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SEC Admonishes Investment Advisers

By    |   Friday, 18 Apr 2014 07:41 AM

It is wise to take note when the director of the office of compliance inspections and examinations (OCIE) at the Securities and Exchange Commission (SEC) has tough words for the financial community.

Such was the case when Andrew Bowden addressed the Investment Adviser Association Compliance Conference in Arlington, Va., last month on behalf of the OCIE.

The OCIE conducts inspections and examinations of SEC-registered investment advisers, investment companies, broker-dealers, self-regulatory organizations, clearing agents and transfer agents. Its mission is to promote compliance with U.S. securities laws, prevent fraud, monitor risk and inform SEC policy.

Bowden has spent several years examining the industry and has concluded most of the problems are associated with individuals who 1) lie, cheat and steal; (2) behave recklessly; and 3) act with conflicts of interest.

Most of the time and resources of his department are spent investigating and detecting those who lie, cheat and steal and implementing preventive policies and measures.

He said reckless behavior tends to manifest when the financial advisers simply forget that they have a fiduciary responsibility to protect their clients' interests over their own.

Bowden cited a recent case brought by the SEC's division of enforcement in which appropriate controls were not in place to prevent electronic theft of funds from a client account, causing a loss of nearly $300,000. This firm enabled 60 employees to access and transfer client funds via pre-signed letters of instruction, cutting and pasting of client signatures and retaining logins and passwords to access their client's external accounts. This environment became ripe for illicit electronic activity.

Bowden suggested alternative funds as a vehicle that can lend itself toward reckless behavior. His risk analysis and surveillance team claims assets under management in this asset class rose 63 percent, from $158 billion to $258 billion, in the 12 months ended Oct. 31, 2013. At least one consultant estimates alternate fund assets will comprise nearly 16 percent of total fund assets by 2022, up from roughly 3 percent in 2011.

Alternative funds permit the financial adviser to invest up to 15 percent of assets in illiquid investments. This represents the cost basis, not market value. As the market value of these illiquid assets rise, the percentage in the portfolio rises. Should the market experience a downturn that triggers redemption of liquid assets, the percentage will increase further. A high level of illiquid assets can contribute to high volatility and loss of liquidity in the markets, thereby harming the clients of the financial adviser.

Conflicts of interest can be subtly insidious as it gradually infects the individual, a firm and even an entire industry. "[S]eemingly everyone in the entire system can incrementally, over time, through the accretion of justifications, customs and excuses, convince themselves that they are entitled to money and opportunities that fairly belong to their clients," Bowden stated.

In 2012, an SEC complaint charged a Los Angeles-based principal adviser, with more than $10 billion under management, of allocating nearly 2,500 options trades during a 27-month period to favored accounts — including his own — at the expense of his clients.

Also in 2012, the SEC settled charges against a Portland, Ore.-based firm for receiving compensation for placing clients' money in particular mutual funds. A scaling provision generated a higher payout rate for higher levels of investment.

In 2004, the SEC amended Rule 12b-1 to prohibit the use of fund brokerage to compensate broker-dealers for selling fund shares. These payments were material, inadequately disclosed (or never disclosed) to investors or fund directors and not in the interest of shareholders. Nearly $100 million was reimbursed along with fines totaling almost $20 million.

"Looking back on it, it's hard to conceive how something so malignant grew into a widespread industry practice," Bowden noted.

Another industry practice of concern to Bowden is fee-based wrap accounts. These structures permit flat annual fees that include advice and transaction execution. Managers can manipulate these accounts by generating large transaction commissions prior to offering the fee-based structure. Once the flat fee is in place, very few trades occur and much of the assets are in cash earning very little return on investment.

Adding to the suspect nature of the financial community, a recent Wall Street Journal report revealed more than 1,600 brokers had not reported bankruptcy filings or criminal charges in violation of the Financial Industry Regulatory Authority (Finra) policy. It is anticipated that Finra will require background checks by brokerage firms for brokers, including those hired from other firms, which has not been done before.

This new policy comes on the heels of another Wall Street Journal report that suggests more than 15 percent of all 633,155 brokers have disciplinary records. Those who have failed the state-sponsored Series 63 examination more often tend to have more red flags, with more than 20 percent for those failing the examination five times.

It's not just the United States that is having an issue with the financial industry. In its latest review of the financial advisory industry, the U.K. Financial Conduct Authority reported massive failings among advisers in disclosing charges to clients, where wealth managers and private banks ranked worse than other sectors did.

The study found 73 percent of the advisory firms did not provide the required information on the cost of receiving financial advice, 58 percent failed to provide clients with accurate, up-front cost estimates and the same number did not give additional information on fees, such as variable charges in the future, according to the Financial Times.

The global financial industry has not served the public well in recent years.

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It is wise to take note when the director of the office of compliance inspections and examinations (OCIE) at the Securities and Exchange Commission (SEC) has tough words for the financial community.
financial, adviser, SEC, charge
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2014-41-18
Friday, 18 Apr 2014 07:41 AM
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