In the adopting release to Rule 206(4)-7 under the Advisers Act (commonly known as the Compliance Rule) the SEC listed certain issues that should be addressed by an adviser’s policies and procedures. Among these issues, the SEC expressed its belief that Registered Investment Adviser’s (RIA’s) fiduciary obligation to its clients includes the obligation to implement policies and procedures that are intended to prevent and detect unauthorized trading in client and proprietary accounts. Unauthorized trading encompasses a wide range of activities including:
- Trading in client or proprietary accounts that were not authorized;
- Mismarking positions intentionally;
- Distorting records with false transactions; and
- Trading over and above the specified limits on position exposures, risk tolerances, and losses.
An RIA should implement strong policies and procedures to ensure that investments are suitable for the client. RIAs should document the steps they take to make certain that clients’ financial situations, risk tolerances, and investment goals have not changed, and that their investments are still suitable for them.
Policies and procedures can help an RIA to detect and prevent unauthorized trading through measures such as:
- Heightened oversight;
- Identifying red flags that may be a sign of unauthorized trading; and
- Conducting special supervisory reviews.
Policies and procedures should specifically prohibit illicit trading practices such as front running and insider trading.
During examinations, examiners scrutinize trade allocation practices, because there is a potential for clients to be harmed. In addition, an RIA should fully disclose on Form ADV its trade allocation practices. These practices should ensure that the RIA will not disproportionately allocate potentially lucrative investments, such as IPOs, to favored accounts. They should also ensure that the RIA does not wait to see what happened in the market before deciding how to allocate trades among clients. In addition, policies and procedures should spell out how clients are charged when the RIA allocates securities participating in block trading.
An RIA’s policies and procedures should address how trading errors are handled. They should give detailed information regarding the notification process after errors are discovered. Policies and procedures should clearly state that clients will be made whole if losses from trading errors occur. Policies and procedures should also address how trading errors will be resolved if they result in a profit.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Boca Raton, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.
RIA Compliance Group, LLC – 5301 North Federal Highway, Suite 380, Boca Raton, FL 33487 – Tel: 561-600-0564 – sales@ria-compliance.com.
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