Choose wisely: New brochures can help CPAs vet investment advisers

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:

1. Should you avoid advisers with disciplinary histories?
2. Should you avoid advisers with conflict disclosures that are not addressed to your satisfaction?
3. 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?
4. 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?
5. Should you demand comparable disclosure from nonfiduciary advisers who aren’t required to provide Brochures and Supplements? Or should these advisers be avoided altogether?

NEXT STEPS

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 (readers@juliejason.com) is co-founder of Jackson, Grant Investment Advisers of Stamford, Conn., an SEC-registered investment adviser.

To comment on this article or to suggest an idea for another article, contact Ken Tysiac, senior editor, at ktysiac@aicpa.org or 919-402-2112.

AICPA RESOURCES

JofA articles

• “Gaining (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, page 46

Publications

• 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)

CPE self-study

• Financial Planning: Process and Environment (#757200011)
• Investments, Sixth Edition (#757500011)

For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.

Web resources

• 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

PFP Member Section and PFS credential

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.