5 Costly RIA Hiring Mistakes

RICHARD CHEN • August 22, 2023
7 minute read

Recruiting top talent is a high priority for most advisory firms, but fast-tracking the hiring and onboarding process and failing to conduct appropriate due diligence on prospective employees can result in potential legal and regulatory liability.

Below, we highlight five faulty hiring practices, the regulatory consequences arising out of such practices and some recommended practices for addressing such risks.

Regulatory Risks

First, the failure to investigate whether employees have been involved in certain criminal, regulatory, or civil disciplinary events during the hiring process could result in unwanted scrutiny from the SEC and other securities regulators.

Investment advisers must disclose in their Form ADV information relating to the disciplinary histories of their employees. Item 11 of Part 1A of Form ADV requires advisory firms to disclose whether its non-clerical employees have been involved in certain delineated criminal, regulatory, or civil proceedings that resulted, or could result, in sanctions. Item 9 of Part 2A of Form ADV requires an advisory firm to disclose any disciplinary event impacting its management persons that that “are material to a client’s or prospective client’s evaluation of [an] advisory business or the integrity of [its] management.”

The SEC has explicitly stated in the past that it will increase scrutiny of advisers who hire employees with a disciplinary history. In a Jan. 11, 2016, risk alert highlighting its annual examination priorities, the SEC’s Office of Compliance Inspections and Examinations noted, “OCIE staff intends to conduct examinations of registered investment advisers that employ or contract with supervised persons that have a history of disciplinary events. These examinations will focus on evaluating the effectiveness of advisers’ compliance programs, supervisory oversight practices, and disclosures to clients and prospective clients, particularly relating to the potential risk associated with financial arrangements initiated by supervised persons with a disciplinary history.”

Because such disciplinary events are disclosed in Form ADV, the SEC and other securities regulators can easily determine which advisers warrant examination. While the SEC has not included a similar statement in more recent risk alerts addressing its examination priorities, one cannot assume that the hiring of employees with disciplinary histories will not garner unwanted attention from the SEC and other regulators. As such, it is imperative that an adviser explore whether any employee has been the subject of a disciplinary event prior to hiring.

Second, the hiring of certain persons involved in disciplinary events described in Rule 506(d) under the Securities Act of 1933 (the “Securities Act”) could result in harmful consequences for advisers to private funds seeking to raise capital for their funds.

Rule 506(d) states that an issuer (including a private fund) cannot rely on the exemption from having to register its securities under the Securities Act if delineated officers or directors of the issuer or its investment manager have been the subject of a felony criminal conviction or a specified order, judgment, decree, suspension, expulsion, or statutory bar for fraud or other violations of law Described in Rule 506(d). Hiring one of these “bad actors” could prevent an adviser from raising new private funds or additional capital for existing private funds.

Although an exception may be available to an issuer if it can demonstrate that it did not know and, in the exercise of reasonable care, could not have known, that a covered person was the subject of a disqualifying event, the exception would only apply where the issuer has made, in light of the circumstances, a factual inquiry as to whether any disqualifications exist. As such, it behooves an adviser to conduct an inquiry as to whether any prospective employee has been involved in a disqualifying event prior to hiring such person.

Third, the failure of an adviser to investigate the political contributions made by a prospective employee prior to hiring could prevent the adviser from receiving compensation from certain government entity clients such as government pension or retirement plans.

Among other things, Rule 206(4)-5 under the Investment Advisers Act of 1940 (the “Advisers Act”) generally prohibits, among other things, an adviser registered with or required to be registered with the SEC from receiving compensation for advisory services from a government entity within two years of the making of a contribution to an official of the government entity by the investment adviser or any covered associate of the investment adviser (including a person who becomes a covered associate within two years after the contribution is made).

“Covered associates” generally include the executive officers of an adviser as well as any employee who solicits business from a government entity or anyone who supervises such an employee. The term “official” means anyone who was, “at the time of the contribution, an incumbent, candidate or successful candidate for elective office of a government entity, if the office: (i) Is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by a government entity; or (ii) Has authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by a government entity.

As Rule 206(4)-5 makes clear, the restriction applies to political contributions made by a covered associate prior to being hired by an advisory firm. As such, advisers have a strong incentive to investigate the political contributions of potential hires.

Fourth, the failure of an adviser to investigate whether a prospective employee has any agreements with his or her previous employers that impose ongoing obligations after termination could result in legal action being taken against the adviser by the previous employer if the employee engages in prohibited conduct while employed by the adviser. Among other things, prospective employees might be subject to agreements with previous employers requiring them to keep information (such as trade secrets and other proprietary information of the previous employer) confidential. Agreements with prior employers might also contain restrictive covenants such as non-compete clauses that prohibit an employee from competing with his or her previous employer or non-solicitation clauses that preclude an employee from soliciting clients and/or employees from his or her previous employer. It behooves an adviser to know what restrictions apply to a prospective employee’s conduct while working for the adviser.

Fifth, the failure of an adviser to investigate whether a prospective employee is engaged in any outside business activities could preclude the adviser from identifying whether there are any pertinent conflicts of interest that must be disclosed and managed.

A myriad of conflicts could exist that impact the adviser and its clients. For instance, if a prospective employee has an ownership interest in a business, the prospective employee has an incentive to recommend an investment in the business or to recommend products or services produced by such business to the adviser’s clients. The failure to disclose the conflict of interest to the adviser’s clients and to manage such conflict could constitute a violation of the adviser’s fiduciary duties to the clients. As such, it is imperative for an adviser to inquire about the outside business activities of prospective employees.

Best Practices

The first line of defense in addressing the above-referenced risks is to conduct appropriate due diligence on any potential hire.

Advisers have numerous tools available to them to conduct background checks on prospective employees. Search engines such as Google and social media profiles can unearth a treasure trove of information about a prospective employee. Searches using the Web CRD system can reveal information relating to a prospective employee’s disciplinary history and certain outside business activities disclosed on a Form U4 if the prospective employee has been previously registered as a registered representative of a broker-dealer or an investment adviser representative of an investment adviser. An adviser can also learn information about the departure of the prospective employee from his or her previous positions if a Form U5 is available. Information relating to the prospective employee’s political contributions might also be publicly available.

Nonetheless, these public searches might not reveal the whole picture. As such, advisers can turn to private companies who can assist with gathering additional information about a prospective employee that is not in the public sphere. Nonetheless, in certain circumstances, hiring a company to perform an employee background check might implicate the Fair Credit Reporting Act, which might require disclosures to and consent from the prospective employee. Additionally, although too lengthy to discuss in this article, advisers should tread carefully when conducting employee background checks, ensuring not to use such information to discriminate against certain candidates.

Where background checks still do not reveal all the information about a prospective employee sought by an adviser, the adviser can simply provide one or more questionnaires to a prospective employee to learn information about his or her disciplinary history, political contributions, pre-existing contractual obligations and outside business activities. To receive a sample due diligence questionnaire, please contact us.

Nonetheless, advisers must still tread carefully when soliciting certain information from candidates. For instance, numerous states, counties and cities have adopted so-called “ban-the-box” legislation which prohibits an employer from asking a candidate about his or her criminal history on a job application. Such legislation typically prohibits an employer from inquiring about a candidate’s criminal history until later in the recruiting process.

If an employer is still uncertain as to whether the due diligence process has revealed all the information being sought, the employer can require the prospective employee to certify or represent (in an employment agreement or otherwise) that all information being sought by the employer has been disclosed. The practice of obtaining such attestations, coupled with appropriate due diligence, bolsters an adviser’s claim that it took reasonable steps to minimize the legal and regulatory risks discussed in this article.

If you require assistance with establishing an employee background check process, drafting employee questionnaires, or drafting employment agreements, we can help. Click here to contact us.

Table of Contents