Complete reliance on third-party outsourcing may negatively impact your compliance program. Other firms’ mistakes can serve as valuable cautionary tales to guide your decision-making process when establishing and maintaining relationships with third-party vendors.

In May 2019, AXA Advisors learned a painful lesson in the form of an enforcement action. FINRA found that from September 2010 through November 2015, AXA distributed documents that negligently misrepresented five bond funds offered with some of its group annuity contracts as “investment-grade” when, in fact, a substantial portion of the funds’ portfolios consisted of high-yield or junk bonds. Due to its reliance on its third-party affiliated life insurance company to classify the bond funds in the group annuity contracts, AXA failed in its responsibilities to implement supervisory systems or written supervisory procedures reasonably designed to achieve compliance with FINRA rules.

The FINRA Sanction provides key takeaways to consider within your overall compliance program.

Due Diligence for Outsourcing Vendors

Outsourcing by financial services companies has unique risks compared to those faced by companies in other sectors. Errors by vendors in the financial services industry can lead to far greater financial losses than errors in other industries. In light of these risks, firms that enter into outsourcing agreements should focus on issues such as:

  • Using due diligence when selecting a service provider;
  • Actively supervising and monitoring each service provider;
  • Ensuring that there is a business continuity plan;
  • Negotiating the inclusion of certain provisions in each outsourcing agreement;
  • Assessing the legal and regulatory requirements arising from each outsourcing arrangement; and
  • Protecting confidential information.

With respect to each outsourcing arrangement, firms need to account for the regulatory and risk environment in which they operate. To that end, firms should have procedures related to outsourcing arrangements. This also applies to those outsourcing arrangements entered into by a firm’s branches or its associated persons.

In the case of AXA, the firm relied on the representations of the third party which violated FINRA Rule 2210. Among other things, this rule requires the firm to have both written supervisory procedures and a process to ensure the fairness and accuracy of communications.

If your firm decides to use third-party support, including advisers or sub-advisers, it is vital that the firm conducts extensive due diligence and oversight. The implementation of adequate controls should ensure that the information used by the firm and distributed to investors is accurate and not misleading. Relying on third parties can put you and your firm at risk for enforcement actions.

Disclose, Disclose, Disclose

If advisors and brokers recommend a product to a client based solely on a firm’s marketing materials and information and fail to follow up and learn about all the features and pitfalls associated with the product, then the advisor, client, and firm are all exposed to significant risk. In making the recommendation, the broker may make incorrect assumptions about the product and answer a client’s questions based on those incorrect assumptions. The client considers the recommendation and the information provided by the advisor and adds the product to their overall portfolio.

AXA was a great example of a valuable lesson in disclosure. It is crucial to make sure that all disclosures accurately reflect the contents of an investment vehicle. Additionally, the contents should be in line with investment objectives. Finally, investors should be fully aware of any potential risks, including if there are high-risk investments that are included. Down the road, if the client learns the truth about an unsuitable product, or in this case, if the regulators learn the truth about a product, then it will lead to enforcement fines and suspensions.

MasterCompliance can provide expert consulting to help your firm’s compliance program related to third-party outsourcing. If you would like to explore additional assistance or services, please contact us.