AdvisorCounsel Law Blog

Recently, I wrote a post that investment advisers and broker-dealers should review their Form CRS in light of new guidance on the disciplinary history section (Review your Form CRS Disciplinary History Disclosure in Light of New Guidance). As that post addressed, earlier in the month, Commissioner Clayton and Directors Blass and Redfearn put forth a Joint Statement Regarding New FAQs for Form CRS. On the same day as the Joint Statement was issued, the staff of the Division of Investment Management and the Division of Trading and Markets amended its Frequently Asked Questions on Form CRS by adding four new questions and answers.

As a follow up to my earlier post, I wanted to examine this guidance, ponder its intent, poke holes in its legality, and question whether it is even good public policy.

The Relevant Guidance

The guidance from the Joint Statement boils down to two major concepts:

1. “Firms do not have discretion to leave the answer blank or to omit reportable disciplinary history from the relationship summary. ”
2. “When responding to the disciplinary history heading in their relationship summaries, firms may not add descriptive or other qualitative or quantitative language.  Adding such language might, intentionally or unintentionally, obfuscate or otherwise minimize the disciplinary history.  However, as we describe below, firms or their financial professionals may provide the relevant disciplinary history directly to retail investors.”

Intent of the Guidance

I think Commissioner Clayton and Directors Blass and Redfearn were feeling pressure from the recent reporting by the Wall Street Journal – Financial Firms Fail to Own Up to Advisers’ Past Misdeeds – on the lack of accurate disclosure on Form CRS. Based on that pressure, they reacted by putting forth the Joint Statement and tried to clear up confusion in the industry regarding disciplinary history reporting on Form CRS. I think their Joint Statement went too far in trying to clear up that confusion, and caused them to provide guidance that is contrary to the Instructions to Form CRS.

Legality of the Guidance

The first bit of guidance referenced above is legally enforceable, was well-intentioned, and was a matter of good public policy. It is based on the Instructions to Form CRS and complies with the intent outlined in the proposing and adopting rule releases.

However, I believe the second bit of guidance is less likely to be legally enforceable, was an overreach in reaction to the Wall Street Journal’s reporting, and is also bad public policy.

The Instructions to Form CRS make it clear that investment advisers and broker-dealers must respond to each question and only include disclosure that is required or permitted by the instructions. Instruction 1.B. states, “You must respond to each item and must provide responses in the same order as the items appear in these instructions. You may not include disclosure in the relationship summary other than disclosure that is required or permitted by these Instructions and the applicable item.” However, instruction 2.B. states, “All information in your relationship summary must be true and may not omit any material facts necessary in order to make the disclosures required by these Instructions and the applicable Item, in light of the circumstances under which they were made, not misleading. If a required disclosure or conversation starter is inapplicable to your business or specific wording required by these Instructions is
inaccurate, you may omit or modify that disclosure or conversation starter.” (emphasis added). Footnote 92 of the adopting release identifies the tension between these two instructions by using the legal signal “Cf.” when comparing the two instructions.

Footnote 91 of the adopting release provides somewhat relevant guidance on instruction 2.B. It states, “We are adopting this provision to ensure that firms are not compelled to include wording in their relationship summaries that is misleading or inaccurate in the context of their business models. This provision may apply in limited circumstances. For example, the headings and conversation starters prescribed by the final instructions are worded at a highly generalized level and cover selected key topics that are broadly applicable to broker-dealers and investment advisers and their relationships with retail investors, irrespective of business model (i.e., relationships and services the firm offers to retail investors, fees and costs that retail investors will pay, specified conflicts of interest and standards of conduct, and disciplinary history).” (emphasis added). This signifies that a firm could add additional content to their discussion on their disciplinary history if they did so to make their disclosure more accurate or less misleading.

In addition, the adopting release goes on to state:

Firms or financial professionals would have the opportunity to provide more information about and encourage retail investors to ask follow-up questions regarding the nature, scope, or severity of any disciplinary history, so that retail investors have the information they need to decide on a relationship. In particular, financial professionals who themselves have no disciplinary history can make clear that a “Yes” disclosure in response to the heading question relates to the firm and other personnel (if applicable) and not to them.

Adopting release at p. 176

The adopting release isn’t clear on whether firms or financial professionals could provide more information in the Form CRS itself, but the ambiguity should be interpreted against the SEC in this case.

Guidance from a single Commissioner or the SEC staff do not have the impact of law. In fact, the Joint Statement acknowledges this in footnote 1. “This statement represents the views of Chairman Clayton and Directors Blass and Redfearn. It is not a rule, regulation, or statement of the Securities and Exchange Commission (“Commission”). The Commission has neither approved nor disapproved its content. This statement has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person.” The introduction to the FAQs have a very similar disclaimer.

This is important because the law in effect is the Form CRS and its instructions. Whereas, guidance is issued to help interpret or clarify an existing law. Whether the Joint Statement and FAQs are even to be considered guidance is up for debate because of the disclaimers they contain. Even if they were to be treated as guidance, I think that a federal court would agree that they are inconsistent with the regulation, which is historically the standard used in determining whether the guidance should be afforded deference. 

Bad Public Policy

I personally don’t understand why an investment adviser or broker-dealer could not provide additional clarification in response to a disciplinary question on Form CRS so long as they do so in a non-misleading way. I believe that the investing public would benefit from having additional, relevant information about the disciplinary history of a firm or a financial professional at a firm. While Chairman Clayton and Directors Blass and Redfearn believe that it could obfuscate or minimize a firm’s reportable disciplinary history, I believe that additional information is fair, and even warranted, in certain instances.

For example, I am aware of a small firm where one of its financial professionals had a single incident that caused the firm to make an affirmative response to the disciplinary history question. The event at issue involved a nearly 30-year old administrative error that resulted in a financial professional temporary having his license to render advice suspended by a state securities regulator in a state that he didn’t even have any clients or prospective clients. I hold this firm and the individual in question in high regard and I think it is unfair that they cannot provide a little bit of context around their affirmative response to make it not misleading.

Chairman Clayton and Directors Blass and Redfearn opted to try and make “black and white” that which is always a balancing act–the federal securities laws.

Should Your Firm Add or Remove Context?

I can’t tell you whether your firm should or should not provide context if it responds affirmatively to the disciplinary history question. That is a business decision. However, you should understand the law, the impact of guidance (and non-guidance), understand that this issue will likely arise during an examination, may be referred to enforcement, and determine whether you are prepared to litigate over this issue. For most investment advisers and broker-dealers with disciplinary histories, the answer will be easy–remove the additional context.

As an attorney in the investment management space, I have seen the use of Morningstar presentations create issues for investment advisers at an increasing rate during examinations conducted by the Securities and Exchange Commissions (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”).

The issues that I have seen typically revolve around the use of hypothetical back-tested performance. Most typically, a financial professional will create a presentation that compares the client or prospective client’s current portfolio to a portfolio being recommended by the financial professional. It will show a distinct improvement in one or more of the following variables: performance, expenses, or risk metrics. These presentations are not reviewed by compliance (or anyone for that matter) prior to their delivery to the client or prospect. OCIE has continually taken issue that these presentations violate Section 206 of the Investment Advisers Act because they are misleading. They also allege that these presentations are “advertisements” under Rule 206(4)-1 and that they violate the rule. The presentations are not typically labeled as hypothetical back-tested performance presentations. Further, the template or stock disclosures provided by Morningstar do not consistently or automatically comply with the no-action letter guidance issued by the SEC.

In any event, if your firm currently permits its financial professionals to use Morningstar presentations (or any similar product or software, such as HiddenLevers), now is a good time to review your policies and procedures. Some things to focus on:

1. How does your firm train and supervise your financial professionals on the use of Morningstar (and performance presentations in general)?
2. Does legal or compliance review each presentation before it is provided to a client? If not, how does it ensure compliance with the SEC’s no-action guidance on backtesting?
3. Have you reviewed the Morningstar presentations and the disclosure and are you confident that your firm’s use of the presentations meets the SEC no-action guidance relating to backtesting?

I believe that Morningstar should try and make some slight re-designs to the presentation formatting and disclosures to maximize the likelihood of compliance for investment advisers. They may also want to provide their users with some type of whitepaper, education, or training to reduce the examination and enforcement risk for users.

* This post was updated on September 22, 2020 at 9:15am to remove any reference to issues involving LPL Financial.

Form U4 requests information about various criminal, regulatory, financial, and litigation matters. While many of these disclosures are relevant and important to clients and prospective clients, others are less important. For example, I have seen countless college incidents. Some involve taxi rides, fake IDs, alcohol, or marijuana. This article is intended to help those who have suffered one of these events contemplate their options for removing these (or even more serious) criminal transgressions. In addition, this article might be helpful for a firm with an otherwise clean Form CRS wanting to explore cleaning up one of their owner’s or employee’s disclosure reporting pages.

The specific questions that appear on Form U4 (which cause information to flow through to the Investment Adviser Public Disclosure and Brokercheck) appear below:

As you will see, certain criminal charges require disclosure regardless of the outcome. These include felony charges and charges involving crimes that potentially implicate moral character (e.g., fraud, false statements or omissions, wrongful taking of property)

If you have an affirmative response to one of these questions on your record, there are a few options to consider:

1. Is the current disclosure even supposed to be on your record? Many times, I see overly-conservative compliance departments make disclosures to cover themselves. Not all criminal charges or convictions require disclosure. A lawyer with knowledge of the specific state law charges should help you make the determination. Further, an FAQ to Form U4 states: “If a registered person is arrested but not charged with a crime, is the arrest required to be reported? A: No. An arrest without a charge is not required to be reported. (02/13/98)” It could be possible that you were arrested, but not formally charged with the crime. Again, state-specific law will determine whether you could rely on this FAQ.
2. Removal of Disclosures.
   • It is also possible that a criminal action can be expunged. Each state’s law is a little different on the impact of expungement. For example, an expungement in certain states will make it so the arrest never occurred. In that case, you would not need to report the charge. There is a growing trend under state law to automatically expunge certain cases through diversion programs for certain offenders. However, the effect of expungement is not the same in all states. You will want to closely review your charges, convictions, and the expungement law in your state to determine whether this is a possible exercise.
   • Once you have received an order of expungement from a state court, there is a process to provide that expungement to FINRA, who will remove the expunged disclosure.

If you have any questions about whether your specific charges should be disclosed or can be expunged, do not hesitate reaching out.

If your investment adviser permitted its supervised persons to receive rule 12b-1 fees through an unaffiliated broker-dealer at any point in the last five years, you should start preparing for an examination by the SEC’s Office of Compliance Inspections and Examinations or an inquiry from its Division of Enforcement. (I recently covered the one of the first enforcement cases where the SEC settled with such an adviser). The SEC rarely brings enforcement cases in isolation these days, and you can safely assume there will be more of these investigations and enforcement actions to follow.

There are a number of hybrid investment advisers associated with independent broker-dealers where this practice may have been prevalent. The recent settled enforcement action involved an investment adviser and its supervised persons that were registered representatives of Triad Advisers, Inc.

If your firm has supervised persons that received rule 12b-1 fees from advisory accounts at any point (but particularly from September 2015 through the present), you should be considering the following:

1. What is our firm’s exposure? How much money is potentially at issue?
2. What did our firm disclose to clients regarding these practices?
3. How many representatives and which representatives were involved in this practice? Was it owners or management at the firm?
4. Has the disclosure and/or the receipt of rule 12b-1 fees been corrected on a go-forward basis? Did we disgorge all of the rule 12b-1 fees?
5. If our firm’s disclosures were inadequate (which they likely were in the eyes of the SEC Staff), have we voluntarily and proactively disgorged these fees? If not, why not? If so, did we include an interest component?

I have been assisting investment advisers for the better part of the last six years on issues involving share class selection and disclosure. I have been deeply involved representing clients’ interest in some of the earliest enforcement actions involving these matters, and have assisted clients successfully avoid enforcement actions altogether. If your firm (i) is trying to assess its risks, (ii) contemplating how to minimize its exposure, or (ii) is seeking counsel or a second opinion on whether its practices or disclosures were or currently are sufficient, please feel free to contact me.

The Securities and Exchange Commission accepted an offer of settlement from Graham, Bordelon, Golson & Gilbert, Inc. (“Graham Bordelon”), an investment adviser with its headquarters is Monroe, Louisiana.

This settled action is markedly different from the roughly hundred other actions involving share class selection practices to date. In this action, the SEC alleged that Graham Bordelon “purchased, recommended, or held for advisory clients mutual fund share classes that charged fees pursuant to Rule 12b-1 under the Investment Company Act of 1940 (“12b-1 fees”) instead of lower-cost share classes of the same funds which were available to the clients. Graham Bordelon’s associated persons received 12b-1 fees in connection with these investments, but Graham Bordelon did not adequately disclose this conflict of interest in its Forms ADV or otherwise. Graham Bordelon also, by causing certain advisory clients to invest in fund share classes that charged 12b-1 fees when share classes of the same funds that presented a more favorable value for these clients under the particular circumstances in place at the time the transactions were available to the clients, breached its duty to seek best execution for those transactions.”

This case is unique for a few reasons. First, Graham Bordelon did not have an affiliated broker-dealer during the relevant period. Instead, all of Graham Bordelon’s associated persons were registered representatives of an unaffiliated broker-dealer. However, the SEC still brought charges against Graham Bordelon.

Second, Graham Bordelon agreed to pay disgorgement of $111,655.10 and prejudgement interest of $14,744.11, even though the SEC acknowledged that Graham Bordelon began providing credits of the 12b-1 fees it received dating back to August 31, 2016. This seems like a fairly large figure for a firm that manages approximately $240 million with a period that is shortened due to the statute of limitations and their crediting process. Based on some back-of-the-napkin math, it appears to be about a one-year period (i.e., from September 1, 2015 through August 31, 2015). This assumes that the SEC Staff did not enter a tolling agreement with Graham Bordelon fairly early in the enforcement inquiry.

Third, the Graham Bordelon agreed to pay a civil penalty of $50,000, which is almost half as large as the disgorgement at hand. By comparison, Cozad Asset Management, Inc. was ordered to disgorge $369,423.75 and agreed to a $10,000 civil penalty. Albeit, they missed the self-reporting deadline by a few days. The SEC accepted civil penalties that appear to be a bit less than half of the ordered disgorgement in other settled actions.

Lastly, it begs the question where the SEC Staff will draw the line in pursuing cases involving associated persons and unaffiliated broker-dealers. For example, if a single, non-control person received 12b-1 fees, it would seem unfair to seek disgorgement from the investment adviser. Obviously, the SEC could allege failures in policies and procedure and disclosure in those instances, but that would set some interesting precedent.

As an aside, I still continue to believe that best execution is the incorrect framework for these cases, as the investment advisers (i) purchased the security they intended, (ii) at the time they intended , and (ii) at the price they intended.

As an update to this article, there has been one other settled enforcement action involving similar facts. See Signature Financial Services, Ltd.

Recently, I was posed with the question of whether an investment adviser registered with the U.S. Securities and Exchange Commission has an ongoing obligation to update its supervised persons’ Form U4s.

I always assumed the answer was yes, but I recently dug into this assumption from a legal perspective. After conducting a bit more legal research, my assumption has not changed, but you would think it would be a bit clearer.

This post assumes that the associated person meets the definition of “investment adviser representative” under applicable state law, has filed their initial Form U4, and been approved to conduct business in a state as an “investment adviser representative”.

The instructions to Form U4 state: “An individual is under a continuing obligation to amend and update information required by Form U4 as changes occur. Amendments must be filed electronically (unless the filer is an approved paper filer) by updating the appropriate section of Form U4.” From a legal perspective, it isn’t clear whether the instructions or any guidance issued by FINRA associated with Form U4 are binding on investment advisers registered with the SEC.

However, the acknowledgement that each representative makes on the form itself states: “I agree to update this form by causing an amendment to be filed on a timely basis whenever changes occur to answers previously reported. Further, I represent that, to the extent any information previously submitted is not amended, the information provided in this form is currently accurate and complete.”  Placing aside other applicable law, this would seem to create a contractual or quasi-contractual obligation to amend the responses to Form U4 on an ongoing basis.[i] It does beg the question what is a “timely basis” .

Notably, FINRA Rule 4530 imposes specific requirements on the timing of amendments involving a criminal matter, regulatory action, civil matters, and judgments and liens. Generally, they must be reported within 10 or 30 days, depending on the event in question.

However, investment advisers registered with the SEC are not subject to FINRA rules. Instead, they (and their investment adviser representatives) are bound by federal and state law. As you may be aware, investment adviser representatives are subject to licensing by states (subject to Section 203A of the Investment Advisers Act of 1940).  By way of example, New Jersey regulation requires that “[a] registered investment adviser representative shall file with the Bureau an amendment to Form U4 within 30 days, whenever there is any change to the information previously reported on the Form U4.”  Similarly, Florida’s applicable rule states: “If the information contained in any Form U4 becomes inaccurate for any reason before or after the associated person becomes registered, the associated person through the investment adviser or federal covered adviser shall be responsible for correcting the inaccurate information within thirty (30) days. If the information being updated relates to the applicant’s or registrant’s disciplinary history, in addition to updating the Form U4, the associated person through the investment adviser or federal covered adviser shall also provide the Office with notice and copies of each civil, criminal or administrative action initiated against the associated person….Associated persons shall file such amendments through the CRD system.”

Without confirmation, I assume that many states have a similar requirement (with the exception of New York, which as of the date of this post unbelievably does not license investment adviser representatives). If a state did not have such a requirement, then the requirement to file an amendment to Form U4 would be based solely in (i) the contractual or quasi-contractual language in Form U4 referenced above, or (ii) the potential for a state to apply its “dishonest or unethical practices” catchall.  Many states have poorly drafted blue sky laws, so I wouldn’t be shocked if one or more states did not have an explicit requirement.

In any event, it seems like a very easy and prudent compliance requirement to implement a procedure to require investment adviser representatives to review and update their Form U4s on an ongoing basis.

[i] The Form U4 has probably not been subject to very many state administrative procedures act processes.

Financial professionals that have entered into an employment agreement or some other form of contract with their employer that contains an agreement not to solicit clients upon their departure are in an extremely difficult place. How do you get out of an employment situation that you no longer want to be in without taking unnecessary risk.

I feel for you. As lawyers, we have rules of professional conduct that prohibit these types of restrictions by employers under the premise that clients should be free to determine who provides them with legal advice. I personally think that the financial advice profession would be better off without these restrictions, but that isn’t the point of this article.

In a previous article, I provided some high level guidance on how to prepare for and avoid litigation on non-protocol transitions. The purpose of this article is to identify strategies for financial professionals that are intended to help work around these restrictive covenants. Keep in mind that this is not intended to be legal advice and you should not rely on this article in making any employment decisions. State laws differ, as do the specific provisions found in employment contracts, and you will want to speak with a lawyer knowledgeable in restrictive covenants and the financial industry before you take any chances.

The approaches described below are intended to be ranked in order of my perceived level of risk. Approaches at the top are less risky than those appearing at the bottom.

1. Broker Protocol. The first thing you want to do is determine whether your transition is subject to the protocol for broker recruiting. If it is, then you really won’t need to worry too much about these restrictions, because the protocol states, “RRs that comply with this protocol would be free to solicit customers that they serviced while at their former firms, but only after they have joined their new firms.”
2. Resign and Don’t Solicit. Another low-risk approach is to resign and not contact any former clients. If your former clients reach out, you could then have an open conversation with them. Most employment contracts are drafted in such a way that former employees are prohibited from initiating contact. This is starting to change slightly based on wording I am seeing in employment contracts, especially at wire-houses that have savvy employment lawyers.
   • Inevitably, everyone has questions about family members and social friends. Stick to the plan. Don’t solicit them. Try not to create evidence that shows you reached out to them. No phone calls or text messages. All of these things can be subject to a subpoena in litigation.
   • Don’t contact clients before you resign and make appointments with them for after your departure date.
   • Don’t send your clients emails, text messages, or postcards saying you opened a new office.
3. Resign, Don’t Solicit, but Make Certain Non-targeted “Tombstone” Announcements. A slightly riskier approach, involves resigning, not directly soliciting clients, but letting it generally be known to the world that you have left. Some examples of this involve updating your LinkedIn, Facebook or Twitter profiles to reflect your new employment. Other examples include taking an ad out in local publication to announce your change. To take it a step further, you might disseminate a message, post or tweet about your new employment. A little bit further, you might send a note-card to former clients stating that you joined a new firm and provide them with your contact information. Each of these actions could be innocent or could be in violation of your employment agreement.
4. Resign and Selectively Solicit Without Creating Record of Evidence. Many financial professionals run in the same circles as their clients. They are friends, family, acquaintances from church, temple or their mosque, or golfing buddies. Solicitation litigation is heavily dependent on the evidence that a former employer presents. A jury or arbitration panel will of course see client accounts bleeding out. That is pretty telling that a former employee is soliciting accounts. However, the evidence they need to hit a home run is the outbound phone call, text message, or email. If you don’t give them that smoking gun, their case will become much more difficult to prove. If you slowly and methodically bump into your former clients in a natural setting, the risk of being found to have violated a solicitation agreement is reduced.
5. Resign and Selectively Solicit Clients. With this approach, you would resign and then selectively solicit your most crucial clients (i.e., most revenue producing, most rewarding to work with, or most likely to tell all of your other clients about your departure). You know that you are legally prohibited from soliciting these clients, but they are worth the calculated risk. If you have to pay damages to your former employer for soliciting them, so be it. Further, you might be willing to simply negotiate a settlement to avoid litigation for the privilege of servicing these clients. By only soliciting a handful of clients, perhaps your former employer might have an incentive to pursue litigation and a temporary restraining order.
6. Resign and Solicit the Heck Out of Your Former Clients. The riskiest approach is to resign and solicit every former client. If you have a non-solicit agreement in place, you can almost guarantee that you will be served with a lawsuit to stop your behavior. Maybe you want to challenge the state of restrictive covenant law in your jurisdiction and serve as a pilot case. Maybe you are prepared to be sued and pay damages. Maybe you know that your employer doesn’t have the resources to pursue litigation. Whatever you are thinking, I don’t condone this approach! But, to each their own.