Chapter 2: Ethics, Laws & Regulations AND the Plan, the Process & the Profession

1. Chapter 2: Ethics, Laws & Regulations AND the Plan, the Process & the Profession The Process of Financial Planning: Developing a Financial Plan Lytton, Grable & Klock 2006

2. Building Blocks: Financial Planning Pyramid Monitoring and Implementation Plan Development Financial Planning Process Decision Making Communication Ethics / Laws / Regulations / Practice Standards

3. This is a BIG Chapter!! Part 1: Ethics and Regulations Part 2: The “F” Word – “Fiduciary” Part 3: Rules Governing Communication Part 4: Ethical Requirements for Financial Planners Part 5: Professional Practice Issues

4. Part 1: Ethics and Regulations Sometimes, you just need a “cop”! 1. Federal 2. State 3. Voluntary: Professional Associations

5. Ethical, Illegal or Good Practice? • Selling-away • Violates FINRA (NASD) Rule 3040 • May subject the broker-dealer to claims of unsuitability, unnecessary fees, and regulatory sanctions • Rebating • Unethical and in most states illegal • Violates FINRA (NASD) Rule 2470 • Violates state insurance regulations

6. Ethics “suggested standards of conduct based on an agreed-upon set of values” where values are preferred attitudes and behaviors

7. Western Moral Philosophical Basis • Teleological– consequential approach or “situational ethics” • Deontological– Absolutism, or universally accepted RIGHT and WRONG • Characterized by predetermination and prescribed proceedings BUT mitigating circumstances may prevail!

8. Practice Standard: “Acceptable” Practice • Deontological (cont’d) • According to society (all or part) • Codified in a code of ethics or statement of standard practice • Practice standards reflect normative ethics, or standards, and define what should be done • Governing bodies, such as FINRA (NASD), or membership organizations, FPA, define these standards • Practice standards may be descriptive – “right” or “wrong” is defined by the outcome

9. “Stealing from Clients is Wrong” “for a practice standard to come into existence and to be enforced, certain groups of people must agree on what is inherently right and wrong. This means that normative standards must be practiced. While it is not necessary for all practitioners and regulators to be in agreement with a standard, standards cannot be enforced if behaviors are evaluated solely on relative outcomes.”

10. Federal Regulations • Securities Act of 1933: “Paper Act” • Securities Exchange Act of 1934: “People’s Act” • Created the SEC • Publicly traded companies required to provide quarterly and annual reports • Maloney Act of 1938 • Registered securities associations to promote self-regulation, which lead to the NASD, now FINRA as of 2007

11. NOTE: • In July 2007, the Financial Industry Regulatory Authority (FINRA) was created from the merger of the National Association of Securities Dealers (NASD) and the self-regulatory functions of the New York Stock Exchange (NYSE). • FINRA is often referred to as the “successor organization to the NASD”

12. Federal Regulations (cont’d) • Investment Advisors Act of 1940: “Fee Act” • Registered Investment Advisor (RIA) – “investment adviser is any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”

13. SEC Definition of Registered Investment Advisor (RIA) • Provides advice or issues reports, analyses or opinions regarding securities • Provides such services for compensation • Is in the regular business of providing such services

14. Federal Regulations (cont’d) • Investment Advisors Act of 1940: “Fee Act” • Investment Advisor Representative (IAR) – Performs services or works for an RIA • 1997 Amendment: Advisors to register with the SEC if • Managing assets >$25M rule • Service in more than 30 states • Advisors to investment companies under the 1940 Act or anyone eligible for exemption under the 1940 Act

15. Form ADV • 2001, Investment Advisor Registration Depository (IARD): electronic system for registering ADV with state(s) and SEC • Part I: • Advisor’s business information • Persons who own or control the business • Any violations by the advisor or other personnel of securities laws or other laws

16. Form ADV (cont’d) • Part II: Written disclosure or brochure describing business practices, fees, and conflicts of interest • Education • Certifications • Types of investments • Fees charged • Methods of analysis • Investment strategies • Descriptions of legal problems

17. Form ADV (cont’d) • Part I: Filed with IARD; Notification with 45 days of status • Part II: Investment Advisors Act of 1940 requires delivery of Part II to all clients or potential clients, and then again annually See Figures 2.1 and 2.2

18. SEC Definition of RIA Exceptions to Registration Requirement • Banks and bank holding companies • Lawyers, accountants, engineers, or teachers if …solely incidental to their professions • Brokers or dealers if…solely incidental to their business as brokers or dealers • Publishers of newspapers, magazines, or business/financial publications of general or regular circulation

19. SEC Definition of RIA Exceptions to Registration Requirement (cont’d) • Persons whose advice relates only to securities that are direct obligations of or guaranteed by the U.S. • Advisors whose only clients are insurance companies • Advisors with fewer than 15 total clients who do not hold themselves out publicly as investment advisors Otherwise, advisors who receive compensation must register. Failure to register may result in a fine of $10,000 and 5 years in jail.

20. 5-yr. Practice Management Records Rules • Receipts and disbursements journals • General ledger • Order memoranda • Bank records • Bills and statements • Financial statements • Written communications and agreements (including electronic transmissions) • List of discretionary accounts

21. 5-yr. Practice Management Records Rules • Advertising • Personal transactions of representatives and principals • Powers granted by clients • Disclosure statements • Solicitors’ disclosure statements • Performance claims • Customer information forms and suitability information • Written supervisory procedures

22. Advisor as Custodian • “Custody” – Direct or indirect access to and responsibility for client’s funds or securities • Advisor must prove that accounts are safeguarded • Advisor must submit to random audits by an accountant • Must disclose this role to the client

23. Advisor as Custodian (cont’d) • Additional documents required; • Journals of securities transactions and movements • Separate client ledgers • Copies of confirmations • Records showing each client’s interest in a security • Client purchases and sales history

24. Investment Discretion “authorized to determine the disposition of assets (e.g., what securities shall be purchased or sold) for the account of another person, whether or not another person may have responsibility for such investment decisions, or if they exercise such influence with respect to the purchase and sale of securities that they may as well have executed the transaction themselves”

25. Advisor as “custodian” has physical possession of the asset, but must follow the client’s directions Advisor with “discretion” or “trading authority” can dictate the disposition of the asset but does not have possession Custody vs. Investment Discretion

26. State Securities Regulators • “Blue sky laws” • North America Securities Administrators Association (NASAA), 1919 • Generally, states require • Form ADV • Series 65: Uniform Investment Advisor Law Exam • Payment of fee • Posting of bond, especially if a custodian • File a U-4 for all IARs serving the advisor’s clients

27. State Insurance Regulators • National Association of Insurance Commissioners (NAIC), 1871 • 8 licenses require examination • 6 licenses require registration only

28. Common Insurance Licenses

29. To Obtain an Insurance License • Be at least 18 years of age • Submit a NAIC Uniform Application to their state insurance regulator • Submit an application fee • Notify the state regulator if an insurance license is held in another state • Provide evidence of Series 6 or Series 7 FINRA (NASD) registration if selling variable contracts • Pass a licensing examination • Secure an insurance company certification showing where business will be transacted • Meet ongoing continuing education (CE) requirements.

30. SROs: Maloney Act of 1938 • Managed and funded by firms participating in a particular segment of the securities markets • provide consumers with protection against fraud • provide a means to enforce SRO rules and standards

31. U.S. SROs

32. FINRA (NASD until 2007) • Most powerful SRO in financial services • Oversees • 5,100 brokerage firms • 99,000 branch offices • 675,000 registered reps

33. FINRA (NASD) Duties • Licenses individuals • Admits firms to the industry • Writes rules to govern stockbroker and firm activities • Conducts regulatory and ethical compliance examinations • Disciplines those who fail to comply with rules • Oversees and regulates equity, corporate bond, futures, and options trading • Operates the largest securities dispute resolution forum

34. Common Securities Exams

35. RIA, Registered Rep or Both? • RIA: Charge a fee for advice • Registered Reps: Execute transactions for a commission • In some cases, an advisor can be registered with the SEC and licensed with the FINRA (NASD) See Figure 2.3

36. Professional Financial Services Organizations • Credentialing organizations • Quasi-credentialing organizations • Designation organizations • Membership organizations Jan. 2005: 87 organizations in the U.S. and Canada offering almost 90 certifications and designations

37. Credentialing Organizations • Certification: Minimum qualification and knowledge level • Experience • Knowledge competency exam(s) • Good standing with the certifying body • Continuing education requirements • Acceptable practice • Fees

38. Credentialing Organizations (cont’d) • Common examples: • The American College: CLU, ChFC • The CFP Board: CFP • CFA Institute: CFA • Quasi-credentialing organizationsand their certifications • AICPA: PFS • IARFC: RFC, RFA

39. Designation Organizations • No examination required, but other experience or education requirements apply • Accredited Business Accountant, ABA • Registered Financial Planner, RFP

40. Membership Organizations • Shared interest in financial services, practice management techniques and objectives • FPA • MDRT • NAPFA: “Hybrid” that offers membership and a quasi-credential/designation

41. NAPFA • Furthers fee-only advising • NAPFA—Registered Financial Advisor • BS + specialized study • 60 hours of CE every two years • Must offer comprehensive planning services • Submit a comprehensive financial plan for review • 36 months of experience providing comprehensive financial services

42. Part 2: The “F” Word Enough said!

43. Fiduciary “anyone who provides financial services and acts in a position of trust on behalf of, or for the benefit of, a third party” trustee, executor, administrator, registrar of stocks and bonds, transfer agent, guardian, assignee, receiver, or custodian

44. Financial Planning Fiduciary • Provides specific recommendations regarding securities • Is paid to provide ongoing financial advice • Works with unsophisticated clients that rely on the adviser’s advice A financial planner becomes a fiduciary when the advice given to a client becomes comprehensive and continuous

45. History of Fiduciary Rules • 1803, Prudence standards • 1942, The Model Prudent Man Rule Statute • 1959, “Prudent man rule” “In making investments of trust funds the trustee is under a duty to the beneficiary … to make such investments and only such investments as a prudent man would make of his own property having in view the preservation of the estate and the amount and regularity of the income to be derived ….”

46. History of Fiduciary Rules (cont’d) • 1974, Employee Retirement Income Security Act (ERISA) • Applies UPIA to investment professionals through the prudence standard of ERISA • 1994, Uniform Prudent Investor Act (UPIA) • Primarily focused on trust and foundation assets, most states apply much more broadly • Applies to • financial planners acting as fiduciaries • investment advisors for charities and pensions • executors, conservators, and guardians

47. UPIA: Fiduciary Standards for Trustees • Standard of prudence • Risk/return tradeoff is a central consideration • No investment restrictions, IF consistent with risk/return objectives and prudence • Diversification is assumed within prudence • Delegation of investment/management allowed, subject to safeguards

48. UPIA: Investment Standards • Prudence – “reasonable care, skill, and caution” • Consider trust portfolio, overall investment strategy, and risk/return • Circumstances:economy; inflation/deflation; taxes; mix of assets; total return; beneficiaries’ resources, investment needs, and any special relationship with assets

49. UPIA: Investment Standards (cont’d) • Reasonable effort to verify facts for investment/management • Investment choice consistent with the trust and UPIA • If trustee chosen for special skills or expertise, they must be used

50. Be objective Monitor investments Investigate investments Diversify portfolios Maintain loyalty to the client Remain impartial Reduce costs to maximize portfolio efficiency Maintain regulatory compliance UPIA “Prudent Man” Expectations for a Financial Planner