Internal Controls – Supervision

November 30, 2005

A recent administrative complaint filed by the State of Massachusetts against a broker/dealer provides another reminder of the importance of strong internal compliance and supervision policies and procedures. In the complaint, Massachusetts is alleging that the named firm instituted weak internal supervisory programs that have enabled its registered representatives to conduct investment advisory activities without being licensed as investment advisor representatives, which in turn led to unsuitable sales of equity-indexed annuities.

The overriding allegation cited in the complaint is the firm’s lack of sufficient supervision and internal controls; and while the complaint is against a broker/dealer, it provides an important lesson for investment advisor firms. Investment advisors need to have established and implemented effective internal controls that are specific to the firm’s operating and business procedures.

While there are many ingredients to an effective compliance program, this recent regulatory action by Massachusetts highlights at least three areas of focus. First, advisor firms should establish a system that requires advisor representatives and employees to disclose outside business activities. The firm needs to review, approve/reject, and monitor all outside business activities. Not only must outside activities be disclosed on the Form U4, but depending on the type of outside activity and the employee, it may also need to be disclosed on the Form ADV. In addition, an employee’s outside activity may potentially come into conflict with the firm’s code of ethics or insider trading policy. An outside activity could also cause potential or real conflicts of interest between the advisor representative and his clients. Advisor firms that do not establish effective policies to review outside business activities and then take appropriate actions based on such reviews are running the risk of future regulatory issues.

A second vital part of any compliance program is having an effective supervision and review program of client accounts to ensure a client’s investment objectives are being met. This includes requiring advisor representatives to only provide services and advice with respect to products that are approved by the firm. Furthermore, it necessary to ensure that those products/services, such as outside money managers, are subject to effective due diligence.

A final component to a good compliance program is conducting on-going monitoring and training of advisory services and annual audits. Advisor firms need to ensure their representatives and employees have a complete and accurate understanding of the firm’s policies and procedures and all applicable regulatory requirements. One of the best ways to accomplish this is by having an annual face-to-face audit each year coupled with on-going training and monitoring procedures.

Has your firm instituted effective compliance and supervisory procedures dealing with outside business activities, unsuitable sales practices, client suitability, supervision, and monitoring of wholesalers and third-party vendors. Do you feel confident your financial advisors are properly supervised and your firm has established an effective compliance program? Or has your firm’s compliance programs grown stagnant? Maybe you need objective advice from a third-party to help improve your internal controls. Is so, give us a call or send us an e-mail. Our goal is to identify deficiencies in your firm’s compliance programs before trouble arises.

Posted by Bryan Hill
Labels: Compliance Program