Transcript Slide 1

Dishonest & Unethical
Business Practices
Spencer Lee
Securities Analyst
Alabama Securities Commission
334.353.7368 – direct
Sometimes it’s Easy to Spot
Dishonest / Unethical Business Practices…
…but other times it’s not so easy
That’s why your efforts in detection and prevention are
critical because the costs are enormous:
• The direct cost to the clients that were ripped off
• Indirect cost to those that stood to benefit from the
client’s funds (e.g., college funds, IRA’s to beneficiaries)
• Shady business practices kill confidence in the market
• Collateral Damage - Unscrupulous reps (and firms)
give the honest ones a bad name
• Especially for IA’s any dishonest practices make a
mockery of the fiduciary standard they are to live up to
A MONOLGUE ON BEHALF OF
UNCHECKED BUSINESS PRACTICES
The point is, ladies and gentleman, that
greed -- for lack of a better word -- is good.
Greed is right.
Greed works.
- Gordon Gekko, Wall Street (1987)
AMBITION vs. GREED
 Ambition is laudable. It’s what drives people to create,
add value and achieve…
 Unethical business practices are, of course, categorically
destructive – to the Rep, the firm and the industry.
 Greed is the vehicle that takes one from ambition to
unethical business practices. It is the result of
ambition run amok. Greed can be found at the root
of nearly every unethical business practice cited in
the NASAA Model Rules.
 Let’s take a few minutes to discuss several specific
examples from the NASAA Model Rules regarding
unethical business practices.
UNSUITABLE TRADES –
NASAA Model Rule 102(a)(4)-1(1)
“Recommending to a client to whom supervisory, management or consulting
services are provided the purchase, sale or exchange of any security without
reasonable grounds to believe that the recommendation is suitable for the client
on the basis of information furnished by the client after reasonable inquiry
concerning the client’s investment objectives, financial situation and needs, and
any other information known by the investment adviser.”
◊ Review client profiles or new account applications to see what products
and/or services would “fit” their profile.
◊ One pervasive misconception among some Reps that results in unsuitable
recommendations is the view that if an investor is “accredited” then
they can be sold anything. Just because someone could “afford to lose
their money” doesn’t mean that they should lose their money. Reps
should not be allowed to skip out on due diligence just because the
client they are dealing with is affluent.
EXERCISING DISCRETION WITHOUT
WRITTEN AUTHORIZATION - NASAA Model Rule
102(a)(4)-1(2)
“Exercising any discretionary power in placing an order for the purchase or sale of
securities for a client without obtaining written discretionary authority from the
client unless the discretionary power relates solely to the price at which, or the time
when, an order involving a definite amount of a specified security shall be executed,
or both.”
◊ IA’s that operate without discretion are thought of as “lower risk” firms
since having to get client approval for transactions makes it more
difficult to manipulate client accounts for their personal advantage.
Therefore, IA’s that operate with discretion without approval to do
so are viewed as particularly treacherous.
EXCESSIVE TRADING –
NASAA Model Rule 102(a)(4)-1(3)
“Inducing trading in a client's account that is excessive in size or frequency in view of the
financial resources, investment objectives and character of the account in light of the fact
that an adviser in such situations can directly benefit from the number of securities
transactions effected in a client's account.”
◊ Churning – typically 6 times the average value of a client’s portfolio is cause for
concern…BUT this is only a “rule of thumb.” Examples where this benchmark is not
necessarily valid:
• Passive portfolios – turnover there should be low
• Day Trading Accounts – turnover, by design, should be very high
• Wrap Accounts – turnover should be high to justify the extra expense
• Rebalancing an account – will show up as higher than normal turnover
REVERSE CHURNING
What is it?
Too few trades in a wrap (fee based) account.
Why is it a problem?
With reverse churning clients are paying MORE for their wrap
account services than they would have if they paid for advisory
services and brokerage expenses separately.
UNAUTHORIZED TRADES –
NASAA Model Rule 102(a)(4)-1(4)
“Placing an order to purchase or sell a security for the account of a client
without authority to do so.”
◊
◊
This (along with unsuitability) is one of THE most commonly cited
complaints from clients involved in securities litigation.
Occasionally allegations of unauthorized trading are accompanied by
accusations of forgery which facilitated the transactions.
TRADING ON UNAUTHORIZED THIRD PARTY
INSTRUCTION - NASAA Model Rule 102(a)(4)-1(5)
“Placing an order to purchase or sell a security for the account of a client
upon instruction of a third party without first having obtained a written
third-party trading authorization from the client.”
◊ For IA’s that deal with corporate clients or trusts, they should maintain
an official list of authorized reps for those accounts (i.e., the people
authorized to act on the account’s behalf). Auditors should inquire about
the Rep’s practices in keeping
these lists up to date.
BORROWING MONEY FROM A CLIENT –
NASAA Model Rule 102(a)(4)-1(6)
“Borrowing money or securities from a client unless the client is a brokerdealer, an affiliate of the investment adviser, or a financial institution
engaged in the business of loaning funds.”
◊ Don’t laugh…it DOES happen. It can come from an “interest free loan”
from a client, “seed money” lent to an IA to get their practice off the
ground, or a promissory note from a client to the IA. Pay close attention to
the IA’s “checks and disbursements blotter” to see if they have payments
going to ANY clients.
LENDING MONEY TO A CLIENT –
NASAA Model Rule 102(a)(4)-1(7)
“Loaning money to a client unless the investment adviser is a financial
institution engaged in the business of loaning funds or the client is an
affiliate of the investment adviser.”
◊
◊
◊
Check the firm’s financials to see if an “account receivable” has been
established to record the repayment of funds lent to a client.
The IA’s checks and disbursements blotter might show funds going
out to a client or a business owned by a client.
Either of the situations noted above must be followed up by requests
for explanations. Documentation should be requested that
indicate the nature of the loan(s) themselves.
MISREPRESENTATIONS –
NASAA Model Rule 102(a)(4)-1(8)
“To misrepresent to any advisory client, or prospective advisory
client, the qualifications of the investment adviser or any employee of
the investment adviser, or to misrepresent the nature of the advisory
services being offered or fees to be charged for such service, or to
omit to state a material fact necessary to make the statements made
regarding qualifications, services or fees, in light of the
circumstances under which they are made, not misleading.”
MISUSE OF THIRD PARTY REPORTS –
NASAA Model Rule 102(a)(4)-1(9)
“Providing a report or recommendation to any advisory client prepared
by someone other than the adviser without disclosing that fact. (This
prohibition does not apply to a situation where the adviser uses
published research reports or statistical analyses to render advice or
where an adviser orders such a report in the normal course of providing
service.)”
◊ One of the more heinous cases for this are ghost written articles or
even rigged magazine covers that give the reader the impression that the
IA is a person of great significance in the financial industry.
CHARGING AN UNREASONABLE FEE –
NASAA Model Rule 102(a)(4)-1(10)
How much is “too much?”
◊ The current rule of thumb for advisory services is 2.00% per annum, BUT
even this depends on the…
• complexity of the account;
• expertise of the IA; and/or
• nature of services being provided.
◊ Beware of the “minimum fee” …it can become an “unreasonable fee” in
disguise if account values fall far enough.
◊ Look for passive portfolios or passive parts of client portfolios (i.e., gov’t
bonds, CD’s, etc…); they should NOT be charged the same advisory
fees as those portions that require active management.
NOT DISCLOSING CONFLICTS OF INTEREST –
NASAA Model Rule 102(a)(4)-1(11)
“Failing to disclose to clients in writing before any advice is rendered any
material conflict of interest relating to the adviser or any of its employees which
could reasonably be expected to impair the rendering of unbiased and objective
advice including:
(a) Compensation arrangements connected with advisory services to clients
which are in addition to compensation from such clients for such
services; and
(b) Charging a client an advisory fee for rendering advice when a commission for
executing securities transactions pursuant to such advice will be
received by the adviser or its employees.”
◊ An example where this can be found are limited offerings where the IA has
significant ownership. By inducing clients to purchase interests in these
investments, the IA stands to benefit personally.
GUARANTEEING RESULTS –
NASAA Model Rule 102(a)(4)-1(12)
“Guaranteeing a client that a specific result will be achieved (gain or no
loss) with advice which will be rendered.”
◊ Obviously the IA’s advertising file is one place to look for violations
of this rule, but review of the IA’s illustrations and use of online search
engines (using the IA or IA Reps’ names) are other sources for
prohibited “guarantees.”
ADVERTISING NOT IN COMPLIANCE WITH
RULE 206(4)-1 – NASAA Model Rule 102(a)(4)-1(13)
Ads must comply with SEC Rule 206(4)-1. This rule generally prohibits:
◊ The use of testimonials;
◊ Advertising certain profitable trades without offering a list of all trades;
◊ Representing that a particular graph, formula, or chart can be used by the
client to determine trading strategies without disclosing their
limitations;
◊ Offering a report, analysis, or service as free, when in fact it is not; and
◊ Untrue statement of material fact or which is otherwise false or misleading.
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CUSTODY - NASAA Model Rule
102(a)(4)-1(15)
“Taking any action, directly or indirectly, with respect to those securities or
funds in which any client has any beneficial interest, where the investment
adviser has custody or possession of such securities or funds when the
adviser's action is subject to and does not comply with the requirements of
Rule 102(e)(1)-1. and any subsequent amendments.”
◊ If an IA operates with custody, the perceived risk level from the
regulators’ perspective goes up dramatically.
◊ “Constructive vs. Physical Custody”
◊ A “Custody” status can be established for an IA if they fail to get third
party checks out of the IA’s office within 24 hours or fail to move
clients’ securities out of the office within 3 business days. Also if
the advisors have access to their clients’ PIN numbers or passwords
this could be deemed as “custody” depending on what they are
permitted to do with the client accounts.
ADVISORY CONTRACT –
NASAA Model Rule 102(a)(4)-1(16)
“Entering into, extending or renewing any investment advisory contract unless
such contract is in writing and discloses, in substance, the services to be provided,
the term of the contract, the advisory fee, the formula for computing the fee, the
amount of prepaid fee to be returned in the event of contract termination or
nonperformance, whether the contract grants discretionary power to the adviser
and that no assignment of such contract shall be made by the investment adviser
without the consent of the other party to the contract.”
◊ Use of Hedge Clauses prohibited (IA’s cannot disavow their fiduciary
responsibility, any attempt to do so violates SEC Rule 215.)
INADEQUATE PROCEDURES REGARDING USE
OF NON-PUBLIC INFORMATION –
NASAA Model Rule 102(a)(4)-1(17)
“Failing to establish, maintain, and enforce written policies and
procedures reasonably designed to prevent the misuse of material
nonpublic information contrary to the provisions of Section 204A of the
Investment Advisers Act of 1940.”
◊ Privacy Policy for the IA should be in conformity with Gramm-LeachBliley (no sharing of non-public information without clients’
permission, regulator request and/or a court order…if the IA
wishes to share non-public information with unaffiliated third
parties they must allow the clients to opt out of the sharing.)
FRAUD - NASAA Model Rule 102(a)(4)-1(20)
“Engaging in any act, practice, or course of business which is fraudulent,
deceptive, or manipulative in contrary to the provisions of section 206 (4) of
the Investment Advisers Act of 1940…”
◊ This can take on many forms. A couple of signs to watch for are:
• IA’s that have client account statements addressed to the IA’s
office AND have no statements going to clients from the
custodian…this gives the IA the opportunity to create two sets of
statements – one legit and the other “cooked” (a check of client
statements will show how statements are addressed); and
• IA’s that use obscure or uncredentialed accountants in the
production of their financial statements (both of these were
warning signs missed by the SEC in the Madoff case)
ENGAGING IN UNLAWFUL CONDUCT THROUGH
ANOTHER PERSON –
NASAA Model Rule 102(a)(4)-1(21)
“Engaging in conduct or any act, indirectly or through or by any other
person, which would be unlawful for such person to do directly under the
provisions of this act or any rule or regulation thereunder.”
◊ This provision addresses the “straw man” concept, whereby an adviser,
through another person or party, commits an act he would
normally be prohibited from doing.
OTHER UNETHICAL CONDUCT –
NASAA Model Rule 102(a)(4)-1 Closing Paragraph
Times change and so do the schemes of those that are willing to bend or
break the rules and regs in place. This paragraph was added as a “catch-all”
section for potential unethical conduct not specifically addressed by any
other rules.
A Tutorial on How Bad it Can Get
A “HOW NOT TO” GUIDE FOR THOSE IN THE INDUSTRY
How NOT to deal with regulators
How NOT to handle client privacy
How NOT to keep your license
How NOT to take compliance seriously
How NOT to accurately promote your services
A Warning to those that Assume a Given Person Poses No Risk
You Could Learn a Lot From a “Dummy”
Learn all you can while you’re here and from now on because there is
inherent value to a well trained work force…
Sincere Thanks for Coming to
Dallas for IA Training 2010