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Regulation
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Chapter Goals
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Discuss the role regulation plays in the financial
services industry.
Describe the key regulatory items that must be
satisfied in dealing with clients.
Explain the responsibilities of a fiduciary.
Illustrate who regulates what in the financial services
industry.
Identify the range of financial planner compliance
factors.
Target selected regulatory issues of special
importance.
Overview
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Regulation in the financial services industry, whether
by federal state or professional association, is
principally concerned with providing appropriate
information and beneficial advice to clients.
Efficient markets mean that accurate and up to date
information is supplied to all investors with buys and
sells done at low transaction costs.
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Assumes that people have the time and ability to
understand and act on that information in the investments
area.
It assumes, then, that all investors act logically and are
highly knowledgeable and that our free market system
ensures that they receive the information they need to make
appropriate decisions.
Overview, cont.
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Regulators assume that people often make incorrect
choices and can be exposed to unscrupulous advice
that is motivated by self-interest.
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Regulators endeavor to represent and protect the average
household.
They establish rules and regulations that constitute
acceptable and unacceptable behavior.
The goal of financial regulation in our system, however, is to
bring about an efficient marketplace with fairness for all
participants.
There are a number of factors that are intended to ensure
that a financial planner and other financial services
individuals will provide appropriate advice.
They include competency, suitability, due care, compliance,
ethical behavior, and documentation.
General Standards of Proper
Professional Behavior
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Competency: The ability to handle a given task with
the expertise necessary to provide a satisfactory
outcome.
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Suitability: Refers to ensuring that the advice and
products provided fit the circumstances and
preferences of the client.
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Arises from a minimum level of general education, a
specialized knowledge of finance received through
education and testing of that knowledge, and a prescribed
amount of practical experience.
Incorporates such variables as yearly income and net worth,
tolerance for risk, age, health status, goals, and other
assets owned that have a similar use.
Having an attractive product is not good enough. The
product must benefit the client.
General Standards of Proper
Professional Behavior, cont.
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Reporting: Presentation of material facts.
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Should be undertaken for two groups: clients and regulatory
bodies.
Client reporting should include information about the
advantages and disadvantages of any recommendation.
Clients should also be given up to date and accurate
information about results.
When there is a potential or real conflict of interest between
the advisor and the client, the advisor should disclose it.
Reporting as it pertains to regulatory bodies should be
prompt and accurate.
It may consist of filing the characteristics of ownership and
operations every twelve months.
Material changes in those factors may have to be reported
within a certain period of time after they occur.
General Standards of Proper
Professional Behavior, cont.
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Due Diligence: Making an adequate investigation of
the merits of an investment or other
recommendation.
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Compliance: Deals with observing all rules and
conditions set up by established laws and regulatory
bodies.
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The effort must be broad enough in scope to provide
appropriate recommendations.
It is important that you are careful and knowledgeable about
the specific advice given.
Compliance should mean not only following all regulations
already set up but also observing the intent of those
regulations in contrast to the narrower approach of doing
what you can “get away with.”
General Standards of Proper
Professional Behavior, cont.
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Documentation: Written support for business
practices and information provided for clients.
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Ethical Behavior: Refers to maintaining standards of
correct conduct and practice.
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A powerful support for advisors should differences with
clients enter the legal arena.
It is sometimes difficult to specify what constitutes ethical
behavior because individual circumstances can mandate
differing behavior.
However, adhering to many of the items in practice we have
already listed including competency, reporting, suitability,
dilligence, and compliance helps underpin ethical behavior.
What constitutes ethical behavior depends on the nature of
the relationship you have with your client.
General Standards of Proper
Professional Behavior, cont.
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The investment advisor has a fiduciary duty to
clients, perhaps the highest type of trust.
A fiduciary has a responsibility to a client that often
involves power over assets, obviously a crucial area.
Such a relationship mandates, among other things,
integrity and fidelity in actions.
Conflicts of interest are to be avoided in a fiduciary
relationship, and when they cannot be prevented
they are to be fully disclosed to clients.
You owe a duty of confidentiality of information to
clients.
Regulation of Investment Advisors
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The Investment Advisor Act of 1940 was established
to protect the investment public against fraudulent
and deceitful practices on the part of investment
people who provide them with advice.
A key part of the act mandates that the advisor
provide full disclosure of any conflicts of interest.
Our discussion will include modifications to the
original act and SEC jurisdiction under it.
Terms of the Investment Advisors Act
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To be considered an investment advisor there are
three criteria that must be met:
The person gives advice or analysis in regard to
securities.
The person is in the business of presenting
investment advice.
The person must be compensated for the services
rendered.
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Any economic benefit received, whether direct or indirect,
would meet the terms of compensation under this standard.
Terms of the Investment Advisors Act,
cont.
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The following are exempt from the Advisors Act:
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A bank or bank holding company that is not an investment
company.
Accountants, lawyers, engineers, teachers whose rendering
of advisory services is incidental to their profession. If they
represent themselves as providing financial planning
services to the public the service is not incidental and they
fall under the provisions of the Advisor’s Act.
Brokers or dealers whose advice is incidental to their
business and do not receive special compensation for this
service. However, these people cannot maintain they are
financial planners or investment advisors. They can refer to
themselves as financial service professionals, insurance
agents, or stockbrokers.
Publishers of general circulation and business newspapers
and magazines who render advice.
Terms of the Investment Advisors Act,
cont.
People whose advice is limited to U.S. government
securities.
6. Those involved in statistical ratings services such as
Standard & Poor’s and Moody’s bond and other ratings.
7. Other people designated by the (SEC)
8. People all of whose clients are within one state where the
advisors have their business and do not render advice on
securities traded on a national securities exchange.
9. People who have less than 15 clients and represent
themselves as advisors to the general public.
10. Those who provide services only to the insurance industry.
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Obligations of an Investment Advisor
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Under The National Securities Market Improvement
Act of 1996:
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To register with the SEC the advisor must file form
ADV, which has two parts.
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Advisors actively managing more than $30 million in assets
will register with the SEC.
Those managing under $25 million will register with the
state in which they do business.
Those who manage assets between $25 and $30 million
have a choice of either.
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Part I provides information about the firm and the
backgrounds of its key employees. It also includes the type
of clients the firm works with.
Part II gives types of services offered, methods of
compensation, and other information.
Obligations of an Investment Advisor,
cont.
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The SEC has requirements and restrictions on
practices, as follows:
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The advisor must keep a set of books and records, in hard
copy or online, that provide sufficient information to protect
clients.
Each year the form must be modified annually, giving
updated information and disclosing any material changes in
operations. Those who register with the SEC and are
accepted are called Registered Investment Advisors (RIAs)
As a restriction on compensation, the advisor cannot share
in the profits of the client unless the client has assets of over
$1 million or is a registered investment company.
The advisor cannot assign the contract with the client
without the consent of the client.
Obligations of an Investment Advisor,
cont.
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Advisors cannot call themselves an “investment counsel”
unless they qualify as an investment advisor under the
Investment Advisor Act.
Under the “brochure rule” an advisor must give each new client
a copy of Part II of the ADV form, or its equivalent and offer to
provide one annually for all existing clients.
Record keeping
 Indicates the way records are to be filed. For example,
maintaining clients’ acknowledgment of receipt of the
brochure – typically, ADV form, Part II.
 Records must be kept for a minimum of five years.
 Records may be kept in electronic files as long as they are
safe and accessible.
 Common records are an income statement, a balance sheet
along with supporting transaction records, a list of securities
purchased and their cost, and others.
Obligations of an Investment Advisor,
cont.
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Anti-Fraud Provision: Fraud is deliberately intending to deceive
in order to obtain something of value.
An advisor cannot defraud any current or prospective
client.
 An advisor cannot act as a principal to sell or purchase a
security from a client without disclosing your acting as a
principal and getting approval to do so.
 As a fiduciary, an advisor cannot do anything fraudulent,
manipulative, or deceptive.
 An advisor must disclose any conflict of interest or
potential conflict of interest to the client.
Performance Fees
 Not allowed except for clients who have a net worth of
$1,500,000 or $750,000.00 under the management of
the RIA.
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Obligations of an Investment Advisor,
cont.
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The SEC pays particular attention to certain areas.
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An advisor cannot assign a contract to someone else
without the approval of the client.
Amendments to form ADV for material changes in people,
practices, etc. must be filed within 90 days of the end of the
advisor’s year.
One is advertising. Selected presentation of past
performance is not permitted; full and fair presentation must
be made. Advisors are not allowed to use testimonials by
clients.
Disciplinary actions against advisors must be
disclosed. You cannot use the term Registered
Investment Advisor or RIA as if it implied that you
had a professional credential. You must have your
own compliance manual.
Obligations of an Investment Advisor,
cont.
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In 2004, the SEC promulgated Rule 204A-1, a new
Investment Advisor Code of Ethics under the
Investment Advisors Act of 1940.
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Provided new standards of conduct and addressed new
conflicts of interest, particularly as they pertained to
personal trading by advisory personnel. Among the
changes are that firms must keep copies of their own code
of ethics which includes:
 Protection of material that is not public information.
 Reporting securities transaction and establishing
policies to be reviewed by a compliance officer
established by each firm. Preapproval for securities
transactions by the firm’s employees is required.
 Advisors should describe the code of ethics to clients.
Obligations of an Investment Advisor,
cont.
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Under the National Securities Markets Improvement
Act (NSMIA) of 1996, the supervisory role of the
SEC was eased by assigning investment advisors
who manage $25 million and under to the states.
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Four kinds of advisors are permitted to register with
the SEC under NSMIA:
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Thus, many financial planners who do not have large
investment management practices are regulated by the
states.
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consultants;
nationally known statistical organizations;
certain affiliated investment advisors who are also in other
types of business; and
those who reasonably expect to manage over $30 million
and will register with the SEC.
Obligations of an Investment Advisor,
cont.
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Although not bound by the entire Investment
Advisors Act, most states follow many of its
principles in registration and regulation.
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They act against illegal, fraudulent, or deceptive acts and
record procedures against insider trading.
Advisors must notify clients about a material change in
ownership and cannot assign the client contract to a third
party without client approval.
Advisors cannot act as principal and sell a security to a
client without prior notification to that client.
All states use the ADV form, and most states require
exams with the National Association of Securities
Dealers (NASD).
The definition of a financial planner can vary by
state.
The NASD
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The National Association of Securities Dealers
(NASD) is a self-regulatory body for the securities
industry.
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Under NASD regulations, those who sell investment
products must associate with a broker-dealer.
The two principal NASD exams are:
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Those who sell products and receive compensation for
doing so must register with the NASD.
Fee-only or fee and commission planners register with the
states or the SEC.
Series 6: A limited registration.
Series 7: A full securities exam.
A Series 65 exam is required for people who
represent themselves as financial planners.
Broker-Dealer Regulation
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When a person sells products and receives
commissions as a commission-only or fee and
commission financial planners do, he or she must
register as a representative of a broker- dealer.
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The broker-dealer is regulated by the NASD and federal
and state authorities.
Those planners must offer only products that have
been screened and approved by that broker-dealer.
The registered representative (RR), who may also
be an RIA and perform financial planning services,
must notify the broker-dealer of transactions and the
broker-dealer supervises the RR’s RIA actions.
Insurance Regulation
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Insurance generally falls under state regulation.
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The NAIC’s Model Insurance Act covers appropriate
actions.
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State regulation is made more uniform through the National
Association of Insurance Commissioners (NAIC).
The Model Insurance Act prohibits certain practices.
 One is twisting, getting a client to switch insurance
policies without a strong reason for doing so.
 The second prohibited practice is selling products that
are not suitable for a client.
 In some states another is calling insurance an
investment.
Insurance agents should disclose certain information as to
commissions, the fact that they are agents, and reasonable
assumptions on policy illustrations including current results.
Other Professionals
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A registered representative is a broker who
represents a broker-dealer in securities transactions
for clients.
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Accountants and lawyers may provide financial
planning advice.
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Regulated by the broker-dealer and by the NASD with
whom they register.
If that advice is incidental to their operations, they need not
register as RIAs.
However, their actions are regulated by the states they
practice in and by their industry associations, the American
Institute of Certified Public Accountants and the American
Bar Association, respectively.
Other Professionals, cont.
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Insurance Agents provides products for individuals
using industry products but he or she is not
employed by any one company.
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Investment advisors need not be financial planners,
although a growing number are offering specialized
or general planning advice.
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A person who renders advice for a fee with or without selling
products is considered an insurance consultant.
Thus, a financial planner who provides advice on insurance
matters can be deemed an insurance consultant and must
register.
Regulated as RIAs and if they are Chartered Financial
Analysts (CFA Charterholders) by the industry’s CFA
Institute.
Targeted Areas
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Some of the areas of particular interest to the SEC or
regulatory authorities are as follows:
The CFP Code of Ethics and Practice
Standards
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The CFP Code of Ethics and Professional
Responsibility, and Practice Standards are
promulgated by the CFP Board.
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The Code of Ethics consists of Part I Principles and
Part II Rules.
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Meant for all people who are practicing CFP® certificants or
engaged in related activities or professions or who intend to
become CFP® professionals. The CFP Board calls these
people Board certificants; we will refer to them as
certificants.
The principles are ideals, and the rules are a more practical
implementation of the principles.
For some planners certain rules may not be applicable in
some cases.
The CFP Code of Ethics and Practice
Standards, cont.
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Part I – Principles
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Part II – Rules
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Integrity.
Objectivity.
Competence.
Fairness.
Confidentiality.
Professionalism.
Diligence.
The rules are practical applications of the ethical principles.
A detailed specification of the rules is provided in the text of the
chapter.
Practice Standards
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Practice standards are the ways in which you operate.
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Standards for CFP® professionals are developed and
implemented by the CFP Board of Standards.
The practice standards follow the six-step financial planning
process:
 Establishing and defining the relationship with a client.
 Gathering client data.
 Analyzing and evaluating the client’s financial status.
 Developing and presenting the financial planning
recommendations.
 Implementing the financial planning recommendation
 Monitoring.
A detailed specification of the practice standards is provided in
the text of the chapter.
Chapter Summary
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Regulation has as its intent providing proper information and
advice to clients.
General standards of appropriate professional behavior
include: competency, suitability reporting, due diligence,
compliance, documentation and ethical behavior.
The Investment Advisors Act protects the investments public
against fraudulent and deceitful practices by people who
provide them with advice.
Under the Act all people who provide investment advice not
incidental to another activity must register with the SEC or
their state and adhere to the Act’s requirement.
All people who call themselves financial planners or who
perform comprehensive financial planning services or as part
of their planning services make investment recommendations
must register with the SEC or with their state.
Chapter Summary, cont.
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The SEC ADV parts I and II provide detailed information
about a firm to that regulatory body and to the public.
The NASD and the broker dealer they are enrolled with
supervise people who sell products to clients. A financial
planner who does so may be NASD registered and be a
Registered Investment Advisor under SEC or state
regulation.
Other financial service professions are regulated under
Federal, State or individual professional regulatory body
requirements.
The CFP Code of Ethics provides seven principles and rules
which follow them that must be adhered to.
The CFP Practice Standards provide norms for planner
activities. They follow the six step financial planning
process.