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Designing a Compliance Program in Changing Times

Financial professionals are increasingly required to more or less protect investing consumers from themselves.

Judith A. Hasenauer, 08/02/2012

It is obvious that the financial services industry is in a period of change. The entire regulatory structure of the industry is in flux, and the economy has stagnated now for several years. Indeed, many of the definitional elements of the industry are changing, and our compliance structures must change accordingly.

This is an era of consumer "protection." It is certain that in a dispute between a financial-services professional and a consumer, the odds strongly favor the consumer. A number of new consumer protection agencies are establishing themselves, and we must all face the fact of new rules, new interpretations of old rules, and the reality that there are numerous "new sheriffs in town." It will be quite some time before the situation settles enough for us to be able to see any sort of finality. Nevertheless, this time of change will still require an active compliance program to avoid enforcement action and litigation.

Once upon a time, a financial-services organization could pretty much rely on the golden rule in its business activities. Consumers--particularly those involved in investments and other financial transactions--were expected to have adequate sophistication to take care of themselves. This is no longer the case. Financial professionals now have a large number of rules that are specific to certain financial products and transactions. Consumers are not expected to have adequate knowledge to protect themselves. Instead, the financial professional is required to more or less protect the investing consumers from themselves. As we have written before, many of these requirements are inconsistent with a commission-driven business. Financial professionals must disregard commission rates in effecting investment transactions--a requirement that is contrary to human nature! Therefore, how do we create an effective compliance program in a period of massive change?

Lawyers spend their entire educational careers studying what went wrong in social intercourse. Once lawyers finish their educations, they spend much, if not all, of their time observing things that have gone wrong and resulted in litigation, prosecution, or enforcement proceedings. This results in a common failure of legal advice: "no one ever proved wrong a lawyer who said no." This bias is common among lawyers and is a good reason why lawyers should rarely be the ones designing compliance programs. If you do nothing, you cannot get in trouble for it.

This does not mean that lawyers should not be consulted on compliance programs. The legal department is often closer to the current thinking in matters being litigated than are line or compliance personnel. They often possess invaluable information on changes to compliance procedures that can avoid future trouble. They should be consulted, and their advice given careful consideration.

It is common for sales people to view the firm's lawyers as the "sales prevention department." It is unfortunate that this view is often warranted. It is for this reason that we believe lawyers should be consulted on compliance design, but final decisions need to be made by non-lawyers. Otherwise, a financial services firm can be "protected" right into failure.

We have reviewed numerous customer information forms used by financial-services firms, primarily directed to suitability screening. Very few were detailed enough to protect the firms from liability in the event of enforcement actions or litigation. Again, human nature plays a role in the design and utilization of these forms. Financial professionals reflect the bias of their customers, who are often reluctant to go into great detail about themselves and their financial status. It is far easier to check a few boxes--often the same boxes from customer to customer--than it is to delve into personal information.

Our observations of a great deal of litigation involving claims of rendering unsuitable financial advice for the customer indicates that the greater the detail about the financial status of the customer, the better result for the financial-services professional. In this context, a form containing questions about what the customer understands about the transaction is invaluable in protecting the financial-services firm. If at all possible, applications, suitability screening forms, and acknowledgements of disclosure should be completed by the customer, not by the financial advisor. It is standard practice in financial-services litigation for the customers to claim that they merely signed the forms provided and completed by the salesperson, and that they were not really understood by the customer.

Compliance procedures are only as effective as is the follow-through afforded to them. The long-standing doctrine of the United States military holds that constant checking and re-checking is absolutely necessary to ensure proper performance. Sales practices are no different. Inspection, review, and personal contact is the pathway to an effective compliance program. Compliance personnel must be empowered to rethink forms, procedures, and sales materials. They must also be given the budget to undertake constant checking of field offices and all personnel and to discipline wayward employees or independent contractors.

Communication is essential if compliance is to be effective. Administrative personnel as well as sales personnel need to have compliance procedures explained so that everyone involved understands and can spot compliance failures. Every compliance executive can tell horror stories about finding one of the top sales people with unapproved sales materials, failure to do suitability screening, or one of a myriad compliance failures that warrant discipline or even termination. Toleration of these failures by top sales people almost inevitably results in litigation or enforcement actions. Compliance personnel need to have the backing of senior management if they are to adequately protect the firm from rogue employees or independent contractors.

Common sense is the best compliance tool in these times of change. Communication of common sense procedures is the easiest way to ensure that sales personnel understand what they are required to do and then follow-up to ensure that these procedures are being utilized. Post-sale communication with consumers is also a key element in ensuring compliance. Post-sale communication can engender confidence in the consumer that correct advice was given and that the financial-services firm really cares about consumer well-being.

The pending changes will pass into permanence, and we will all have a better idea of what we must do.

Judith A. Hasenauer, JD, CLU, is an attorney with the law firm of Blazzard & Hasenauer, P.C. She devotes her practice exclusively to the financial services industry, providing consulting on the development and regulatory clearance of products, compliance issues, distribution issues and related matters, such as advisory activities and industry initiatives.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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