The duty of care requires an advisor to make a reasonable investigation to support its recommendations. Beyond these fiduciary obligations, RIAs must comply with 1) substantive prohibitions and requirements; 2) contractual provisions; 3) recordkeeping rules; and 4) administrative oversight. With this framework in mind, below are some areas of likely SEC scrutiny.
Regulatory Risks
Standing on its own, the upheaval caused by COVID-19 should be disconnected from conflicts of interest. Whatever conflicts of interest were present before the crisis likely will persist. That said, advisors should be mindful of changes in business relationships or revenue models. If a new source of revenue implicates fees or expenses, or affects previous materiality determinations, an advisor may need to enhance or change its disclosures.
The market downturn invariably will create pressure on valuation, particularly with respect to more complex Tier 2 and 3 investments. From the SEC's perspective, overstated valuation produces overstated fees and false performance advertising. For that reason, it is essential to align valuation practices with established policies and procedures. Documenting the process will help an advisor to defend future regulatory challenges of difficult valuation determinations.
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Investment Recommendations
With the disruption caused by COVID-19, it is paramount that advisors monitor portfolio risk and advise their clients adequately and promptly. Given the impact on investment performance, an advisor's fiduciary duties may result in a need for them to reexamine investment strategies and product offerings.
In addition, advisors should review their portfolios to ensure that the allocation of investment opportunities is consistent with investment objectives and policies. Critically, advisors should exercise diligence and document the basis for recommendations and portfolio maintenance. Examiners and enforcement staff ultimately will test the basis of recommendations and decisions made during the crisis.
Robo-advisors, and other model-based portfolio providers, are likely to face increased scrutiny from the SEC. Guidance issued by the Division of Investment Management in February 2017 addressed several issues associated with this business model, including disclosures and procedures related to changes in market condition. At the time, the staff expressed concern that models and algorithms would fail to adapt to market changes, or that clients would be surprised by defensive measures. Examination and enforcement staff are likely to compare disclosures to actual firm responses, including any model adjustments prompted by market disruption.
Liquidity challenges in the broader market are likely to encourage an increase in principal transactions. Registered advisors should be mindful of the requirements of Section 206(3), which prohibits principal transactions without disclosure and consent. Similarly, cross-trades between clients are subject to the antifraud provisions.
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Insider Trading Compliance
The recent Enforcement guidance expressly addressed investment advisors in one specific context: insider trading compliance. Section 204A of the Advisers Act requires advisors to establish, maintain and enforce written policies and procedures reasonably designed to prevent the misuse of material, nonpublic information. Given the emphasis on insider trading, advisors should reevaluate the design and execution of relevant policies and restrictions. Documentation is critical to demonstrating compliance.
With the dramatic increase in remote access by clients and employees, advisors also should reevaluate cybersecurity protocols. Cybersecurity continues to be a top concern for the commission, and the SEC has issued significant guidance to advisors over the last several years. More generally, asset management firms should review and ensure the proper processes and procedures are in place to supervise remote employees.
In 2016, the SEC proposed a rule that would require advisors to put business continuity plans in place.The objective of a business continuity plan is to hold the firm to their fiduciary obligations and minimize potential harm due to service interruption. Although the SEC has not finalized a rule, it has regularly stated that it expects RIAs to maintain robust business continuity plans as part of a firm's fiduciary obligation.
In addition, the decline in portfolio value almost certainly is impacting advisors. Should financial condition deteriorate substantially, advisors may be required to disclose that impairment to clients.
Advisors also should be mindful of obligations that arise following business combinations. In 2008, market consolidations produced enforcement interest long after the crisis subsided. For example, after Barclays Capital acquired the advisory business of Lehman Brothers, the SEC alleged in 2014 that Barclays failed to enhance its compliance infrastructure to support the acquisition. According to the SEC, these control failures resulted in improper principal transactions, overcharging of fees, custody violations and reporting concerns. Barclays paid a $15 million penalty and engaged an independent compliance consultant.
Avoid Tomorrow's Problems
To minimize risk of SEC violations following the pandemic, advisors should monitor, review and reevaluate their compliance efforts:
- Monitor and reevaluate portfolios and products to ensure consistency with client objectives. Evaluate business model changes for conflicts of interest.
- Review policies and procedures and make any necessary revisions to address the changing circumstances. Pay particular attention to policies related to valuation, client transactions, insider trading, supervision and cybersecurity.
- Documentation is key.
After the immediate crisis subsides, be mindful that for years to come the SEC and other regulators may scrutinize judgments that seemed valid and reasonable in a dynamic and sometimes dire environment.
Paul Helms, a partner at international law firm McDermott Will & Emery and a former SEC Enforcement attorney, manages risk associated with complex securities issues. He defends clients facing SEC and government inquiries, conducts internal investigations and handles securities litigation.
Jodi Benassi, an associate at McDermott Will & Emery, focuses her practice on complex litigation and investigations.
(Photo: Diego Radzinschi/ALM) 
