Stock Market Volatility & Your Compliance Program


Author: Chris Payne

On March 11, 2020, the Dow Jones Industrial Average closed down 1,465 points, or nearly 5.9%. This drop meant a total decrease of more than 20% from its all-time closing high, signifying the index was now officially in a “bear market”, thus ending the longest bull market in history. The S&P 500, NASDAQ, and Russell 2000 indexes quickly followed suit.

The return of the bear market and the dramatic increase in market volatility brings to the forefront compliance issues many investment advisers have not had to deal with since the credit crisis of the mid-to-late 2000s. The rarity of these issues means many advisers may lack experience in dealing with them.

1. Marketing & Communications

During marketing turmoil, effective investment advisers typically increase their communications with their nervous client base. We encourage this behavior, as investment advisers that go silent or refuse to answer their client’s phone calls are more likely to find themselves looking at an increase in complaints (see #2 below) and/or litigation, and an outflow of clients to competition. Neither outcome is desirable for the business.

This is no excuse, however, for failing to adhere to your advertising procedures. Although there is some variation between firms, most firm compliance programs require that communications directed to more than one person concerning advisory services be reviewed and approved by the CCO prior to distribution. This includes items such as mass emails and client letters, newsletters, websites, blogs, and one-pagers that are not customized for individual clients.

In addition, the books and records requirement of the Adviser’s Act, requires RIAs to make and keep a copy of each marketing material the RIA circulates or distributes. For the most part, firms abide by this rule without much issue. HOWEVER, the Act also requires firms to keep originals of all written communications received and copies of all written communications sent relating to the investment advisor’s advisory services. Many of these communications are captured by the firm’s email archiving provider, but with text messaging becoming more and more common with employees of all ages, we expect that many advisers are conducting business more frequently via text, and that client-facing employees are more likely than ever to get inbound texts from anxious clients. If you aren’t capturing text messages via your archiving technology solution, you have a problem.

Action plan: Remind all employees that advertisements must be approved and distributed via the proper channels. Advisers who conduct business via text should verify that the text messages are being captured in the firm’s archiving solution. If not, the firm should remind all employees that text messages from clients should be responded to via email.

2. Client Complaints

Clients do not typically complain much when the market(s) perform well. However, during periods of stress and extreme market volatility, you may see an influx of complaints. Unlike FINRA, the SEC does not exactly define what constitutes a complaint. If your policies and procedures define a complaint, you should familiarize yourself with the definition, and when an event occurs that falls within that definition, all employees should follow the process laid out in the procedures. Typically, the procedures require the employee who receives the complaint to report is to the CCO along with all relevant supporting documentation. The CCO will be responsible for fully investigating the issue and coordinating a response. Under no circumstances should any member of the firm, even an owner, attempt to resolve the complaint on his or her own without first reporting it to the CCO and his/her supervisor. Even if the firm made an obvious mistake, it’s still a good idea to check with compliance and/or legal counsel before admitting wrongdoing.

RIAs are required to keep books and records that show who filed the complaint, when it was received, who was involved, and what the resolution was. Firms should retain copies of all correspondence relating to the complaint as well as documentation showing what actions they took in regard to the complaint and their reasons for doing so.

Action plan: Firm personnel, particularly those who interact on a daily basis with clients should familiarize themselves with the firm’s complaint policy.

3. Suitability / Compliance with Investment Policy Statements

Although not all firms maintain formal investment policy statements (“IPS”) or risk tolerance questionnaires (“RTQs”), all investment advisers are subject to suitability obligations, which is a component of the firm’s fiduciary duty owed to clients. Although not necessarily a legal document, during market volatility IPS and RTQs serve as a link between the client, the investment adviser, and the investment portfolio. A well-crafted IPS or RTQ provides a documented structured decision-making process for clients and advisers and hopefully offers clarity between the party as to responsibilities. Suitability documentation becomes extremely important during bear markets as both a tool for the investment adviser and a reminder to clients that they were involved in the risk measurement and asset allocation process.

Action plan: Investment advisers should routinely compare client accounts to their IPS/RTQ. Advisers should seek to adhere with the IPS/RTQ to the extent possible, as these documents may prove invaluable during client complaints, litigation, and regulatory inquiries. If during market volatility, clients are routinely asking you to make exceptions to the IPS, document these conversations and have the client sign off on a new policy statement.

4. Trade Errors

Everyone makes mistakes, and in fast-moving, high-stress trading environments, Portfolio Managers and Traders are more likely to make trade errors. Alexander Pope’s famous quote “To err is human, to forgive divine” is true to a point, but forgiveness from clients and regulators is conditional on following firm procedures and making clients whole.

Although the Advisers Act does not directly address trade errors that occur in the execution of trades for client accounts, investment advisers are fiduciaries required to put their clients’ interests ahead of their own. When trade errors are identified, the investment adviser then has a duty to make the client whole.

Action Plan: Trade errors will happen, so you need to be prepared. Advisers, particularly the CCOs, supervisors, portfolio managers, and traders should review their policies and procedures manual to ensure that procedures for correcting trades are in place, and that the CCO and/or other senior management personnel provide sufficient oversight to ensure that impacted clients are actually made whole. Finally, the Adviser should maintain a log or file documenting the correction of trading errors.

Conclusion: We hope that you find these reminders of some value during this stressful period. In these extraordinary times, we are reminded of the value of the adviser-client relationship. The value advisers bring to their clients is never more apparent than in times of volatility and panic. If you need assistance in administering your compliance program, Key Bridge Compliance is ready to support you.

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