clients. Don’t you agree?

Giachetti: Interesting. I just issued a compliance alert to my mailing list about exactly this. I’m currently handling two cases right now.

What you’ve been doing is considered a wrap program by the SEC. And I strongly advise people not to do that.

Advisor: Why is that?

Giachetti: First when you were paying the trading costs, which made you a wrap program sponsor, did you file a wrap program brochure?

Advisor: I had no idea that I had to.

Giachetti: I appreciate that. So much to keep track of! But here is the position the SEC has taken: if you were previously paying for transaction fees on behalf of your clients, under a wrap program or not under a wrap program, its position is that you must have elevated your fee to cover those transaction fees. That is the position the SEC is taking with every wrap program sponsor.

Advisor: I don’t see how that impacts me.

Giachetti: Follow their logic. The SEC assumes you built in some cushion in your AUM fees that allowed you to pay those transaction fees, and the suspicion is that you made that a profit center. So if you were doing that, and then the custodians eliminated those transaction fees for the ETFs you’re recommending, by their logic, you got a windfall.

Did you tell your clients about this windfall, in writing?

Advisor: I – no. Windfall, you say?

Giachetti: Did you amend your ADV when the transaction costs that you were paying went away?

Advisor: I didn’t think I had to. It was something the custodians did, not me.

Giachetti: You’re a fiduciary. The SEC took the position, in those two cases I’m working on, that you must write a check back to your clients. You must give back that windfall.

Advisor: Even though I didn’t get a windfall?

Giachetti: Yes. But in this case, there may be a way for you to get in front of it. You need to go out to your clients and tell them what you did with that windfall, how you reinvested back into your firm, maybe in new technology, new resources and people, and how that resulted in enhanced services for your clients.

And think about this from their standpoint: If the custodians were to increase transaction costs, the converse of what actually happened, how do you think the government would feel about you increasing your fees? Probably not so much.

They’re getting into your business today, and in some respects, I think they’re right. You’re fiduciaries. You have an obligation to disclose. But you’re also businesspeople, and you are allowed to run a business, and I still think – I don’t know for how long – you are allowed to still make a profit. That’s what capitalism is.

But we have to be careful with this. Mr. Advisor, you need to be careful. If you’re putting money in your pocket now that you otherwise were paying before, you will have some explaining to do. My advice to everybody is that you don’t want to be a wrap fee provider.

I imagine that must be pretty much all the things you’re worried about with this audit.

Advisor: Actually I have one or two other questions that I’m hoping you can address for me. My firm – which provides great service to our clients; did I mention that? – my firm has reached a growth plateau, and I need to start my inorganic growth phase. I was approached by a private equity firm that has agreed to take a minority interest in my firm for a considerable sum, and they’re projecting a 20% annual return on their investment.

Giachetti: A 20% return. Hard to find nowadays.

Advisor: Yes. I told them that this was somewhat aggressive, since, after all, I need to make a profit too. My current margins don’t allow that.

Giachetti: So you turned down the money?

Advisor: Not exactly. They’ve shown me how I’ve been over-servicing my clients. And they’ve made some interesting suggestions on how we can increase our staff efficiency by scaling back on a lot of unnecessary client service things that we had been doing before.

If I stop over-servicing them, then I’ll be more profitable, and they’ll be able to meet their revenue goals.

What would the SEC have to say about that transaction?

Giachetti: They’re going to say that this is a very big disclosure issue. You should go out to all your clients and say, I want to advise you that someone has made an investment in my company. And our service offering is going to be revised.

Materially, you should indicate how.

Advisor: I was hoping they wouldn’t notice. And if my clients don’t complain if we go from two meetings a year to a phone call or two, why should the SEC care?

Giachetti: The SEC wants your clients to be able to determine, with all the facts in front of them, whether they – the clients – continue to believe they’re still getting value commensurate with the fees that they’re paying your firm.

Again, if you decide to go along with this arrangement, then it’s all about disclosure. Disclosure will generally set you free. Do not be afraid to disclose. I believe in aggressive disclosure and bold type and the words ‘conflict of interest.’

If things hit the fan, you want to be able to go back and rely on your documents.

Advisor: All right; I’ll go ahead and amend my ADV about this new investor in my firm.

Giachetti: Just amending the ADV wouldn’t do it. We would then have to tell the clients, we have amended our ADV, and here’s why.

Only then have we affirmatively disclosed and given the clients the opportunity to make a decision.

Advisor: I’m not sure I want clients to 'make a decision.' What if they make the wrong decision? I want them to stay with me.

Giachetti: I appreciate that. I’m not sure the SEC will be as understanding.

Advisor: So maybe you can help me with this other issue that has recently come up. I have a number of tech workers as clients, and I might have mentioned that I offer them great service.

Giachetti: Good for you. I think I did hear you mention that, yes.

Advisor: But here’s the thing: some of them are invested in this new thing called ”crypto.” Have you heard of it?

Giachetti: Once or twice, yes.

Advisor: To be perfectly truthful, I’m not altogether sure what it is or what to do with it, but lately, these tech clients have been talking to me about these holdings. So, since I provide great service, I went out and found a portfolio reporting solution that brings in the value of these holdings and lets me track them and include them in our consolidated performance reports. It’s pretty neat, actually.

Giachetti: That’s really great service. So what’s your question?

Advisor: So I did a little research, and I've been telling my clients to be careful about how they keep their crypto in a private wallet, and stuff like that.

Giachetti: Yes. Good advice.

Advisor: Since I’m now reporting on those assets, and giving this advice, I’ve decided to include those assets in my AUM fee. I can tell you, with all the jumping up and down in valuations, it’s made my fees unpredictable lately, but I’m more profitable than ever.

Giachetti: I’m sure you are. Forgive me for being curious. Do you know where those assets are located?

Advisor: They’re in a secure wallet. With a key.

Giachetti: A wallet! Like this one? (Pulls a wallet out of his back pocket.)

Advisor: No; don’t be ridiculous. It’s an electronic wallet.

Giachetti: On a computer?

Advisor: Yes; on a computer. I’m not totally sure which one.

Giachetti: Have you visited that wallet on that computer?

Advisor: I’m not sure how I would do that.

Giachetti: Do you know for sure that that wallet is secure?

Advisor: My client says it’s in something called 'cold storage.' It sounds like he might have put the computer in the refrigerator to keep it safe.

Giachetti: Do we know what crypto is? Is it an investment?

Advisor: That’s a good question. Thank you for asking that question. I’m glad my clients aren’t getting too deeply into that. But some of my clients have made a lot of money, which is what I would normally associate with an investment. I’ve read where some people consider crypto to be an asset class, and a great diversifier from ordinary stocks and bonds.

Giachetti: It’s regulated, too, right?

Advisor: Not really, I don’t think, no.

Giachetti: So to summarize, as a fiduciary, you don’t know exactly where this crypto is, it is not regulated, but you want to give advice of some sort and charge on it?

Advisor: Yes. That’s right.

Giachetti: I just wanted to make sure I understood.

Advisor: I’m pleased with your ready grasp of the situation.

Giachetti: Thank you. Are you managing those crypto assets?

Advisor: Well – sort of.

Giachetti: Tell me what you mean, exactly, by ‘sort of.’ That’s the sort of answer that makes the SEC examiners curious.

Advisor: My clients came to me for advice on this crypto stuff, and I told them that I don’t approve of their crypto things as investments. But they’ve made a lot of money in them, and I found out that I could get the ability to include them in my portfolio reporting software, so they’re included in my performance statements.

Giachetti: And you are continuously monitoring those investments and making recommendations on them?

Advisor: My standing recommendation is that they should sell when they can. And the performance statements go out every quarter, which seems pretty continuous to me.

Giachetti: So this is another profit center for your firm.

Advisor: I’m glad they have these holdings, because it’s expanded the asset base that I can charge on. And those crypto things are appreciating in value, so my fees have gone up.

Giachetti: I’m curious about one thing. Have you given your clients any specific disclosures about the vagaries and potential risks of cryptocurrency exposure?

Advisor: Mostly verbally. As I said, every once in a while when we get together, I tell them that this is their most volatile asset, and maybe they should diversify. But I have to tell you, so far nobody has taken that recommendation.

Giachetti: Could you be making your highest fees on the appreciation of the crypto?

Advisor: It has boosted my overall AUM fees, if that’s what you’re asking. Yes.

Giachetti: It has.

Advisor: Yes.

Giachetti: But no disclosure.

Advisor: Nothing in writing. Just the verbal conversations. I’m not sure otherwise what to disclose. Maybe if I understood more about that wallet thing –

Giachetti: Are you helping your clients buy the physical coins, the bitcoin or the ethereum?

Advisor: There are no physical coins. They’re on something called the ”blockchain.”

Giachetti: So what do your clients actually own? Metaphysical assets?

Advisor: I’m not sure you understand what crypto is. Maybe we need to educate you on this.

Giachetti: I think I have a pretty good handle on the situation. These things that you are charging an asset-based fee on are not regulated, there is no tangible asset, there is no tangible wallet, and you said that you aren’t executing the transactions. Is that what I heard you say?

Advisor: They bought them on their own. I’m not sure where. Something called Coinbase or something.

Giachetti: And you get to charge on it. So please satisfy my curiosity. Do you take payment in crypto? Do clients use bitcoin to pay your AUM fees?

Advisor: Certainly not. Much too risky, and I’m not even sure what I would do with a bitcoin if you somehow inserted one on my computer.

Giachetti: (laughs.) And, of course, you have E&O insurance for your crypto exposure.

Advisor: I have E&O insurance for my practice. With Markel.

Giachetti: Have you read the contract? My friends at Markel are much too smart to cover crypto exposure. Do you know that crypto coins are not securities? And if they are not securities, then there would be no errors and omissions insurance?

Advisor: Are you suggesting that I should not be charging on these client assets that I’m going to all this trouble to report on? I should remind you that my firm is not a nonprofit organization.

Giachetti: I think, based on your level of knowledge, that you shouldn’t even be discussing these things with your clients, much less charging on them.

If you still insist on doing it, against my very clear recommendation, you should at least be giving some real disclosure about it. Maybe have your clients sign a ”hold harmless” document. The SEC is going to come in and decide, this is not a security, it is not regulated, nobody knows where the hell it is, and you’re making a fortune. I think the examiners are going to be very interested in this new profit center you’ve developed.

Advisor: What if I don’t charge, but I do some research and give advice on the subject?

Giachetti: That isn’t going to help you, because you’re getting compensated indirectly through other assets. I have a lot of RIAs like you who are now starting to actively counsel on it, and if you are actively counseling on it, in addition to the acknowledgement that I would want signed by your clients, I might want some disclosure.

I have other large firms that are putting these assets in sleeves of their asset allocation portfolios. They’re buying exchange-traded trusts. And we’re going to see more coming out.

What you need to be careful about is your clients are going to start to press you. There are some ETFs coming out. And every day when you look at the markets, one of the leading stories is always crypto, crypto, crypto. Crypto goes up ten percent in one day, and nobody can figure out why.

That’s got to scare us.

Advisor: So about my upcoming visit from the SEC –

Giachetti: This issue is right there on the latest SEC exam. The SEC’s position is going to be that you can’t charge on that unless you execute the transactions and make clear that the transactions were nondiscretionary. And even if you only give advice on those holdings, you need to disclose the limitations of the recommendations and the risks associated with crypto. I’ve developed several corresponding disclosures, but I have to tell you, many firms are playing with fire, from both a liability and a regulatory perspective here.

Advisor: Okay, moving on. There’s another issue I’ve been thinking about, which I think you’re going to appreciate. I remember how you were putting out notices that the SEC didn’t like it when advisory firms like ours were charging different fees for different asset classes, saying it was a conflict of interest because it would create an incentive for us to put more client money into the asset classes that we were charging more for.

Back then, I used to not charge my clients on their cash allocations. But lately I’ve finally given in and set a policy where, reluctantly, our firm now charges our regular fees on our clients’ cash holdings. Do I deserve some congratulations here? When the SEC comes in and examines me now, they’ll see that I’m finally charging on cash holdings, and that will probably work to my advantage now. Right?

Giachetti: I think you have hit probably the most germane topic of the last three months for the SEC.

Advisor: Really? Cool!

Giachetti: First of all, you’re right; the SEC has never liked non-level fees. What the government doesn’t understand, unfortunately, is that many firms decided, as fiduciaries, that they should not command as high a fee on bond assets held to maturity as they should on equity assets that are probably much more volatile, and that you may want to trade in and out of on a more frequent basis.

From my perspective, that was the correct thing to do, to charge less. But the SEC’s position was that firms should charge the same on all client assets, and that is commonplace now.

Advisor: So that means they’re going to like the fact that I’m now charging my regular fees on cash. Right?

Giachetti: The SEC is now taking a different position on cash holdings, which is disconcerting to me. It only reflects the punitive nature of this current commission.

Advisor: Punitive? Did I hear that right?

Giachetti: Their concern now is that you’re charging 100 basis points on an asset that is yielding one or two basis points. They’re going to ask: why are you doing that?

Advisor: Because they told me to?

Giachetti: They never had this concern before. Never.

Advisor: So they’ve changed their mind? Right when I –

Giachetti: Yes. In their eyes, you are now making a profit on an investment where the client makes a loss. You might consider going back to not charging on cash.

But if you decide to stay with this new course, I’ve developed a policy, and disclosures, and I make sure all my clients have these. Cash is an asset class. And as I have pointed out to the SEC, during many examinations, they – the SEC, I mean – treat it on their own regulatory documents that it is an asset class.

The SEC hates when you point out things to it that are in its own documents. Because it doesn’t always read its own documents. But the truth is, if you had your clients in cash during the downturn in 2008-9, your clients would have hugged you and sent you baked goods every day.

Advisor: So I’m in the clear, or not? That baked goods thing sounds good.

Giachetti: You have a choice. You can go back to not charging on cash. Otherwise, you need to tell clients that you treat cash as an asset class, that at times you may hold cash for tactical purposes, that there is no assurance that holding that cash will make sense, but there may be times when the return on the cash is lower than the fee that you charge.

And you should have a corresponding policy. If you don’t, the SEC is going to come in and see that you’re making money where the client is losing money.

Advisor: All this disclosure stuff sounds messy. My clients are going to be reading something the size of a prospectus by the time we get finished here.

Giachetti: I feel for you. I really do.

Is that everything you’re worried about?

Advisor: Well, I do have a couple of other things that might come up in the examination. Minor stuff.

Giachetti: Tell me about them.

Advisor: In my earlier life, I worked with some of the biggest brokerage firms in the business, and I kind of got into a rhythm.

Giachetti: A rhythm?

Advisor: Every 10 years, I would get these big up-front bonus offers from other firms that wanted to recruit me and my clients over to them. 300% of my production, can you believe that? And then that arrangement would end, and I would get another offer, and I would shake the money tree again.

Giachetti: Didn’t you tell me you were a fiduciary?

Advisor: I’m in a different regulatory environment right now. I switched to an independent broker-dealer, registered as an RIA, and darned if the broker-dealer didn’t pay me a whole bunch of recruitment money, only they didn’t call it a “recruiting bonus.” I think we agreed to call it an up-front payment to, in their words,”offset the cost of moving my book of business to the new BD.”

Giachetti: A transition allowance?

Advisor: I had several offers, and the best offer was for a lot more than it cost to make the switch. It doesn’t cost that much to go fee-only these days.

Giachetti: But I can assume that you used that transition allowance for the benefit of all your clients, right?

Advisor: Actually, no. I put it in my own pocket, as the rightful owner of my firm. It’s like my 7-10-year performance bonus. And I’m looking forward to the next seven or eight years when I can put myself up for auction again.

So that’s my question. Is there some kind of regulatory issue there?

Giachetti: There actually is a little issue there.

Advisor: Please don’t tell me more disclosures?

Giachetti: Of course you have to disclose it. I’m sure you amended your ADV to indicate you got this transition allowance.

Advisor: I indicated that I switched firms on my ADV.

Giachetti: And I’m sure you pointed out very clearly that there was a conflict of interest.

Advisor: Not… really. I didn’t change the service that I offer my clients. I offer great service to my clients, which I probably should have mentioned earlier.

Giachetti: So your clients never got any notice about this bonus arrangement? Didn’t you breach your fiduciary duty to provide material disclosure as to this money you were receiving in exchange for telling clients to transfer their assets to this new firm?

Advisor: I never thought about that.

Giachetti: How do you feel about disclosing that now?

Advisor: I’m not sure I want my clients to know that I got paid to transfer them. Especially after some of those grumpy testimonials they gave me that I decided not to put up on my website.

Maybe you could help me draft a letter that they wouldn’t really understand what the hell I’m saying. Could you do that for me?

Giachetti: Oh, I’m not very good at that.

Advisor: There’s another issue I wanted to ask you about.

Giachetti: You seem to have a lot of issues.

Advisor: I think you’re going to like this one. Can you believe these interest rates? Interest rates are practically zero right now! I’ve told my clients that the investment markets have typically returned 7-10% a year, but to be conservative, I’m now projecting 5% a year – which happens to be about twice what my clients would have to pay if they refinanced their mortgage and took out some equity.

So I’ve told some of my clients that refinancing is a way to get more of their money in the markets. If I can’t manage those assets to get them at least a 5% return, I should get out of the business altogether. Don’t you agree?

Giachetti: This also creates a lot more money for you to charge an AUM fee on, right?

Advisor: That’s a nice side benefit to this strategy.

Giachetti: I’m sure it’s a fine practice that you’re engaging in. Let me ask you this: did the clients pledge assets to secure those loans?

Advisor: Their homes.

Giachetti: Their homes.

Advisor: Yes.

Giachetti: You don’t care if they end up living without a house. You just want to get those extra assets to manage.

Advisor: Of course not. I would prefer them to be living in a house.

Giachetti: Did you tell them about the conflict of interest you had by making that recommendation? That by them going into debt and providing you with the proceeds, you were going to make a higher fee?

Advisor: I’m just trying to make them wealthier. I’m trying to accelerate the building of their wealth. That’s the goal.

Giachetti: If the markets decline, you still are making money on those assets, correct?

Advisor: Right.

Giachetti: If they couldn’t pay their mortgage, you would still be making money, correct?

Advisor: I would still be servicing their account, yes.

Giachetti: So you wouldn’t want them to sign an acknowledgment or put disclosure on Form ADV about pledged asset loans, or recommending that they engage in these types of activities?

Advisor: I’m not sure what I would say. Should I say that this is a great way for me to help them get even wealthier? That I’m working harder on their behalf to accelerate their wealth? Would that work?

Giachetti: In addition to your crypto and cash, you’re also making a profit margin on this.

Advisor: Yes. This is going to be a good year for me.

Giachetti: Are you also recommending that your clients borrow money on margin?

Advisor: At these interest rates, it’s a no-brainer. Look at what the bull market has done.

Giachetti: And this is just a guess, but are you also charging on the higher margin value?

Advisor: Yes.

Giachetti: Because you have to get paid, correct?

Advisor: I’m glad you understand. We provide excellent service to our clients. People should be willing to pay for that.

Giachetti: How do you think the SEC is going to react when they find out that you are getting paid a premium on the higher margin balance?

Advisor: That was exactly what I was going to ask you. Do you see an issue there? By the tone of your voice, I’m beginning to suspect that they’re not going to congratulate me.

Giachetti: Very good, excellent guess. My hunch is, since I have had to deal with this on behalf of new advisors coming to me in a panic, having to write checks back for hundreds of thousands of dollars – that this is another opportunity for the SEC to force client reimbursement.

Advisor: Out of my pocket? Hundreds of – ?

Giachetti: – thousands of dollars, yes. Maybe you should stop telling clients to leverage themselves in the market or stop charging on those additional assets. At the very very least, you want to put some disclosure in your ADV and have your clients sign a separate acknowledgement that they understand the conflict of interest, especially if you’re charging on the higher margin balance, and recommending that they go out and engage in margin borrowing.

Advisor: With all these disclosures, who’s going to want to work with me?

Giachetti: But you provide such excellent service.

Advisor: Did I mention that?

Giachetti: Do you think the SEC cares about that?

Advisor: No?

Giachetti: Not at all.

Advisor: Well, anyway, another situation that has come up that I wonder about. I am working with a custodian that is (like all custodians these days) offering me a whole lot of tech services, not just trading and custody, but also rebalancing and a lot of convenience regarding the processing of new clients and some integrations with the other tech I use. There’s a whole lot of benefits to working with this custodian. I think right now, my custodian’s tech is the best fit for my firm.

Giachetti: Sure.

Advisor: The only problem is that they take payments for order flow, and there’s also a pretty big spread between the rate on their cash sweep accounts and what the money markets are paying – and that is coming out of my clients’ pockets.

Recently, another, smaller custodian has asked for my business, but I don’t think its technology is quite as good. But it doesn’t take payment for order flow and it lets me put client cash in any fund or money market that I want. But its tech isn’t as good – did I mention that?

For now, I’m going to stick with the custodian that offers better tech for my firm and have my clients get a little less on the execution and on their cash balances. I’m worried that the SEC might think I have a conflict of interest. Do I?

Giachetti: This sounds like a great decision for your firm’s bottom line.

Advisor: Yes. It’s helping me. But I’m not quite so sure it is the perfect thing for my clients.

Giachetti: I am looking at your ADV right now, and I can’t find any disclosure about the benefits that you receive from your current custodian.

Advisor: It’s just the tech stuff that they provide to everybody.

Giachetti: They do.

Advisor: Yes.

Giachetti: But you didn’t disclose that you might receive those benefits?

Advisor: I’m not sure that it makes me any different from anybody else.

Giachetti: Did you disclose that perhaps, unless you make a separate transaction, the client’s cash must stay in a proprietary money market, where your clients will not receive market returns?

Advisor: Do I have to disclose that?

Giachetti: Kinda sorta, yeah. But I feel for you. You would otherwise have to make all these transactions, and that takes up a lot of time. You’d have to hire people and it would drive up your internal costs.

Advisor: No. That’s the problem; I don’t think I’d be as profitable if I went with a smaller custodian.

Giachetti: I can see that. At the end of the day, the most important issue is for you to protect your profit margin. For all this great service you provide, it’s important that you stay in business.

Advisor: I agree. Is there a disclosure issue here, or should I be more proactive in shifting my custodial relationship where there are fewer conflicts?

Giachetti. This is a difficult issue. I think you need to do what is best for your clients. However, sometimes what is best for your clients may be something in between. If you’re telling me that this new leaner custodian, their technology offering is not as robust as what you have now, and that your clients may not receive the same type of technology support, and it could potentially adversely impact your offering, then perhaps you stay with the larger custodian.

But you disclose that on Form ADV. Disclose that there is a conflict of interest, that you do receive these types of benefits, some of which support your business enterprise, and some of which may not.

I would imagine that custodian is not only giving you that technology, but there may be some other things they are going to give you.

Advisor: For instance?

Giachetti: I was recently involved in an SEC exam that blew my mind. It was a very large firm, and they couldn’t find anything, but of course they had to find something.

What they hung their hat on was that their custodian, because this advisor was very charitable and has two large foundations and runs some charity events, this custodian made a donation.

Well, the SEC thought that was material.

So do you have disclosure about these things on your ADV? About the types of benefits that you might get from your custodian? If they were to give $5,000 to a charity, have you ever heard of such a thing?

Advisor: Terrible. Dirtbags.

Giachetti: Terrible. Dirtbags. Absolutely. And it is a good thing the government is all over that, isn’t it?

Advisor: As long as they’re not all over me, sure. I feel more protected by the minute. The longer you talk, the more protected I feel.

But... what if the smaller custodian offers the same tech services, but it would be inconvenient for me to shift my clients to the smaller custodian, even though they would probably get better execution and certainly more return on the cash balances.

Giachetti: Well, we certainly don’t want to inconvenience you.

Advisor: I was hoping you’d say that.

Giachetti: That could impact your profits, right?

Advisor: It would be a lot more work.

Giachetti: You would have to hire somebody to transition all those assets?

Advisor: Actually, we have software now that does most of the work.

Giachetti: So the real issue is that you don’t like to contact your clients. You only want to hear from them when they have an issue. You don’t want to be proactive.

Advisor: Wow! It’s like you’re reading my mind here. In our new client service model, now that we've stopped overservicing them, we let them mostly contact us whenever they need something.

Giachetti: And the clients would be quite stunned to hear that you want to do something for their benefit.

Advisor: Well, I guess it might come as a surprise.

Giachetti: I think in that situation, if it was clear that you had this opportunity, and it was discoverable by the SEC by review of your correspondence and emails – which I’m sure you’re monitoring on an ongoing basis…

Advisor: Hourly.

Giachetti: Hourly; sure. Then I think you would have a lot of explaining to do. I think in that situation, as a fiduciary, you have an obligation to always act in the best interests of your clients. Alternatively, if there is any issue relative to a conflict, you must clearly and conspicuously disclose it to your clients.

Advisor: Is that an issue that the SEC is ever going to look at, is whether I’ve shopped for the thriftiest custodial relationship? There are best execution rules, but I’ve never heard of anybody having an enforcement issue there.

It seems like payment for order flow at one custodian and not another might be something they would be interested in. No?

Giachetti: The examiners have not looked at that issue specifically yet. But they do look at best execution.

But I have convinced them, after 20 years of trying to educate them, that there is no best execution for mutual funds. They all trade at the same price at the end of the day. Believe it or not, they would ask about your best execution policy on mutual funds, and this is before the share class issue.

I would say there is an issue there. Whether or not the SEC is going to call you on it, with all these other issues to distract them, is hard for me to say.

Advisor: Another custodial issue that I’ve been facing, remember that big custodian that I’m working with?

Giachetti: I do.

Advisor: While I was talking to that smaller custodian, my representative at my larger custodian (who shall remain nameless, but they have a very large selection of mutual funds) has come to me and pointed out that I don’t use any of its proprietary funds.

Giachetti: As I remember, you said you use mostly ETFs.

Advisor: Right. And that’s a problem for them. They have a spreadsheet that tells them that my relationship with them isn’t as profitable as it needs to be for me to keep working with them – because all that technology costs them so much money.

Giachetti: Yes. This is already happening with some of my clients. So what solutions did they offer?

Advisor: They said they were going to have to start charging my firm a monthly custodial fee to stay on the platform – which I would have to pay out of pocket. (Gulp!)

But if I switch client money out of the ETFs over to their funds, they’ll waive those custodial fees that I’d otherwise have to pay. A long time ago, I had decided that those funds have much higher expense ratios than the ETFs that I’ve been using up until now. But after this conversation, some of their in-house funds are starting to look better and better to me.

Is that something the SEC might worry about?

Giachetti: Let’s be honest; they are not looking better. I’ll bet if I looked at your fund analysis process, those funds wouldn’t even show up anywhere; they were screened out.

Advisor: They’re pretty darned expensive. But maybe not so bad now, and of course my clients would, in effect, be paying the custodial fee instead of me – and they would never see it on any balance sheet or anything.

Giachetti: I hate to say this, but if you decide to go ahead and do this, at the very least you have another disclosure issue.

The SEC might see this as a big reimbursement issue. This is happening every day.

It’s ultimately about a bigger, broader issue that they’re paying very close attention to: the share classes in client portfolios.

I have a case right now on the West Coast for a well-known manager that is being asked to pay back millions of dollars to their clients. Millions.

They were not my client; they hired me after the fact. A lot of firms find me after the s**t hits the fan.

Advisor: Which is why I have proactively brought you into this a week before my exam.

Giachetti: Very proactive indeed

The issue for them was two-fold: I know it is a lot of work for you, Mr. Advisor, when an advisor transfers in a mutual fund portfolio, for you to figure out whether they’re in a higher fee class, higher expense class. Better to let them just keep those funds, right?

Advisor: I wouldn’t want to incur any taxes.

Giachetti: And maybe you didn’t notice that a transfer from one share class to another is generally not a taxable event. If the client holds onto those assets and is paying a higher expense ratio, the SEC is going to expect you to make up the difference.

Advisor: What about moving my client assets over to this custodian’s in-house funds?

Giachetti: It’s a variation on the same issue. In cases like that, where they determine that you could have had your clients in basically the same funds with lower expenses, they will go back five years, and calculate what you should write a check back to your clients, and that can be very expensive.

Advisor: But I didn’t get paid on that additional expense!

Giachetti: The SEC isn’t going to look at it that way. You’re a fiduciary. You’re getting paid on those assets.

Everyone should have a detailed protocol. When I sit down with the firm, the first thing I look at is: what do we do when we get a new client? And share classes are one part of it.

If you were to use Vanguard funds, and you failed to convert from the Vanguard advisor class to the Admiral share class, two basis points, the SEC is going to figure that out and make you pay back the difference to clients.

Advisor: If I convert my client ETFs to the custodian’s proprietary funds, I’m moving them into the institutional share class – which prevents me from paying the custodian’s fees out of pocket. This is not a share class issue.

Is the SEC going to care about that?

Giachetti: It is a material conflict of interest and a material breach of your fiduciary duty.

Why? Because you would not necessarily have invested in those proprietary mutual funds, lowest share class or otherwise. But you determined to do so because you had an economic incentive to make that change. And you need to disclose that to clients.

If you don’t, again, get your checkbook out.

You can run your business the way you want. But be prepared to write a check, because that is all this SEC cares about. They need to find a way for you to write a check to your clients.

Advisor: So I won’t do that. And as it turns out, I have another option. The custodian says that instead of investing in their funds, I could simply give up the free transaction option, and pay ticket charges on the transactions I make, and if I do that, they’ll waive that custodial fee.

Giachetti: Your clients would actually be the ones who are paying those charges, am I right?

Advisor: Actually, yes. Is there an issue if I choose that option?

Giachetti: I would say in that circumstance, you might win. I don’t see any reason why you should pay your clients’ custodial fees unless you are receiving some sort of economic benefit and you need to disclose that.

I am a big believer in letting the client know that there is a cost to making transactions. I do think you need to disclose that.

At some point, the custodians have to make money. They are not in this business for free, and they need to be compensated.

Profit is not bad. So long as you are treating your clients fairly, and you disclose any potential conflicts, you are allowed to make a profit and custodians need to make a profit also.

By the way, how often do you change the ETFs in client portfolios?

Advisor: I’m a buy and hold sort of advisor.

Giachetti: I’ve been putting paragraphs in my clients’ ADVs for four years now, about portfolio activity, where the SEC looks for what they call ‘reverse churning.’

Advisor: Wait, I thought buy and hold was a good thing.

Giachetti: This is the most disgusting thing about how the commission looks at things. You have these ETFs that you’ve sat on for years. And you are getting paid on that. So they come in and ask: how come you aren’t making more active trades on those accounts?

Advisor: They’re good investments. They’re consistent with my clients’ objectives. There was no reason to turn them over. Are you telling me I have an issue there?

Giachetti: In their eyes, if you turned them over, they would see that you’re doing something for the money you charge. How ridiculous is that? But they’re going to look at it, and you might be getting questions about it.

Advisor: So I have to make a bunch of unnecessary trades to prove that I deserve the fees I charge?

Giachetti: No, I’m not saying that. But you should have a paragraph on your ADV about portfolio activity, that says that just because you did not make transactions, that does not mean you are not doing your fiduciary duty and monitoring those assets on an ongoing and continuous basis.

Advisor: I’m getting tired of all this disclosure.

I guess there’s one last question. I negotiate fees with my clients, which means that some are paying on a different schedule than others. Does the SEC care about that?

Giachetti: Are the fees dependent on the person who is interfacing with the prospect? In other words, more senior or more junior people?

Advisor: Of course not. We treat all our clients the same.

Giachetti: Do you disclose why you might discount your fees and why similarly situated clients might be paying more or less than others?

Advisor: If I did, I guess what I’d say is that some clients ask for a discount and some don’t.

Giachetti: Are you keeping track of that in the office? Do you have a fee schedule deviation form, where it is approved?

Advisor: Sounds like a lot of unnecessary paperwork. We have fees all over the place.

Giachetti: I’m not saying it is a bad practice, fee differentials, but it can be problematic to the SEC, that if Mr. Jones came in to see three different people in your office over three days, Mr. Jones would be quoted three different fees. So you are begging the SEC to challenge that. Unless you have some kind of oversight process that you can demonstrate to them.

Advisor: I wasn’t planning to beg them to challenge anything. I was hoping they wouldn’t look too closely at it.

Giachetti: The whole idea of asset-based pricing is pretty scary to me. Because now you have to prove on an ongoing basis as to why the client was benefiting from an asset-based pricing standpoint.

Advisor: So it sounds like I’m going to sail through this upcoming audit, right?

Giachetti: I absolutely want to wish you the best of luck with it.

Bob Veres' Inside Information service is the best practice management, marketing, client service resource for financial services professionals. Check out his blog at: www.bobveres.com.

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