Are regulatory violations by broker-dealers and registered investment advisors on the rise? Certainly the volume of screaming headlines makes it seem like regulators are busier these days.
The Securities and Exchange Commission (SEC) filed 734 enforcement actions last year, one shy of the 2011 record. The North American Securities Administrators Association (NASAA) reported that enforcement actions at the state level against brokers and advisors nearly doubled last year, and they are seeing large increases among those with $25 million to $100 million under management. FINRA, whose focus is on broker-dealers and their affiliated registered reps, reported that for the third quarter of 2012, sales practices complaints against their members were up 280%.
I cringe when I see negative news stories involving a registered rep, trader, investment banker, hedge fund, wealth manager or financial planner. Their actions besmirch the reputation of all of us, regardless of our role in financial services. We know that many consumers and members of the press don’t know the difference between financial services players, so when a scandal sees light we all appear stained by the same bad ink.
As head of a custodian that serves RIA firms and their clients, I suffer even stronger emotions when learning of an indictment or finding against a fiduciary advisor, as that is our milieu. When RIAs commit unethical acts against clients, they are FINOs—Fiduciaries In Name Only. Unfortunately, these FINOs use the cloak of their position to exploit the trust of their clients.
While advisory professionals make up a relatively small sample of the regulatory actions, violations that do occur are real head-scratchers. Take a recent SEC finding against an advisor who sold an ownership stake in his firm to a client. The order stated that the advisor sold a minority interest in his RIA firm “to a client at a fraudulently inflated price,” which he apparently justified by “employing several devices to artificially inflate the value.” The SEC order also identified two other occasions when the advisor placed clients in investments in which he and the firm had “personal and pecuniary interests without first disclosing the facts,” thus giving rise to conflicts of interest.
Regrettably, this is not an isolated scenario, though the fraud charge makes it unusual. Sellers of advisory firms often have an inflated perception of value, but typically negotiate at arm’s length. While I have no special insight into this matter, in cases like this, the client is at a clear disadvantage because his advocate—the advisor—is presenting the deal or investment as truthful and the circumstances as free of conflict.
Who should the client turn to when presented with these “opportunities”? What processes exist inside the advisory firm to protect the client from the advisor, especially if he is a sole proprietor also functioning as his own chief compliance officer, chief financial officer and chief operating officer?
Many advisors ask whether they should have clients invest in their firms, sit on their boards or participate in investments that they have made. I almost always react negatively to these notions. Conflicts of interest naturally arise when crossing the line from advisor/client to client/partner. Generally, I don’t think professional firms lend themselves well to passive ownership, but when a client becomes a shareholder—assuming the deal is clean—the relationship becomes even more complicated. For each decision, the advisor must determine whether he is making it for the benefit of his clients or the benefit of his shareholder. While the interests may not be mutually exclusive, the new relationship certainly puts the fiduciary standard to the test.
Knut Rostad, president of The Institute for the Fiduciary Standard, recently wrote an interesting piece (“What fiduciaries should be reminded of on Valentine’s Day,” Investment News, Feb. 10, 2013) about the principles a fiduciary advisor should apply. He identified core duties, which I think of as the Six-Way Test (a spin on Rotary International’s Four-Way Test: Is it the truth? Is it fair to all concerned? Does it build goodwill and better friendships? Will it be beneficial to all concerned?):
Rostad’s Six Core Duties
- Serve in the client’s best interests.
- Act in the utmost good faith.
- Avoid conflicts of interest.
- Disclose all material facts and conflicts, and manage all material conflicts.
- Act prudently, with the care, skill and judgment of a professional.
- Control investment expenses.
These guidelines are clear when providing advice to clients, but how do they relate to the running of your business? Employing these fundamental principles, evaluate your conduct under the following scenarios:
- I do not have a formal succession plan.
- I have not communicated to my clients what would happen to them and their investments in the event of my death or disability.
- I have received a payment from a broker-dealer or custodian to join or stay with a firm.
- I have select clients on my advisory board who are privy to my business activities.
- I have not adequately planned for my own retirement.
- I have personal debt out of proportion to my income or my assets.
- I have invited select clients to participate in private investments with me.
Just as loudly pronouncing your religious beliefs doesn’t make you more holy, calling yourself a fiduciary doesn’t make you more trustworthy. In the end, your reputation rests on your behavior. In many cases, advisors find themselves tumbling down the rabbit hole because of a simple mistake that they make worse and worse. The initial intent may not have been malicious, but the outcome depends on how the advisor decides to correct his first misstep.
As we have learned so many times, there is usually more to each story. Often the first financial trouble, malfeasance, negligence or breach of fiduciary duty starts with good intentions via one of these types of transactions between advisors and clients. This is a good example of the client not doing his or her due diligence and the advisor apparently losing perspective on right and wrong.
Regulators are taking a whole new look at private equity transactions via fund offerings with RIA ownership and discretion, loans, private ownership transactions and valuations. But fraudulent acts can only be determined after they have been committed. The conditions that exist in one’s practice and one’s personal life reveal solid leading indicators of the possibility of exploiting clients, deceiving partners and circumventing rules.
Regulations provide clear instructions for fiduciary conduct, yet jails are filled with perpetrators who chose to ignore them. As a result, clients suffer with little recourse. Meanwhile, the business of financial advice continues to struggle with its identity in the minds of the consumer and the reporting of the press. We have a unique opportunity to move from protecting the old ways to embarking on a path of enlightenment that will be fair to all concerned. The process begins with each individual advisor applying the filter of the fiduciary standard to the running of their business as well as to serving their clients.