Advisory Agreements | Disclosures | Ethics | Fiduciary

True or False: Can investors protect themselves against investment adviser fraud?

Can investors protect themselves against investment adviser fraud?

February 4, 2015

By:  Jaqueline M. Hummel, Managing Director

Given all the scandals in the financial services industry, investment advisers are faced with clients that are much more skeptical. Aside from telling your clients how trustworthy you are, what can you say to make them comfortable enough to trust you with their hard earned money? First, be upfront about what they can and cannot expect from you as an investment adviser. To help you out, here is a True or False quiz I devised to help investors understand what they should expect from their investment advisers.

1.    Investment advisers must meet certain capital requirements and have certain credentials.

 False. There are few barriers to enter the field of investment management; investment advisers may have little education, a minimal amount of capital, and still legally be allowed to manage money for other people.  Federal and state registered investment advisers[1]  are not legally required to have any particular qualifications to manage money. Many states require that a person who wants to provide investment advice for a fee must register with that state and pass the Uniform Investment Adviser Law Examination, more commonly referred to as the Series 65 exam. There are no prerequisites to taking this exam, and the cost is generally around $165.[2] Individuals working for federally registered investment advisers generally do not have to take this exam if they serve only institutional clients. There are no continuing education requirements for investment advisers.

Federally-registered investment advisers are not required to maintain a specific amount of capital or insurance.  State securities regulators typically require investment advisers to maintain a net worth between $10,000 and $50,000, or have a surety bond in a similar amount. Advisers that have access to client funds are required to maintain a higher bond or net worth.

Advice to advisers: You can make clients comfortable by giving them the required disclosures, and explaining what they mean.  Providing them with Form ADV Part 2A will provide disclosure about your firm, the length of time it has been in business, the firm’s investment style and the associated risks, its code of ethics, potential conflicts of interest and any disciplinary actions. Hopefully the information in this document will show that your firm is well established, experienced in investing, and has no regulatory red flags. You should also provide potential clients with your Form ADV Part 2B, which discusses your specific education, experience and background.  It should also contain any designations you may hold, as well as an explanation as to what is required to achieve them. Although advisers are legally required to provide these documents, presenting them upfront and discussing their contents can help investors understand what you and your firm have to offer.

2.    There are “safe” investments.

 False. Potential clients should also understand that there are no guarantees when investing in the stock market.  Investment advisory firms do not (or should not) guarantee that clients will receive specific returns, and securities investments ALWAYS carry risk. Even conservative investments are subject to risk. If a client wants to preserve principal, invest in a bank certificate of deposit, United States Treasury Bill or guaranteed insurance contract.

Advice to advisers: Explain to clients the types of investments your firm recommends and the risks associated with these investments. You should also manage client expectations about investment returns by explaining that all investments have an inherent amount of risk, and generally investments with greater returns involve taking greater risk. If you have concerns about a client’s ability to understand the investment you are recommending, then consider whether this client is a good fit for your firm.

Be prepared to discuss ways to avoid situations like those faced by the clients of Bernie Madoff. Ponzi scheme operators typically emphasize how safe their investments are, the consistency of the returns, and complex strategies. The SEC has a great piece on Ponzi schemes and how to avoid them, at   If a potential client has any qualms about your firm and its investments, give the client a copy of this SEC document, and go through it, step by step. Discuss the client’s responsibility to review his or her statements periodically, to ensure their desired investment strategy is being carried out appropriately.

Finally, make sure that both you and your clients understand and are comfortable with the investments recommended. For less sophisticated or risk averse clients, investments like mutual funds and ETFs are easy to understand, liquid and provide transparency.

3.    Investment Advisers are fiduciaries so investors have the right to sue them if they fail to do the right thing.

False. It is true that investment advisers are held to a fiduciary standard under federal and state laws. Fiduciary duty requires the adviser to hold the client’s interest above its own in all matters. Conflicts of interest should be avoided if at all possible. There are some conflicts that inevitably occur, and the adviser must clearly and accurately describe those conflicts and how the adviser will maintain impartiality in its recommendations to clients.

In addition to disclosing conflicts, the basic fiduciary duties of an investment adviser are:

  • Put clients interest first
  • Make reasonable investment recommendations independent of outside influences
  • 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

This high standard of care would seem to provide an investor with a great deal of protection and the ability to sue advisers for a breach of this duty. There is, however, a hitch. There is no private right of action under Section 206 of the Investment Advisers Act of 1940, which means clients cannot sue their advisers for damages incurred for Advisers Act violations.[3]

Advice to advisers: Telling a client that you are legally required to put his or her interests first is a great selling point. But given that legal remedies may be limited, explain to your clients the process for ensuring that your fiduciary obligations are being met, and how the firm ensures compliance with this process.

For example, discuss with your client the firm’s process for selecting appropriate investments. For mutual fund or ETF investments, discuss the criteria your firm uses to select funds for its platform, including consideration of longevity of investment team managing the fund, the fees and expenses of the fund and how they compare to the industry, the fund’s track record and how it compares to industry benchmarks. Talk about the on-boarding process, where the client’s individual situation and investment needs are taken into account before any recommendations are made.

Explain the obligations of investment advisers imposed by state regulation and the Advisers Act. The SEC and state regulators have passed certain rules and requirements that require investment advisers to formalize policies and procedures to address their fiduciary and regulatory obligations under the Advisers Act. Specifically, Rule 204A-1(a)(a) of the Advisers Act requires all investment advisers to adopt a code of ethics that contains standards of business conduct that the adviser requires of its employees and reflect the adviser’s fiduciary obligations. Most states require advisers to adopt a similar code.

The SEC also passed rule 206(4)-7 of the Advisers Act, which requires federally registered investment advisers to establish and maintain policies and procedures reasonably designed to prevent violations of the securities laws. Similarly, many states require that investment advisers provide a compliance manual as part of the registration process. Investment advisers are also required to appoint a Chief Compliance Officer, who is responsible for administering the compliance program.

Explain to clients that the main goal of an adviser’s compliance program is to provide controls over activities where investor harm is most likely to occur. Discuss your firm’s compliance program and its enforcement and oversight by compliance personnel. If you can articulate how your firm’s policies and procedures protect clients, this should provide clients with some reassurance.

4.    Investment advisers are routinely examined by the SEC so if they are doing anything wrong, they will be banned from the business.

 False. Investment advisers are highly regulated, so it would seem reasonable to assume that they receive periodic visits from their regulators.  Unfortunately, this is not always the case, at least for SEC-registered advisers. For example, in 2014, the SEC examined 10% of the approximately 11,000 federally-registered investment advisers.   Generally this means that only 1 in 10 investment advisers will be examined by the SEC in any given year. And there is no guarantee that an examination will find specific wrong-doing, or that there will be appropriate follow up.

For example, the SEC conducted two investigations and three examinations of Bernie Madoff’s advisory business and took no action against him.  He was not caught until his two sons ultimately turned him in to the FBI, after he confessed to his multibillion-dollar fraud scheme. In another widely-reported fraud scheme, the Stanford Financial Group was examined four times by the SEC from 1997 through 2004.  The examiners concluded that the firm was likely engaging in a Ponzi scheme but no action was taken by the SEC’s enforcement staff until 2005. (Investors in that scheme are still waiting to recover their money.) State registered advisers tend to receive more frequent examinations, according to the North American Securities Administrators Association.

Advice to advisers: Firms that want to gain credibility regarding their investment practices and compliance processes should consider having an independent third-party review their investment process and compliance program. For firms serving the 401(k) market, the Centre for Fiduciary Excellence provides an assessment for certifying that an adviser’s investment process meets a recognized fiduciary standard.[4]  There are also many compliance consulting firms that can perform a review of a firm’s compliance policies and procedures. Even if your firm decides not to share the results of that review with clients, it is a useful tool for understanding potential gaps in a firm’s processes. Periodically having an independent review also shows clients your firm’s commitment to maintaining and improving its compliance procedures.

5.    If an advisory agreement gives an adviser full discretion to manage a client’s assets, the adviser could invest in a Ponzi scheme.

False. Most advisory agreements provide that an advisory firm with the given authority to manage the assets in the client’s account(s), but that authority is generally limited. In many situations, the adviser is required to allow a client to place reasonable restrictions on the account, including types of investments.  This means that a client can specifically restrict the advisory firm from investing in certain types of investment products, such as any hedge funds or private equity funds. Investments could be restricted solely to mutual funds and/or ETFs, which are regulated, liquid investments that have a readily ascertainable market value.

Advice to advisers:  Explain to the client the account opening process, the sections of the advisory agreement relating to investment discretion, and the role of the independent custodian (if applicable). If a client understands that investment discretion will be limited based on the advisory agreement, and that further limitations can be placed on the discretion of the adviser through the custody arrangement, this may provide more comfort that the adviser should not be able to use their funds for an illegal investment scheme.

Most investment advisers have an account opening process, which includes providing the client with a questionnaire to determine an investment strategy designed to meet the client’s investment objectives and risk tolerance. In the retail environment, the questionnaire includes questions about the client’s financial risk tolerance, experience with investing, understanding of investments, investment timeline, expected use of funds, etc. Based on the answers to these questions, the IAR will then provide the potential client with a recommended investment strategy or strategies. The client then decides whether the recommendations are appropriate, and, if so, agrees to allow the IAR to implement the strategy. This becomes part of the contract, so that the advisory firm is legally bound to only invest in the investment strategy chosen by the client.

Discuss with client their responsibility to keep an eye on their investments. For example, if client assets are held at an independent custodian, encourage the client to review his or her monthly statements carefully to ensure that the funds are being invested as expected.

Additionally, the custodial arrangement may also allow the client to place certain restrictions on his or her advisory account. The custody agreement allows clients to designate an investment advisor with authority to trade in the client’s account.  In some situations, a client can specify that the adviser’s authority over the custody account is limited to trading; the advisor in that case would not have any authority to withdraw assets from the account. The custody agreement may also allow the client to give the advisor broader authority to allow for disbursements, but specify that any disbursements could only be made into specific accounts designated by the client. The client may also be able to further specify that only certain types of assets may be purchased for the account, such as mutual funds and ETFs.

If your firm does have custody, consider providing clients with a copy of the SEC’s Investor Bulletin: Custody of Your Investment Assets, at This document discusses the Custody Rule under the Advisers Act and provides advice to clients on how to perform due diligence regarding custody arrangements.

Finally, explain to the client that terminating the contract is simple. Most advisory contracts provide that client can also terminate his/her advisory agreement at any time by the client by providing the adviser with written notice. The notice requirement varies, but generally a client can terminate the contract with less than 30 days’ notice. The adviser is then obligated to close out the account and refund any portion of the advisory fees paid in advance. Many times clients will simply transfer their assets to another custodian without providing any notice to the adviser.

There is no fool proof method for preventing fraud. The best advice an adviser can give clients is:

  • Investigate the adviser who will be handling your account and the firm he/she is associated with. Look for professional certifications and designations and a solid work history, and no regulatory actions. The firm should have a clean record with state and/or federal
  • Maintain your assets at a financial institution that is separate from the advisory firm (broker/dealers, banks and trust companies provide custody services), and review your statements
  • Invest only in securities and investment strategies you can understand, meet your liquidity needs, and that provide transparency (e.g., open-end mutual funds, ETFs).

If it sounds too good to be true, it is. Avoid investing in investment products that promise or guarantee outsized returns.


[1] Investment adviser firms with more than $100 million assets under management are required to register with the SEC. Investment advisers with $25 million or less assets under management generally have to register with the state where they conduct business. The rules regarding registration are more complex than simply an “assets under management” test but beyond the scope of this article

[2] The exam consists of 130 test questions, and a passing score is 72 percent (94 correct responses for 130 test questions).

[3] Private plaintiffs are only able to sue their advisers under Section 215 of the Advisers Act. Section 215 provides that contracts made in violation of the Act, or the performance of which would violate the Act, are void. Damages under this provision are limited to advisory fees paid. See Transamerica Mortgage Advisors v.Lewis, 444 U.S. 11 (1979), 12-13.

[4] See for more information on CEFEX certification