Through FactRight’s TrueDiligence platform, we help broker dealers and registered investment advisors select best-in-class programs for their alternative investment platforms. We also work with our clients to ensure that they have time-tested processes and procedures in place for when the regulators come knocking. When it comes to processes and procedures, some of the very first questions our clients ask us relate to the role and composition of the investment committee for alternative investments. Let’s tackle some of the most common questions here.
What is the role of the investment committee? Is one even necessary?
The compliance function of an investment committee (IC) makes it indispensable for all retail firms. But the specific purposes of the IC depends on who you ask and what their needs are:
- From the perspective of a broker dealer home office, the job of the IC is to keep the firm out of trouble while providing sufficient investment alternatives to attract and retain quality registered representatives. Ensuring that the firm is following its own written supervisory procedures is paramount to these efforts.
- From the perspective of a registered reps, the job of the IC is to keep the reps out of trouble by removing from their consideration potentially problematic programs, while providing them with a sufficient selection of investment alternatives to enable them to attract and service clients.
- For smaller RIAs, these two functions are often combined. One person (or small team of people) typically selects the programs available for investment, and recommends investments to specific clients. Wearing two hats magnifies the importance of meticulously observing the formalities of the IC review process, as we’ll talk about later in this post.
It is easy to grasp the separation of roles within a broker dealer structure. The home office is responsible for establishing procedures and ensuring compliance with such procedures. Their primary mandate is to determine whether an investment program may suitable for at least some investors—the so-called “suitability per se” under FINRA rules. The registered rep is responsible for determining specific client suitability.
Though the RIA’s obligations are not couched in terms of suitability (instead, they are subject to the more exacting fiduciary standard), most RIAs are responsible for both these types of determinations. Whether the investment is in the best interest of the client involves the critical assessment of whether the investment is sound in the first place.
The dual roles may create a conflict of interest in selecting the right investments. For example, an RIA may seek specific products to implement particular client strategies, often relating to tax planning or other individual considerations. Under such circumstances, it may be tempting to approve a product solely based upon its usefulness in a unique client situation, and neglect a full vetting of the program’s attributes. For all retail firms, and for small RIAs especially, the role of an IC is to make sure this doesn’t happen.
What should be the size and composition of the investment committee?
In practice, the composition of the IC can vary based upon the size of the firm. For small RIAs, often the firm’s owner constitutes the IC. In this case, documentation of the review and approval process may replace the creation or operation of an actual committee. However, following established procedures remains critical, and can help evidence that the RIA is complying with its fiduciary obligation to its investors.
For larger RIAs and broker dealers, the committee typically consists of the chief compliance officer, the chief due diligence officer, and the president. It may also be advisable to have a top producing IAR or registered representative as a non-voting member of the IC, to help determine the potential demand for an approved product. (More on that below.) It might also be advantageous in invite product experts within or outside the firm to attend the IC meeting. A FactRight analyst sits on the IC of most of our TrueDiligence clients. And remember, not every committee member need have a vote on whether to approve or decline a product. We do note that it is best practice for IC approval decisions to require unanimity. Obviously, absolute consensus becomes harder to achieve the more voting members there are, so these factors point toward a relatively small number of voting members on the IC.
IC members should have a thorough understanding of the firm’s risk tolerance and select investment options accordingly. Even RIAs and broker dealers with high risk tolerances should avoid taking unnecessary risk, i.e. risk for which there is an insufficient corresponding probable return. And IC members shouldn’t be pushovers—they need to ask the tough questions for deals that reps may be clamoring for.
How should investment committees operate?
Contrary to logic, regulators typically assess the firm’s actual compliance with written procedures, rather than the quality of those procedures or even the outcome of a particular investment. It is therefore essential for the firm to establish operational procedures that they can live with, and to explicitly provide parameters for making any exceptions to policies.
The IC does not need to meet regularly, as long as periodic meetings are triggered by specific criteria (e.g., there is a new program to review, a material event has occurred for a program on the platform, etc.). But be consistent in enforcing the criteria. For example, don’t skip a committee meeting just because a member or due diligence officer is familiar with the sponsor’s similar investment programs, or for any other reason. From a liability perspective, it is also important to not approve every deal brought before the IC. Of course, pre-vetting of deals is recommended to save the valuable time of IC members. However, rubber-stamping every deal brought to the committee may indicate to regulators that the actual decision-making is occurring elsewhere, and not through the IC process.
Most often, one member (who has performed thorough due diligence on the program) will be tasked with presenting a summary of the investment program’s features, risks and opportunities. These should be documented in a report to the IC. (FactRight presents deals and provides investment committee reports and recommendations to the ICs of our TrueDiligence clients.) Committee members ask questions of the presenter, and they explore any potential red flags together before a vote is taken or else further discussion is tabled for a future meeting while additional information is gathered.
After the initial approval process, the firm should take active deals to committee periodically to assess whether the firm should continue to sell an offering. (For tips on ongoing due diligence of public programs, see here.) This is particularly important given the increasing number of perpetual life programs available to investors. And although they might not seem like it, closed programs may also require proactive selling decisions, since clients often continue to buy shares through distribution reinvestment programs. Remember, the IC’s job extends beyond approving a product, then forgetting about it.
What are some product selection pitfalls for the investment committee to avoid?
Understanding the IC’s role, properly constituting and structuring it, and consistently following reasonable processes will help minimize the chances that you’ll approve a program that will cause you headaches down the road. Appreciating that not every product selected through these steps will be a home run for you or your clients, what are some traps that you can avoid to further bolster your risk management?
In our experience, the composition of retail alternative investment platforms often is driven by relationships. As a wholesaler or national accounts representative moves from one sponsor firm to another, they maintain their existing retail contracts, and promote the new product they are presenting as a “have-to-have” for the retail firm. Alternative investment platforms often evolve based upon these relationships, as well as through aggressive sales tactics. We see that prior sponsor interactions with the firm (through, for instance, rep conference sponsorships) can play a role in the composition of the alternative investment platform. While relationships are important, they often do not result in a well-constructed platform of investment choices. Don’t compromise your IC process based on the strength of a relationship you may have with a product sponsor.
Related to both initial selection and ongoing monitoring, we recommend that clients only have programs on their platforms that are truly marketable or are actually being sold, to reduce unnecessary ongoing coverage obligations, and to control product expenses, as there are costs to maintaining programs on your platform. For broker dealers in particular, a large platform may seem strategic from a rep satisfaction standpoint, but the larger the platform, the larger your potential exposure, and the higher your product management costs.
Even as the DOL fiduciary rule for broker dealers and their reps remains in limbo, in some form, the fiduciary environment is here to stay. Broker dealers should make sure that it does not offer products that unduly incentivize registered representatives for riskier programs for which clients may not be suitable. In particular, beware of programs that pay higher than standard selling commissions, or devise other compensation for registered representatives, or for placement agents (which may manifest in increased sales pressure).
Bringing it together
While most firms consider themselves to be risk averse, their current and prior platform selections provide insight into their true firm’s risk profile. In our experience, there is a wide spectrum of these profiles. However, the key element is not determining the “right” risk profile, but in establishing reasonable parameters and operating within those parameters.
The IC is the primary enforcer of these boundaries. It must ensure consistent adherence to the procedures, documenting it every step of the way. In establishing and operating you IC based on these best practices, you’ll be protecting not only your firm, but the clients that you serve.