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Dishonest & Unethical Business Practices Spencer Lee Securities Analyst

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.

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Dishonest & Unethical Business Practices Spencer Lee Securities Analyst

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  1. Dishonest & Unethical Business Practices Spencer Lee Securities Analyst Alabama Securities Commission 334.353.7368 – direct

  2. Sometimes it’s Easy to Spot Dishonest / Unethical Business Practices…

  3. …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

  4. 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) A MONOLGUE ON BEHALF OF UNCHECKED BUSINESS PRACTICES

  5. 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.

  6. 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.

  7. 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.

  8. 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

  9. REVERSE CHURNINGWhat 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.

  10. 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.

  11. 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.

  12. 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 broker-dealer, 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.

  13. 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.

  14. 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.”

  15. 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.

  16. 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.

  17. 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.

  18. 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.”

  19. 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. Take a look at the ad on the following slide and see how many “problems” you can find…

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  21. 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.

  22. 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.)

  23. 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-Leach- Bliley (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.)

  24. 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)

  25. 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.

  26. 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.

  27. 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 NOTto handle client privacy How NOTto keep your license How NOT to take compliance seriously How NOT to accurately promote your services

  28. You Could Learn a Lot From a “Dummy” A Warning to those that Assume a Given Person Poses No Risk

  29. Learn all you can while you’re here and from now on because there is inherent value to a well trained work force…

  30. Sincere Thanks for Coming to Dallas for IA Training 2010

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