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

Building Blocks: Financial Planning Pyramid

Plan Development

Monitoringand

Implementation

Financial Planning Process

Decision Making Communication

Ethics / Laws / Regulations / Practice Standards

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

Part 1: Ethics and Regulations

Sometimes, you just need a “cop”!

1. Federal2. State3. Voluntary: Professional Associations

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

Ethics“suggested standards of conduct based

on an agreed-upon set of values”

where values are preferred attitudes and behaviors

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!

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

“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.”

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

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”

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.”

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

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

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

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

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

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

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.

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

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

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

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

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”

Custody vs. Investment Discretion 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

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

State Insurance Regulators National Association of

Insurance Commissioners (NAIC), 1871

8 licenses require examination

6 licenses require registration only

Common Insurance LicensesLicenses That Require An Examination

Licenses Not Requiring An Examination

Life Variable Contracts* Accident and Health Travel Property and Allied Lines Auto Club Casualty and Allied Lines Viatical Settlements Personal Lines Reinsurance Intermediary Crop Excess Lines Title Bail Bond *NASD & life licenses required

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.

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

U.S. SROsSRO Acronym Industry Members National Association of Securities Dealers

NASD Broker-dealers

American Stock Exchange AMEX Securities Firms Chicago Board Options Exchange

CBOE Options trading firms

Municipal Securities Rulemaking Board

MSRB Municipal bond dealers

National Futures Association NFA Derivatives trading firms New York Stock Exchange NYSE Securities trading firms Options Clearing Corporation OCC Options trading firms

FINRA (NASD until 2007) Most powerful SRO in

financial services Oversees

• 5,100 brokerage firms • 99,000 branch offices• 675,000 registered reps

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

Common Securities ExamsSecurities License Testing Format

Testing Time Number of Multiple Choice Questions

Investment Company Products/ Variable Contracts Limited Representative - (NASD Series 6)

2 hours and 15 minutes

100

General Securities Representative - (NASD Series 7)

6 hours total; 3 hours per part

250; two parts of 125 each

Uniform Securities Agent State Law Examination - (Series 63) (NASAA)

1 hour and 15 minutes

65

Uniform Investment Advisor Law Examination - (Series 65) (NASAA)

3 hours 130

Uniform Combined State Law Examination - (Series 66) (NASAA)

2 hours and 30 minutes

100

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

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

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

Credentialing Organizations (cont’d)

Common examples:• The American College: CLU, ChFC• The CFP Board: CFP• CFA Institute: CFA

Quasi-credentialing organizations and their certifications• AICPA: PFS• IARFC: RFC, RFA

Designation Organizations No examination required, but other

experience or education requirements apply• Accredited Business Accountant, ABA• Registered Financial Planner, RFP

Membership Organizations Shared interest in financial services, practice

management techniques and objectives• FPA• MDRT

• NAPFA: “Hybrid” that offers membership and a quasi-credential/designation

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

Part 2: The “F” Word

Enough said!

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

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

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 ….”

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

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

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

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

UPIA “Prudent Man” Expectations for a Financial Planner Be objective Monitor investments Investigate investments Diversify portfolios Maintain loyalty to the

client

Remain impartial Reduce costs to

maximize portfolio efficiency

Maintain regulatory compliance

1940 Act, UPIA, and RIAs Hold the client's interest above all other

matters. Use the highest standards of care when

working with clients. Avoid conflicts of interest. If conflicts of interest cannot be avoided, be

diligent in disclosing such information to all interested parties.

Disclose compensation methods.

1940 Act, UPIA, and RIAs (cont’d)

Ensure client confidentiality. Select broker-dealers based on their ability to

provide the best execution of trades for accounts where the adviser has authority to select the broker-dealer.

Make recommendations based on a reasonable inquiry into a client's investment objectives, financial situation and other factors.

Legal Ramifications Burden of proof is with the advisor

Both the planner and the firm can be held legally liable for a breach of fiduciary duty

In some cases, criminal charges may apply

Fiduciary Standards & the SEC Apply to SEC-registered RIAs and their

representatives

Rules are de facto universal, as most states follow the federal guidelines

Broker-dealers and registered reps are exempt from the fiduciary and ethics rules

Stockbroker Client Requirements per the FINRA (NASD) The brokers must:

• Know a client’s investment goals and objectives. • Make investment recommendations suitable to

meet the client’s objectives.

• Make trade accurately.

Based on these standards, stockbrokers currently are not considered to be fiduciaries.

Stockbroker Client Requirements per the SEC The brokers:

• cannot call themselves financial planners. May use financial consultant, wealth manager, etc.

• are exempt from most disclosure rules. Must only disclose that• brokerage accounts are different from managed

advisory accounts• they may be paid incentive income from third parties

Part 3: Rules Governing Communication

Everybody wants a say about what you say and how you say it!

Communication Rules: NAIC Advertising: Create product interest or induce the

public to purchase, increase, modify, reinstate, borrow on, surrender, replace or retain a policy

Applies to any communication used to enhance sales: business cards, brochures, ads, etc.

Clear, easily understood, not misleading message

States control maintenance schedule requirements for advertising files, which range from 3-4 years to 7-10 years

Communication Rules: FINRA (NASD) BROAD definition of

advertising, but constrained by “control over who receives it”

Sales literature defined as for the general public or clients available upon request

Communication Rules: FINRA (NASD) (cont’d)

Requirements include:• Approval by registered principal• Filing with the FINRA (NASD) (including electronic

advertising, but excluding any filed with SEC)• Written communication must be archived by the

issuer for not less than 3 years from initial use, including names of those who prepared and approved its use

Communication Rules: SEC

“unlawful for any person to use the mail or any other form of interstate commerce (including telephone and email) to employ manipulative or deceptive practices in conjunction with the

purchase or sale of any security”

Communication Rules: SROs & FCCTelephone Consumer Protection Act of 1991

• Controls calls for business solicitation• Limits hours to 8 a.m. to 9 p.m., local time• Requires a “Do Not Call” list• Exceptions for:

• Established working relationship• Prior permission from call recipient

Communication Rules: SEC, FCC & FTC Securities Exchange Act of 1934

• 1997 amendment to paragraph (f) of Rule 17a-4 allowed broker-dealers to store records electronically in a non-rewriteable, non-erasable format

• email communications between broker-dealers or other financial intermediaries and their clients or the general public must be archived for at least 3 years for possible review

Gramm-Leach-Bliley Act (GLBA) of 1999

• Established the Financial Privacy Rule and the Safeguards Rule, regulated by 8 federal agencies and the states

• “Financial institutions” – banking, insurance, securities, lending, real estate settlements, taxes, financial advice, financial counseling, debt collection, etc.

• Established notice requirements and restrictions on disclosing consumers’ nonpublic personal information without disclosure and consent

GLBA, SEC and Financial Advisors SEC Regulation S-P:

as a general rule, the initial privacy notice must be given to a customer

or proposed customer no later than when a registered adviser

provides each client with a written disclosure statement or investment

advisory contract

Part 4:Ethical Requirements for Financial

Planners

Can you trust what they say?

SEC, Rule 204A-1 Amendment to the Investment Advisors Act

of 1940 Every adviser must have a code of ethics

that sets forth standards of conduct expected of advisory personnel

Designed to reduce conflicts of interest, especially for advisor managed mutual funds

Code of Ethics Must Include Appointment of a chief compliance officer Written business conduct standards reflecting the

firm’s fiduciary duty Chief compliance officer and supervised persons

must comply with federal securities laws Reporting and review of an adviser’s personal

investment transactions; Supervisor’s approval before an RIA representative

invests in an IPO or private placement

Code of Ethics Must Include (cont’d)

Prompt internal reporting of any violation of the code

Requirement that all employees receive subsequent code amendments

Adviser must keep copies of the code, records of code violations, and actions taken as a result of any violation

Copy of the receipt from all RIA representatives acknowledging receipt of the code

SEC Rules 206(4)-7 and 204-2 Identification of conflicts of interest and risks facing

the RIA Description of the portfolio management process

used by the RIA Description of trading practices Description of the policies for proprietary trading of

the RIA and RIA representatives Policy on the accuracy of client disclosures, including

account statements and advertisements

SEC Rules 206(4)-7 and 204-2 (cont’d)

Policy on safeguarding clients' assets Description of, security of, and protection of books

and records maintained by the RIA Description of marketing policies, including the use

of solicitors Processes to value client holdings and calculation of

fees Description of safeguards for client privacy for

records and information Disaster recovery and business continuity plan

SEC Rules 206(4)-7 and 204-2 (cont’d)

Annual review is required and must be documented, as well as any actions required

Chief compliance officer requirements• Knowledgeable of Investment Advisors Act of 1940• Position of power to make, implement, and enforce

necessary policies and procedures

Professional Association Codes of Ethics CFP Board Code of Ethics & Professional

Responsibility (adopted by FPA)• Applicable to certificants and candidates

IARFC example NAPFA example

• NAPFA Fiduciary Oath

What do these codes have in common?

Part 5:Professional Practice Issues

1. Continuing education2. Professional liability insurance3. Regulation, arbitration and litigation

CE: Organization, State Regulator, and SRO Requirements CFP Board, 30 hrs. every 2 years, of which 2

must be an approved Code of Ethics and Professional Standards program

NAPFA, 60 hrs. every even-year biennial

IARFC, 40 hrs. per year

CE: Organization, State Regulator, and SRO Requirements (cont’d)

NASD (now FINRA), 1995, Rule 1120 Regulatory element

• Computer-based training on licensing and registration, communication, product suitability, and professional conduct

• Completed with 120 days of registered rep’s 2nd anniversary of registration approval date, and every 3 years in the future

Firm element• Broker-dealer provided formal training programs

Failure to Comply? CFP Board will not

renew certification

NAPFA relinquish all benefits of and references to the organization

Failure to Comply? FINRA (formerly NASD) Registration is inactive if the regulatory element is

not satisfied, and remains so until fulfilled Employer subject to penalties

1996, the NASD censured and fined Citicorp Securities, Inc. $25,000 and ordered it to disgorge $300,000 for violating NASD CE

requirements – involving only 19 employees

Professional Liability Insurance: E&O Insurance Protects against claims for actual or alleged

negligent acts, errors, or omissions of a planner, or others for whom the planner is legally liable, in the rendering of or failure to render services

Fiduciary liability insurance, sub-category for fiduciary breaches

No coverage for acts of fraud

Professional Liability Insurance: E&O Insurance (cont’d)

Before purchasing, ask:1.Will the insurance cover prior

acts? 2.Will all legal expense be paid? 3.Where is policy in force? 4.What is covered? (exclusions

apply)

Professional Liability Insurance:Fidelity Bond “Dishonesty” or fiduciary bond to cover

negligent or dishonest actions (e.g., fraud, theft, forgery, and embezzlement)

Planners may be required by SEC or state regulators to post such a bond

Planners involved in business covered by ERISA must post a bond

Avoid Claims of Misconduct Practice professional ethics Use disclosure and commonly acceptable

practice management standards as a fiduciary, regardless of role

Get client’s written agreement prior to gathering data or making recommendations• Figure 2.6 Sample Client Disclosure Form• Figure 2.7 Sample Planning Agreement• Figure 2.8 Sample Investment Management Agreement

Avoid Claims of Misconduct (cont’d)

Know the laws and follow them Disclose anything that might be considered a

conflict of interest Avoid anything that appears unethical, illegal,

or below commonly accepted practice standards

Regulation, Arbitration, Litigation U-4 Form: Required to be filed upon

employment with a FINRA (NASD) license – requires resolution through arbitration but does not bind the client to the same process

Brokerage contracts and account applications require the client to pursue arbitration (See Figure 2.9)• Arbitration: Resolution bilaterally binding• Mediation: Solution is not binding

Regulation, Arbitration, Litigation (cont’d)

For violations of FINRA (NASD) rules, federal securities laws, rules, and/or regulations• censure • fines • suspension or barring of a professional or

organization Criminal offenses may be turned over to

state or federal court system

Summary Professions require ethical practice

standards Understand the ethical and legal

requirements of the financial planning profession

Understand the ramifications of failing to follow those standards