Key Risks In Investing for High Net Worth Clients (and Suggested Risk Controls)

Fiduciary & Investment Risk Management Association

Annual Training Conference

Thomas G. KennedyDirector, Compliance

Citi Private Bank Asset Management & Trust Citi Global Wealth Management - Investments

April 7, 2008Intended for use by FIRMA Conference attendees only.

The views and information presented herein

are the views of the presenters and do not necessarily represent

the views of Citigroup. The information contained herein should

not be considered tax, legal or investment advice.

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Objectives of Today’s Presentation

Discuss relative risks of doing business with High Net Worth (“HNW”) clients.

Review specific key risks in providing investment services to HNW clients, and outline effective controls to mitigate them, in the following areas of concentration:

• Risks in developing investment products.

• Sales practice risks.

• Client acceptance risks.

• Portfolio management risks.

Conclusion.

Q&A

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Are HNW Clients Risky Business?

Definition of “High Net Worth” varies.

One school of thought is that while they vary greatly in size and can vary in terms of how they are set up, HNW families can be your least risky high net worth client segment, because the client can often be attributed with a level of sophistication that does not attach to other retail customer segments. They are often supported by people who are sophisticated professionals who are paid to increase costs minimally, while increasing returns and protection substantially.

Similarly, at least with regard to larger family relationships already represented and developed, it may be less risky to provide investment, tax and and estate planning related products and services. These are already sophisticated and wealthy individuals and have established entities such that they take on characteristics that are not unlike institutional investors.

On the other hand, HNW family members are not always so sophisticated, many are often not “institutional” customers and there can be un-defined clients brought to you by the HNW client and their related parties (foundations and endowments, operating companies, others), and these clients do present many risks . . . .

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Investment & Wealth Advisory Services Provided To HNW Families and InvestorsRisk varies depending on what products or services are provided to HNW clients. Detailed quantitative portfolio risk and performance

reporting.

Strategic assessment of objectives and results.

Asset allocation consulting.

Search and selection of “best of breed” managers.

Ongoing oversight and evaluation of managers.

Complete investment program management, and individual separately managed accounts

Specialized investments.

Art Advisory.

Philanthropic Services.

Private Equity/Alternative Investments.

Wealth Structuring.

Tax Planning/Financial Planning.

Trust & Estates Advisory.

Bullion & Currencies.

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Different Wealth Management Roles Carry Different Risk Profiles

Broker, custodian or other agent (e.g. Private Banker).

Trustee.

Investment manager.

Advisor/Counselor/Protector.

Fund manager/Administrator.

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Product Design & Management Risks: Anticipate Customization for HNW Clients

Know your boundaries: HNW client/sales staff demand for the following can present a wide variety of risks if not properly be controlled;

• cross border investment and wealth advisory services, including asset protection and/or tax advice,

• wealth structuring products (such as establishment of personal investment companies, personal trading companies),

• inclusion of alternatives such as “hedge funds” (limited liability companies, limited partnerships), structured products, and derivatives, among other investment types.

Provision of advice flows from the provision of trust and asset management services and you will be pushed to differentiate yourself.

• Incremental product differentiations with exponential variable roles.

• HNW only generally to make it relevant and role/cost effective. Business risk management efforts typically focus on standard products and services currently offered, should also be mindful of

client demand for special services. Is adequate expertise available to manage such products and services anticipating that there will be exceptions requested? If outside resources are used to assist with the delivery of products and services, are procedures established to assess the

impact of failure by the third party and monitoring of same? Do your procedures call for monitoring not only the introduction of new products or services, but the customization of standard

product offerings for clients?

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Product Design & Management Risks: Developing Investment Products that are Tax Efficient

A fiduciary can stay out of the tax advice business and supply “tax neutral” services, or go a little further. For example restricting itself to only being a trustee for “compliant” structures that require the trustee to be involved in interpreting tax advice.

Common investments that are tax driven, such as trust owned life insurance, can be complicated in their administration.

Basic assumptions are always being tested: Tax free municipal bonds are safe investments, until you consider the recent issues regarding Mono line insurers and auction rate markets.

Implementing after tax driven results within investment products requires complicated discipline, data collection and careful and expensive structuring of systems but can be particularly important to the HNW client.

Tax issues can be complex domestically, international complexities raise the bar. Understanding the domicile and tax status of the client is critical.

Black lists: From Mexico to Italy, new legislation is squeezing out traditional tax havens and arbitrage opportunities (and for Mexico, Delaware LLCs) by putting them on black lists that subject connected settlors to taxation of controlled foreign corporations, and trustees to taxation as deemed residents.

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Product Design & Management Controls: Formal Product Approval Programs

Bank and securities regulations generally require product approval procedures. These programs :

Describe the product or service, customized for the target markets, objectives and time horizon for achieving the objectives.

Identify (or reference) specific fiduciary responsibilities associated with the product or service, and describe (or reference) applicable controls and oversight processes.

Define the business and risk parameters within which the fiduciary product or service will be offered, and frequency of re-consideration.

Address execution of the product or service within applicable legal and regulatory requirements (including tax), as well as operational and control processes, risk considerations (both for client and the corporation), conflicts of interest and termination processes.

Ensure coverage of requirements in all countries/jurisdictions in which the product or service will be provided, offered/sold, booked and/or, in the case of funds, registered.

Legal and Compliance (including Tax) and Risk should be a required sign-off and compliance testing should be conducted to meet the requirements stated in laws to have pre and post product roll-out reviews.

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Sales Practices Risk: Misleading Marketing & Advertising of Investment Products

Once the sale teams make presentations to complex HNW clients or prospects regarding products and services, it may be too late.

Have your sales teams complied with complex laws on marketing (e.g. Advisers Act and NASD Rule 2210), that require approval and control of any advertising, or plans to distribute before use with clients or prospective clients particularly when the HNW clients are composed of multiple individual and entities in different target markets?

There is often difficulty with use of composites when structuring customized investment portfolio products for HNW clients.

Does your bank ensure that the services are permitted under the applicable law of the jurisdictions where the target clients are domiciled or marketing is conducted, and that they meet the minimum disclosure standards required by applicable law and corporate policy?

If sales teams are not properly trained on the nature of the products and services that they are providing, they can potentially mislead clients and this can result in inappropriate investment product sales.

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Sales Practice Risks: Selling Investments in Cross-Border Environments

HNW clients are increasingly becoming multi national, and the nature of larger financial services firms are increasing marketing products and services in multiple jurisdictions.

Sales practices in a cross border wealth management business can be your biggest reputation and regulatory risks.

U.S. companies being censured by U.S. regulators is one thing, censured by overseas regulators can be worse.

Jurisdictions maintain complex laws concerning eligibility, disclosure, licensure and dollar limits on business activities.

Jurisdictions maintain limits on the number of clients or visits a foreign company or sales agent may conduct in a country.

Onshore legal and compliance resources in offshore sales may not be equipped to handle the issues, and need to ensure local legal and regulatory expertise is obtained.

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Sales Practice Controls: Marketing Approval, Licensing & TrainingEstablish procedures that cover the approval and control of any advertising, or plans to distribute or present any marketing materials to clients or prospective clients and/or give any presentations to clients or prospective clients regarding investment services.

These procedures must ensure that the advertising, marketing materials and presentations used by any parties, including sales and marketing, are permitted under the applicable law of the jurisdictions where the target clients are domiciled or marketing is conducted, and that they meet the minimum disclosure standards required by applicable law and corporate policy.

Policies typically require that marketing material be reviewed by Legal or Compliance, and, Compliance typically includes monitoring and testing to ensure that such a review is conducted.

Sales and portfolio management staff should be properly licensed and trained. Applicable laws requiring employees involved in investment and fiduciary activities to receive appropriate fiduciary training stem in part from an institution’s requirement to ensure that officers or committees to whom it entrusts its fiduciary oversight be competent to perform their fiduciary duties, and are required by customer protection driven regulations.

Legal and Compliance should develop rules of engagement in advance for sales persons who travel to jurisdictions in which they are not resident, including limits on entertainment, travel, requirements for licensure, disclosure, translation, and jurisdiction specific training and supervision.

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Sales Practice Controls: Documentation & Disclosure Procedures Fiduciary or investment relationships should be evidenced by a written and signed contract or agreement, approval by legal counsel.

Clients establishing relationships should be provided with adequate disclosure about the products and services, which may be found in final account documentation, agreements, prospectuses/offering memoranda, or other disclosure documentation (e.g. Form ADV Part II) required by applicable law where the product/service/service provider is located, booked, sold and/or registered or the standard practice of an industry or market.

At a minimum, product/service information should include: (i) product/service description; (ii) product/service objectives; (iii) product/service risk characteristics; (iv) fees; and (v) standard disclosures as required by applicable law and market practice.

At some frequency (typically annually), current portfolio holdings and performance information for clients relationships involving discretionary or advisory securities or asset accounts/portfolios should be made available to clients.

Compliance monitoring should include ongoing review of marketing materials and periodic testing of account documentation, statements and performance.

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Sales Practice Risks: Investment Suitability, KYC and Objective Setting

Time horizons, risk appetites, other issues can be drastically different for accounts within the same HNW relationship.

Sometimes it is difficult to determine who the primary decision makers are.

Opacity issues inside of fund and PIC structures, disclosure requirements that are intended for the investor and other risks.

Related relationship entities such as family members and trusts, account level, constant diligence to get this right.

Trusts, Limited Partnerships, Corporations, Individuals.

• Whose money is it?

• How deep do you pierce?

• How consistently do you apply your policy? A policy is only good if you have QA functions that ensure consistency of application.

Regulatory driven suitability limitations, such as Regulation D and Regulation S must be adhered to.

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Sales Practice Controls: KYC and Suitability Review

•Businesses offering any kind of investment product, whether on a non-fiduciary or fiduciary basis, but especially for discretionary fiduciary products or services, or fee based investment advisory accounts, must document and retain their suitability analysis/evaluation of a client’s stated experience, investment objectives, risk tolerance, time horizon and any other relevant suitability factors/information.

•Regulations require that client suitability information be collected and documented and used to evaluate investment activity through means such as surveillance, relationship reviews and other methods, and they should be periodically updated and confirmed to the client.

•These procedures can be combined with other critical procedures that also involve information collection from the client such as know your customer, and can be used also to implement client acceptance, country of origin and product limitation risk frameworks.

•Consideration of estates/ guardianships/non-standard accounts of other types, other accounts where termination may be difficult, public figures or high profile client/control persons.

•Monitoring, testing and reporting, and periodic reviews for suitability should be imbedded within the suitability policies and procedures.

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Client Acceptance Risk: Bridging Sales to Portfolio Management Investment guidelines and restrictions that are communicated by/to clients during the sales process must be

accurately captured, and implemented.

Communication with the client is critical: Understanding the context of the account in the client’s overall investments, can play a role in how much risk should be built into a portfolio and affects the diversification and concentration that should be put into the portfolio.

Ensuring customization does not go beyond the disclosures made and product parameters defined in the account documentation.

Ensuring non-standard assets, such as non-financial assets held, own bank/parent/affiliate holdings, asset allocation/ concentrations, loans & guarantees with unique covenants, closely held companies, mineral and gas, alternatives are appropriate.

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Client Acceptance Controls: Pre-Acceptance Review for Fiduciary Accounts Prior to accepting a discretionary and/or investment management account, appropriate parties must review to ensure that the business can properly administer and/or manage the assets in the account, and that evidence of this review is documented and retained.

This is an appropriate time to ensure conflicts between fiduciary capacities and other capacities the firm has are addressed (e.g. other lender/investment banker capacities taken vis a vis the client).

Ensure capacities of the bank/adviser and client are identified (e.g. trust accounts versus agency accounts, discretionary versus advisory, principals versus beneficiaries), keeping your roles straight, maintaining client confidence.

Correctly ascertain tax status and domicile of accounts and incorporate it into investment strategies and structures.

There are roles for qualified portfolio management staff to play in reviewing investment assets for appropriateness, and Compliance or designated fiduciary control officers are often a required participant in the review process for new business. Periodic tests or targeted reviews are also conducted.

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Portfolio Management Risks: Delivery Risks Based on HNW Client Non-Standard Portfolio

Potential greater need to carefully handle threatened litigation/customer complaints, breaches and errors. Due diligence on non-financial or closely held assets held, due diligence on 3rd party investment

managers/funds retained. Non-traditional products or services that make surveillance difficult. Obtaining consent, restrictions on own bank/parent/affiliate holding, trading with affiliates, non-approved

counter-parties. HNW clients often have customized asset allocation needs/ and may come with investment concentrations,

and will often request compliance with complex investment guidelines. HNW clients often require more monitoring on margin levels. Monitoring performance, best execution, and tracking error is sometimes required to be more transparent to

the HNW investor. Managing actual or perceived conflicts of interest remain important. Detecting suspicious activity by portfolio management or external parties. Overdrafts/un-invested cash issues can be more difficult than usual (perhaps due to varied or multiple

investment authorities).

Other.

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Portfolio Management Risks: Investing in Non-U.S. Markets for U.S. Customers

There are ways to get international exposure without having to build out overseas.

Due diligence in these investments can be very different than those focused on U.S. markets.

Using ADRs, investing in funds, such as mutual funds and ETFs to obtain exposure.

Investing directly in the markets requires a full build out of international investing.

• Using agents/sub-advisors.

• Investing directly and building or obtaining research,

• Clearing, and custodial issues.

• Foreign exchange considerations.

• Regulatory limitations.

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Many fiduciary laws governing banks and investment advisors/funds require their boards and management to delegate fiduciary investment discretion only to appropriately qualified officers, committees, or agents.

This governance framework must be imbedded in business supervisory procedures that designate/delegate responsibilities to responsible officers and/or committees. They need to be customized to each business, and specify in writing, how such functions and each of the specific risks associated with the functions will be overseen.

Roles and responsibilities of titles and functions like Chief and Senior Investment Officer, Portfolio Team Leader, Portfolio Manager, Investment Committees, Manager Selection Committees, Fiduciary Review Committees, and Product Manager should be defined.

Competent Legal and Compliance resources, as well as Risk Managers are required to be designated to support these activities with defined roles and responsibilities.

Portfolio Management Controls: Supervision of Investment Management

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Portfolio Management Controls: Other Important Operational/Trading Procedures Brokerage placement procedures (governing broker selection/execution), and analysis of trading to ensure reflecting best execution.

Regulatory reporting, such as quarterly production of the quarterly Fiduciary and Related Assets Schedule RC-T and annual/periodic Form ADV Part I for Advisers etc.

Vendor management standards for specific fiduciary delegations.

Price Verification procedures (ensure that there are timely and accurate valuations).

Operational errors, fiduciary breaches and client complaints resolution and appropriate escalation.

Compliance and risk managers are typically consulted as procedures are developed and/or revised, and may be involved in the governance procedures associated, and will typically independently monitor and test many of these procedures.

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Portfolio Management Controls: Conflicts of Interest/Self Dealing/Insider Trading ProceduresA fiduciary is duty bound to proactively identify when its own interests conflict with those of the fiduciary client or beneficiary.

Product approval process assumes development and implementation of appropriate procedures to ensure products/transactions in portfolio management and trading are reviewed for conflicts of interest, including specific legal counsel involvement to determine whether client consent is necessary/possible.

Conflicts disclosed to clients, at minimum where required by applicable law, and ensure that applicable law does not require avoidance by declining a transaction or activity.

Most fiduciary laws specifically require adoption of methods that prevent the use of material non-public information in connection with the purchase, sale or other disposition of fiduciary assets.

Preference is to keep those engaged in discretionary fiduciary activities on the public side of the bank’s information barriers, separate from the investment banking activities of the firm.

Maintain Codes of Ethics for asset management businesses that require pre-clearance, blackout periods and surveillance. These same procedures are often used to prevent conflicts of interest, such as front running.

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Portfolio Management Controls: Monitoring, Testing and Surveillance

Discretionary accounts should be reviewed promptly, including reviews of all assets upon the acceptance of a discretionary account or relationship, and annually. This may be satisfied by a more frequent (e.g. daily) review of investments against the client’s investment guidelines together with demonstrable evidence of supervision of portfolio management activities decisions supported by research and individualized account attention.

Management Information Systems (i.e. exception reports, and procedures) should be considered in most advanced asset management businesses.

Investment account review processes should be documented and carried out, on topics like performance and tracking error, investment concentrations, guideline surveillance, retention of securities not on approved research lists, overdrafts and broker selection and monitoring, etc.

Reconcilements and monitoring and clearing of operational/trading/reconciliation exceptions must also be addressed.

Responses from appropriate departmental manager regarding steps taken /to be taken regarding risk management.

Results of testing including departmental self assessments should roll into reporting mechanisms with key risk indicators to keep management aware of risk management efforts, and follow up on key risk management issues with departmental managers and escalate to higher level, if required should be assured.

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Conclusion: Components of an Effective HNW Investment Risk & Compliance Program Strong management commitment.

Qualified sales and investment management staff, committees, product managers, and legal, risk and compliance managers.

Well defined risk identification/assessment process, and policies & procedures applicable to product design & management, sales practices, suitability, portfolio management and fiduciary oversight that are customized to meet the incremental risks involved in investing for HNW clients.

Effective disclosures, documentation, review, communications & training programs customized for HNW clients and services to ensure that there is no lapse or diminishment of compliance and control.

Robust approvals, monitoring/ surveillance, testing and reporting (including escalation & corrective action follow-up) built into investment and portfolio management sales and trading procedures.

Continuous Improvement of all of the above.