Meeting Your Fiduciary Duty: Focus on Advisory Account Documentation

Scott Wilkinson

Scott Wilkinson

01.29.20 in Compliance & Regulation

Compliance and Regulation

While the Department of Labor’s original fiduciary rule was vacated by the Fifth Circuit Court of Appeals in June 2018, the push to expand the definition of “fiduciary” has not completely stopped. Both the Department of Labor and certain states (including Massachusetts and New Jersey) are considering fiduciary rules of their own. It’s still too early to gauge what the overall impact will be, but it’s safe to assume that meeting your fiduciary duty will remain a hot topic.

This renewed focus on ensuring that advisors are fulfilling their fiduciary duty will come from both regulators and well-informed clients. How can you ensure that you’re meeting everyone’s high standards? What steps can you take to demonstrate that you are acting as a fiduciary? To explore these questions further, let’s start at the beginning by defining fiduciary duty.

Defining Fiduciary Duty

With more than 600 pages of securities law between the Securities Act of 1933, the Securities and Exchange Act of 1934, and the Investment Advisers Act of 1940, defining fiduciary duty should be easy. Unfortunately, there isn’t a single definition to reference.

Here, our understanding of the term comes from two sources: SEC v. Arleen Hughes (1948) and SEC v. Capital Gains (1963). Combined, the SEC (in Hughes) and the U.S. Supreme Court (in Capital Gains) provide five conditions that must be satisfied by individuals entrusted with fiduciary duty:

  1. To act in the client’s best interest

  2. To avoid conflicts of interest; and, if that’s not possible

  3. To disclose all material facts fully and completely

  4. To act with utmost good faith

  5. To not mislead clients

Currently, regulatory scrutiny is focused on dually registered firms that offer multiple account platforms to clients. The regulators’ interest centers on how advisors initially determine the most appropriate relationship type (i.e., brokerage, advisory, or consultative) for each client, as well as how the advisor evaluates—on an ongoing basis—whether that relationship continues to remain in the client’s best interest.

The Importance of Documentation

You don’t need the SEC to tell you that relationships are complicated. But why is the relationship type of such concern? It’s all about reverse churning.

Reverse churning is the term used to describe situations where a client who makes infrequent trades is placed in a fee-based account. Over the length of the relationship, there is potential for the advisor to benefit from higher compensation earned through the ongoing annual advisory fee—with little to no corresponding benefit to the client.

Of course, regulators aren’t in your office every day. They don’t see you meeting with clients or hear what you discuss on the phone. So, how can they evaluate if an account type or relationship is in your client’s best interest? Simple: through your advisory account documentation.

How to Document Your Work

You’re not likely to find a rule or statute that explains exactly how you should document your work within advisory accounts. Luckily, we’ve answered this question once or twice before and have some reasonable suggestions.

At Commonwealth, we draw our guidance on advisory account documentation from the requirements outlined in the Investment Company Act Rule 3(a)-4. (Your firm may have different requirements.) This rule provides a nonexclusive safe harbor for individuals providing discretionary management services under which those individuals will not be considered as running a 1940 Act mutual fund. The safe harbor has a number of conditions that must be satisfied, and several of those are instructive when it comes to maintaining advisory account documentation. Let’s take a closer look at three important requirements.

Individualized management. The safe harbor requires each account to be managed in line with the client’s financial situation and investment objectives. To that end, your advisory account documentation should include this information, and documentation should be updated at least annually.

The individualized management discussion should also include whether an advisory account continues to be the appropriate vehicle for your client. For example, some clients are best served in a transactional brokerage account. Take the time to examine which model best fits your client’s needs, and document that examination in your notes.

Client contact. Another requirement of the safe harbor is that each client be contacted at least annually to determine whether his or her financial situation and/or investment objectives have changed. We strongly recommend that preparation for these meetings be documented in the client file.

  • Have you reviewed the client’s most recent account statement and made notes detailing your observations?

  • Have you run a report compiling the effects of potential changes in the client’s asset allocation?

  • Have you done research into a new fund or product that you feel would be a good fit for the client and included that information in your notes?

You might also add copies of any reports to the client file, as they further demonstrate your analysis and management of the account.

Reasonable restrictions. Finally, under safe harbor, advisors are required to give clients the ability to impose “reasonable restrictions” on the management of their account. For example, clients may wish to eschew the use of so-called sin stocks in their portfolio. Ask clients directly whether they wish to have such restrictions on their account. If they do, carefully document what the restriction actually means. Some clients may consider gambling or alcohol use to be a sin, and others may not. This conversation gives you an opportunity to empower each client to control his or her account—and presents you as receptive and accommodating to the client’s outlook on life.

In the interest of full disclosure, there are two additional conditions related to quarterly statements and indications of ownership. These are handled at the broker/dealer level and thus aren’t relevant to advisory account documentation from an advisor standpoint. With the above three conditions in mind, however, let’s examine how to pull all this documentation together.

Summarizing the Client Meeting

You may choose to provide a written meeting summary to your advisory clients. Personalized reviews can serve as both clear advisory account documentation and a way to strengthen the advisory client relationship. Here, best practice is to develop a template that includes topics that should be addressed with each client. Templates will vary based on your client base, but there are a few things you should certainly include in each summary: 

  • Premeeting research

  • Your notes from the client meeting

  • Any work you do after the meeting

You’ll want to recap what you’ve talked about, reassure your clients about the state of the markets, and highlight your role in ensuring that they’re in the best possible position to reach their goals. Also, use this personalized review as an opportunity to address any new ideas for the portfolio that you may have suggested during the meeting, and give clients additional materials that support your wish to include them in their account.

Mitigating Your Risk

None of this can guarantee you’ll avoid regulatory scrutiny or a client complaint. But if you thoroughly document all client interactions, you’ll be better prepared if an issue does come up. And it will make addressing those issues much easier than it would be otherwise.

Editor’s Note: This post was originally published in September 2016, but we’ve updated it to bring you more relevant and timely information.

This material is for educational purposes only and is not intended to provide specific advice.

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