The Securities Litigation Expert Blog

SEC Regulation Best Interest - The Final Rule

Posted by Jack Duval

Jun 13, 2019 8:03:07 AM

Accelerant SEC Regulation Best Interest - Logo 

This blog post continues my series on SEC Regulation Best Interest ("RBI") and the DOL Rule.

After having disappeared for about a year, SEC Regulation Best Interest (“RBI”) is back, in finalized form.  The new rule will have an effective date 60 days after it appears in the Federal Register and a compliance date of June 30, 2020.[1]  The compliance date is when RBI goes live for all customers at all broker-dealers (“BDs”).

Like the '33 Act, the '34 Act, and both of the '40 Acts, as well as FINRA itself, the raison d'etre of RBI is to protect investors.  The SEC writes: [2]

We are adopting a new rule 15l-1 under the Exchange Act ("Regulation Best Interest") that will improve investor protection by: (1) enhancing the obligations that apply when a broker-dealer makes a recommendation to a retail customer and natural persons who are associated persons of a broker-dealer… and (2) reducing the potential harm to retail customers from conflicts of interest that may affect the recommendation.  (Emphasis added)

As a quick refresher, most of the language in the Proposed Release has been accepted, including that:

  • The RBI “standard of conduct draws from key principles underlying fiduciary obligations”;[3]
  • RBI is designed to “enhance the BD standard of conduct beyond existing suitability obligations”;[4]
  • RBI is still recommendation-based (like FINRA's Suitability Rule 2111). In particular, “regardless of whether a retail investor chooses a broker-dealer (“BD”) or an investment adviser (or both), the retail investor will be entitled to a recommendation (from a BD) or advice (from an investment adviser) that is in the best interest of the retail investor and that does not place the interest of the firm or the financial professional ahead of the interest of the retail investor”;[5]
  • The obligations of RBI exist at the time of the recommendation. (This is a key distinction from the continuous fiduciary obligations owed by investment advisors to their clients);[6]
  • The RBI standards cannot be satisfied through disclosure alone;[7]
  • To the chagrin of many, the final version of RBI still does not define “best interest” but does give significant discussion to the four elements that must be satisfied to meet the best interest standard.

There have been a number of significant modifications to the Proposed Rule.  I have summarized them below.[8]

Modifications of the Proposed Regulation Best Interest

Definition of a “Retail Customer”

A “retail customer” is now defined as:

any natural person who receives a recommendation from the BD for the natural person's own account (but not an account for a business that he or she works for), including individual plan participants… The plan representative will be a retail customer to the extent that the sole proprietor or self-employed individual receives recommendations directly from a BD primarily for personal, family or household purposes. [9]

Implicit Hold Recommendations

While BDs will not be required to monitor accounts, in instances where a BD agrees to provide the retail customer with specified account monitoring services, it is our view that such an agreement will result in buy, sell or hold recommendations subject to RBI, even when the recommendation to hold is implicit.[10]

Recommendations as to Account Types and Rollovers

RBI expressly applies to account recommendations including, among others, recommendations to roll over or transfer assets in a workplace retirement plan account to an IRA, recommendations to open a particular securities account (such as brokerage or advisory), and recommendations to take a plan distribution for the purpose of opening a securities account.[11]

Dually Registered Firms

RBI does not apply to advice provided by a BD that is dually registered as an investment adviser (dual-registrant") when acting in the capacity of an investment advisor.[12]

“Best Interest” Determination is Fact Specific

Whether a BD has acted in the retail customer's best interest in compliance with RBI will turn on an objective assessment of the facts and circumstances of how the specific components of RBI - including its Disclosure, Care, Conflict of Interest, and Compliance Obligations - are satisfied at the time that the recommendation is made (and not in hindsight).[13]

Definition of “Conflict of Interest”

RBI now defines a conflict of interest as, "an interest that might incline a BD - consciously or unconsciously - to make a recommendation that is not disinterested”.[14]

Disclosure of Material Facts

The final version of RBI revised the Disclosure Obligation to require disclosure of "material facts" regarding conflicts of interest associated with the recommendation.  This explicitly requires BDs to provide "full and fair" disclosure of material facts, rather than requiring BDs to "reasonably disclose" such information.

We are also clarifying that at a minimum, a BD needs to disclose whether or not account monitoring services will be provided (and if so, the scope and frequency of those services), account minimums, and any material limitations on the securities or investment strategies involving securities that may be recommended to the retail customer.

Also, we conclude that the basis for a BDs recommendations as a general matter (i.e., what might commonly be described as the firm's investment approach, philosophy, or strategy) and the risks associated with a BDs recommendations in standardized (as opposed to individualized) terms are material facts relating to the scope and terms of the relationship that should be disclosed.[15]  (Emphasis added)

The Care Obligation

The final version of RBI added explicit focus on the costs of a recommendation and reiterated that meeting the standard will be judged by how the BD established a reasonable basis to believe the recommendation was in the client’s best interest.

We are expressly requiring that a BD understand and consider the potential costs associated with its recommendation, and have a reasonable basis to believe that the recommendation does not place the financial or other interest of the broker-dealer ahead of the interest of the retail customer.  Nevertheless, we emphasize that while cost must be considered, it should never be the only consideration.  Cost is only one of many important factors to be considered regarding the recommendation and that the standard does not necessarily require the "lowest cost option".

... determining whether a BDs recommendation satisfied the Care Obligation will be an objective evaluation turning on the facts and circumstances of the particular recommendation and the particular retail customer.  We recognize that a facts and circumstances evaluation of a recommendation makes it difficult to draw bright lines around whether a particular recommendation will meet the Care Obligation.  Accordingly, we focus on how a BD could establish a reasonable basis to believe that a recommendation is in the best interest of its retail customer and does not place the BDs interest ahead of the retail customer's interest, and the circumstances under which a BD could not establish such a reasonable belief.[16]

We are clarifying that an evaluation of reasonably available alternatives does not require an evaluation of every possible alternative (including those offered outside the firm) nor require BDs to recommend one "best" product, and what this evaluation will require in certain contexts (such as a firm with open architecture).[17]

We further clarify that, when a BD materially limits its product offering ... it must still comply with the Care Obligation... and thus could not use its limited menu to justify recommending a product that does not satisfy the obligation to act in a retail customer's best interest.[18]  (Emphasis added)

Conflicts of Interest

Eliminate the distinction between financial incentives and all other conflicts of interest; and focus on mitigating conflicts of interest associated with recommendations that create an incentive for the associated person of the BD to place the interest of the firm or the associated person ahead of the interest of the retail customer.[19]

Elimination of Sales Contests

We are requiring BDs to establish written policies and procedures reasonably designed to identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or the sale of specific types of securities within a limited period of time.[20]

General Compliance Obligation

Establishing a new general "Compliance Obligation" to require BDs to establish policies and procedures to achieve compliance with RBI in its entirety.[21]

Federal Securities Laws, Scienter, and State Laws

Compliance with RBI will not alter a BDs obligations under the general antifraud provisions of the federal securities laws.  RBI applies in addition to any obligations under the Exchange Act, along with any rules the Commission may adopt thereunder, and any other applicable provisions of the federal securities laws and related rules and regulations.[22]

Scienter will not be required to establish a violation of RBI.

We note that the preemptive effect of RBI on any state law governing the relationship between regulated entities and their customers would be determined in future judicial proceedings based on the specific language and effect of that state law.[23]

No Waiver of Compliance or Protections

In addition, under Section 29(a) of the Exchange Act, a BD will not be able to waive compliance with RBI, nor can a retail customer agree to waive her protections under RBI. Furthermore, we do not believe RBI creates any new private right of action or right of rescission, nor do we intend such a result.[24]

“Federalizing” the Suitability Rule

FINRA CEO Jay Cook recently commented that FINRA is:

… thinking more generally about are there aspects of our rules that might need to be adjusted/aligned with where the SEC lands.  It’s not surprising because most of the sales practice requirements historically have come from the FINRA rulebook.  Reg BI is sort of federalizing sales practice issues… There’s a suitability element to Reg BI, and that’s when we’re talking about looking at alignment with our rulebook; if they (the SEC) have covered 100 percent of our suitability rule, then we might look at whether we need our suitability rule or do we need it in all circumstances?[25]

My guess is that FINRA Suitability Rule 2111 will be modified, possibly to focus on institutional investors.

In subsequent posts I will unpack the implications of the finalized RBI in more detail.

__________

Notes:

[1]      Regulation Best Interest: The Broker-Dealer Standard of Conduct; 17 CFR Part 240; Release No. 34-86031; File No. S7-07-18; 2 and 371. Available at https://www.sec.gov/rules/final/2019/34-86031.pdf; Accessed June 9, 2019.

[2]      Id. at 5.

[3]      Id. at 1.

[4]      Id.

[5]      Id. at 2.

[6]      Id. at 1.  As discussed below, this is true unless there is an explicit representation by a Registered Representative that positions will be monitored, which must be disclosed by the BD.

[7]      Id.

[8]      There were also a number of less significant modifications which I have left out of this summary.

[9]      Id. at 33 and Footnote 62.  A “retail customer” also includes a nonprofessional trustee who represents the assets of a natural person.

[10]    Id. at 34.

[11]    Id.

[12]    Id. at 35.

[13]    Id.

[14]    Id.

[15]    Id. at 37.

[16]    Id. at 38.

[17]    Id. at 39.

[18]    Id.

[19]    Id. at 40.

[20]    Id. at 41.

[21]    Id. at 42.

[22]    Id. at 43.

[23]    Id.

[24]    Id. at 44.

[25]    Melanie Waddell; ThinkAdvisor; “FINRA’s Cook: SEC Reg BI Compliance to Be a Heavy Lift”; May 8, 2019.  Available at: https://www.thinkadvisor.com/2019/05/08/finras-cook-two-issues-top-of-mind-regarding-sec-reg-bi-compliance/; Accessed July 12, 2019.

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Topics: supervision, Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Securities Exchange Commission, Regulation Best Interest

Jack Duval Quoted in AdvisorHub Article on Protecting Senior Investors

Posted by Jack Duval

Jan 10, 2019 7:22:42 AM

 

Accelerant Managing Partner Jack Duval was quoted yesterday in an AdvisorHub article on abuses of senior investors.

The article discusses the hiring of Jacqueline Rahn, the wife of Trevor Rahn, a J.P. Morgan broker who was fired for abusing elderly investors.

The original Accelerant blog post about Trevor Rahn can be found here.

__________

 

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Topics: fraud, Senior Investors, supervision, Protecting Senior Investors, Elder Abuse, dementia, Alzheimer's, financial exploitation

SEC Regulation Best Interest - State Fiduciary Laws

Posted by Jack Duval

Oct 26, 2018 7:52:58 AM

Accelerant SEC Regulation Best Interest - Logo 

This blog post continues my series on SEC Regulation Best Interest ("RBI") and the DOL Rule.

There has been some hand-wringing over the past year about the potential of a fractured fiduciary duty landscape for Broker-Dealers ("BDs") and their Registered Representatives.  The concern is that individual states will impose a fiduciary standard on Registered Representatives while the FINRA suitability standard, and ultimately SEC Regulation Best Interest ("RBI"), cover the rest.

Allow me to allay these concerns:  the fractured fiduciary landscape already exists, and has for decades.

Nevada's Fiduciary Statues

The event that started the concern was Nevada passing legislation that imposed a fiduciary duty on anyone giving financial advice.  In short, the Nevada law:  "imposes a statutory fiduciary duty as set for in Chapter 628A of the Nevada Revised Statutes on Broker-Dealers and Investment Advisers."[1]

However, four other states have common law fiduciary duties for registered representatives and 31 additional states have quasi-fiduciary duties required under common law.[2]  I'm defining "quasi-fiduciary" obligations as Finke and Langdon do: those that exceed the FINRA suitability rules but do not expressly classify BDs as fiduciaries.[3]

Table 1: Fiduciary Status of Registered Representatives by State[4]

 Accelerant LLC Jack Duval - table of fiduciary status of registered representatives by state

Thus, 36 states already have some form of fiduciary duty required of registered representatives.

Voluntary Fiduciary Status for Broker-Dealers?

The existing uneven fiduciary duty landscape has not hampered BDs business efforts and I wouldn't expect it to in the future.[5]  Furthermore, if BDs were to find complying with the varying standards too taxing, they could just implement a fiduciary standard nation-wide.

Given SIFMA’s[6] long-standing resistance to a fiduciary standard, voluntary adherence to one is highly unlikely.   However, this might be more economical in the long-run, especially if more states pass their own fiduciary statutes.

As I have discussed in this blog posts series, I believe the pseudo-fiduciary standard under RBI will be difficult and expensive to implement.  BDs and their clients would be better off under a fiduciary standard.  Further, from a purely business perspective, adopting a fiduciary standard would help BDs compete with registered investment advisory firms which have been winning the battle for clients and assets.

Given the disappointment in many states with the defeat of the DOL Fiduciary Rule and RBI, it would not be surprising to see more states adopt fiduciary statutes.  Fiduciary expert James Watkins opines that “So long as states enact fiduciary laws that don’t impact a pension plan like a 401(k), they have every right to act,”.[7]

__________

Notes:

 

[1]       Nevada Secretary of State; Website; Available at: https://www.nvsos.gov/sos/licensing/securities/new-fiduciary-duty; Accessed October 25, 2018.

[2]       Michael Finke and Thomas Langdon; The Impact of the Broker-Dealer Fiduciary Standard on Financial Advice; March 9, 2012; Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2019090; Accessed October 26, 2018; 13.

[3]       Id. at 14.

[4]       Id.

[5]       See supra Note 2.

[6]       Securities Industry and Financial Markets Association; https://www.sifma.org/about/.

[7]       Mark Miller; U.S. states eye protections for investors if federal regulation falters; Reuters; April 12, 2018; Available at: https://www.reuters.com/article/us-column-miller-fiduciary/u-s-states-eye-protections-for-investors-if-federal-regulation-falters-idUSKBN1HJ1NT?feedType=RSS&feedName=PersonalFinance; Accessed October 25, 2018.

 

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Topics: supervision, Investment Suitability, FINRA Suitability Rule 2111, Suitability Expert, Securities Exchange Commission, Regulation Best Interest

SEC Regulation Best Interest - Lost Gains Cases

Posted by Jack Duval

Oct 4, 2018 9:12:46 AM

Accelerant SEC Regulation Best Interest - Logo 

This blog post continues my series on SEC Regulation Best Interest ("RBI") and the DOL Rule.

A "lost gains" case is one in which the claimant is asking for gains they believe they should have earned but did not.  These cases are different from the traditional securities litigation, where the claimant is asking for actual losses that have been incurred. 

Because the damage theory involves foregone gains instead of out-of-pocket losses, lost gains cases are generally considered to have a higher degree of difficulty.

On the face of it, this is common sense.  If an investor puts $10 million into an account and it declines to $5 million.  Most arbitrators can understand how the client has been damaged.  However, if the same investor puts $10 million into an account and six years later it's still worth $10 million, this is likely to generate less sympathy.

However, in my experience, lost gains cases can represent some of the most abusive fact patterns.

In the lost gains cases I have been involved with, the client’s accounts were essentially treated as an ATM for the Registered Representative.  These fact patterns involved extremely high fees charged for products that were churned into and out of the accounts at issue (as well as account-level fees).  The results were that the Registered Representative appropriated the growth of the accounts.

What growth wasn't appropriated was lost to the short-term holding of the investments.  That is, the investments were never invested as intended and allowed the time needed to generate returns.

In these cases, the clients were invested during strong bull markets but did not participate because of the abusive nature of the trading in their accounts.  

Six years later, they had experienced no growth while their Registered Representatives had made millions (literally).  In a bear market, such a pattern would exacerbate the decline in the accounts due to market forces and be discovered much sooner.  Bull markets hide these kinds of abuses, and the current historic bull market will surely be no exception.

However, what is different this time is the SEC’s pending Regulation Best Interest (“RBI”), which could be made law before the market declines.

Lost Gains Cases Under Regulation Best Interest

Under SEC Regulation Best Interest, lost gains cases should be easy.

This is because the burden of proof will be on the respondents to show their strategy was in the client's best interest and, as I've discussed in my RBI blog post series, they will need to produce contemporaneous evidence of their analyses showing how they came to that conclusion.[1]

In the fact pattern discussed above, this will be impossible.  Furthermore, a key defense will be removed.

Long-Term Time Horizons and the Risks of “Time Diversification”

In many securities litigations, a client's long-term time horizon is used as a defense to justify aggressive investments.  The logic is that the longer an investment is held, the less likely it is to generate a loss.  This is known as “time diversification”.  The problem with time diversification is that it is, at best, only partially correct, at worst it is a setup for disastrous portfolio decisions.[2]

The paradox of time diversification is that in order to benefit from higher returns (in equities usually) the client must increase their risk of interim declines in order to reduce their risk of a terminal loss.[3]

If RBI becomes law, the long-term time horizon will take on a different implication. 

Time Horizon, Fees, and Taxes under Regulation Best Interest

It has always been true that the longer a client's time horizon, the more important minimizing fees and avoiding taxes become.  This is not a matter of debate.  This is not something that reasonable minds can differ upon.  This is a 100 percent mathematical certainty.

Under RBI, this will become a key focal point.

If a client with a long-term time horizon is put into high fee products, charged high account-level fees, and/or churned into and out of commission product on a short-term basis, there is no way to argue it is in their best interest.

For instance, if fees can be reduced by one full percentage point per year, in 30 years time, the difference in terminal values will be about 30 percent.[4] 

For taxable accounts, the difference can be even more stark.  Annual after-tax returns of mutual funds often fall between one and two full percentage points compared to their pre-tax returns (the ones that are advertised).[5]

When combined, high expenses and tax-inefficient investing destroy investor returns.  In such a scenario, the broker, investment manager, and government all get paid before the investor, who is taking all the risk.[6]

Furthermore, the deleterious effects of high fees and taxes are completely return agnostic.  The return-destroying math holds true through all markets, good, bad, or sideways and compounds over time, to the investors disadvantage.

Costs Under Regulation Best Interest

As I have written about here, the SEC has recognized the importance of costs under RBI.[7]

While cost is not the only factor when evaluating an investment or investment strategy, it is one of the most important, if not the most important.  The customers tax status is also critical, which is why it is part of the profiling required under FINRA Rule 2111 and under RBI.[8]

RBI requires the Registered Representative undertake a fact specific analysis before the recommendation is made.  As mentioned above, this analysis will need to show why the recommended investment or strategy is in the best interest of the client compared to other investments offered by the firm.[9]

Any firm that can effectuate stock transactions for a client can purchase index ETFs for the same client (and most will have selling agreements with index mutual fund providers).  Thus, virtually every Broker-Dealer will be required to show why their investment or strategy  recommendation is better over the long-term than an index ETF or mutual fund on a net after-fee, after-tax basis (for their long-term investors).

This will present a significant hurdle for BDs because almost all equity investors are categorized as long-term investors, which is as it should be.[10]

Thus, all client accounts with a long-term time horizon will require an analysis that justifies the fees charged and taxes generated compared to low-fee, low-tax alternatives such as index ETFs and mutual funds.  In my opinion, this analysis will have to be rigorous, mathematical in nature, and be based on conservative assumptions.

Supervision to Avoid Lost Gains Cases

Supervisors will need to insure their Registered Representatives have undertaken a fact specific analysis for all their clients.  For those clients with a long-term time horizon, supervisors will need to insure the analyses comport to industry standards, reflect the client’s best interest given their particular facts and circumstances, and that the findings are reflected in the client’s portfolio.

__________

Notes:

[1]      Regulation Best Interest; Jack Duval; Available at: http://blog.accelerant.biz/blog/topic/regulation-best-interest; Accessed October 4, 2018.

[2]      “The Myth of Time Diversification: Analysis, Application, and Incorrect New Account Forms”; Jack Duval; PIABA Bar Journal; Spring 2006; Available at: http://blog.accelerant.biz/myth-of-time-diversification-whitepaper-0; Accessed October 4, 2018.

[3]       Statistically, the risk of interim declines is known as “first passage time probability”.

[4]       Reducing Attorney Fees (Investment Fees, that is); Jack Duval; Available at: https://blog.bant.am/index.php/2018/04/03/reducing-attorney-fees-investment-fees/; Accessed October 4, 2018.

[5]       Taxes – Another Killer of Attorney Returns; Jack Duval; Available at: https://blog.bant.am/index.php/2018/06/04/taxes-another-killer-of-attorney-returns/; Accessed October 4, 2018.

[6]        Wealth Confiscation by Your Three Investment “Partners”; Jack Duval; Available at: https://blog.bant.am/index.php/2018/09/07/wealth-confiscation-by-your-three-investment-partners/; Accessed October 4, 2018.

[7]         SEC Regulation Best Interest – Reasonable Care; Jack Duval; Available at: http://blog.accelerant.biz/blog/sec-regulation-best-interest-reasonable-care; Accessed October 4, 2018.

[8]         Under RBI, the Retail Customer Investment Profile includes “tax status”; SEC Regulation Best Interest; Release No. 34-83062; File No. S7-07-18; 406.  Available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf; Accessed October 4, 2018.

[9]          A separate issue is investments not offered by the firm.  This will likely come up for advisors who only sell one type of product such as insurance.  This is a key difference between RBI and the fiduciary duty imposed upon Registered Investment Advisors.  An Investment Advisor's duties are not limited to the products their firm sells.  This is a non-trivial difference and a significant shortfall in RBI.

[10]        Short-term investors should not be invested in equities.  The received view is that only funds which can be held for five years or more should be invested in equities, although some authors suggest avoiding equities unless having a 12-year time horizon.

 

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Topics: supervision, FINRA Rule 2111 (Suitability), Investment Suitability, Suitability Expert, Securities Exchange Commission, Regulation Best Interest, Fact Specific Analysis, Lost Gains Cases

Protecting Senior Investors - Deconstructing a Supervisory Failure

Posted by Jack Duval

Aug 30, 2018 8:10:55 AM

 

This blog post continues a series I began in 2012 highlighting regulatory efforts to protect senior investors.  (My previous blog posts on protecting senior investors can be found here.)

On August 24th, The New York Times published an article relating the predatory abuse of senior investors by a broker engaging in unauthorized trading and churning of their account.[1]

Client Profile

The profile of the senior investors is typical in many abuse cases.  The father was 89 years old, had suffered two strokes and was residing in an assisted living facility.  The mother was 84 years old, had been diagnosed with Alzheimer’s, and was in the process of being moved to the same facility as her husband.

There was an younger adult daughter living in a community for adults with developmental disabilities and an older adult daughter who had been overseeing the parents accounts.

Fact Pattern

In 2017, Trevor Rahn, a broker at JP Morgan, began unauthorized trading in the account (which was worth about $1.3 million at the time) and in the first six months of the year  generated $128,000 in commissions.

It appears Mr. Rahn was selling positions that had been held for years and using the proceeds to purchase new-issue closed-end funds (“CEFs”).  The closed-end fund purchases were not mentioned in the article, but Mr. Rahn’s CRD lists CEFs as a product involved in the dispute.[2]

Furthermore, the commissions generated could not have been generated from stock trades alone, and were almost certainly from high-commission new issue CEFs.  The New York Times article mentions $47,600 in commissions in August 2017.  A look at the statement page in the article reveals there were $822,000 in sales proceeds and $796,300 in purchases.  At a 1.25 percent commission rate on the purchases and sales, there would have been $20,500 in commissions generated.  Less than half of the $47,600 reported.

However, if the sales of stock were made at a 1.25 percent commission rate and the proceeds invested in new-issue CEFs paying 4.5 percent commissions, the math works out very close:

  • $822,000 sold at 1.25% = 10,275;
  • $796,300 in purchases at 4.5% = 35,833;
  • This results in total commissions of $46,108 versus the $47,600 reported.

Supervisory Red Flags Missed

There were a host of missed supervisory red flags.  So many that it defies simple explanation.  What’s worse is that many of the red flags existed before the unauthorized churning trades took place.  The following is a list of supervisory red flags that should have been triggered under standard industry practice and systems:

Pre-Trade Red Flags

The following account traits should have resulting in the account being on heightened supervision and/or generated exception reports:

  • Two senior investors, aged 84 and 89;
  • Special needs adult child;
  • An unsophisticated daughter overseeing the account;
  • High cash flow needs for two parents and one child in assisted living communities;
  • Asset allocation of 93 percent equities (and possibly higher given the six percent in mutual funds could also have been in equities), and;
  • Lien on Trevor Rahn:[3]
    • Rahn had a $763,000 lean outstanding against him from Deutsche Bank Securities.
    • Under a forgivable loan, Mr. Rahn owed Deutsche Bank $748,011 when he resigned to go to JP Morgan. Upon signing with JP Morgan, Mr. Rahn received an upfront loan of $1,404,084 and $468,000 in restricted stock.
    • He chose not to use any of his upfront cash to pay back the loan from Deutsche Bank.

Client Statement:

Accelerant Protecting Senior Investors Jack Duval - Client Statement

Trading Red Flags

Even if the pre-trade red flags were missed, the trading in the account should have triggered multiple supervisory red flags immediately:

  • Sudden and uncharacteristicaly high turnover;
  • 344 unsolicited trades being entered in one account;
  • Multiple small odd-lot orders instead of block trades;
  • Large purchases of new-issue closed-end funds, and;
  • 10 percent cost/equity ratio (the costs were 10 percent of the account value).

Account-Related Red Flags 

Finally, if the pre-trade and trading red flags were missed, the following account-related red flags should have generated supervisory inquiry:

  • Sudden decline in account value (unrelated to market movements), and;
  • Realizing over $342,000 in long- and short-term gains on sales.

Supervision

Even casual supervision should have prevented the abuse described above.  The SEC and FINRA have made the protection of senior investors a regulatory priority since 2006.  (See my blog post with a timeline of regulatory actions to protect senior investors.)  Their focus has only intensified over the years and broker-dealers have been well informed of their obligations in this area.  (Access my Protecting Senior Investors white paper.)

Because of the high potential for abuse by brokers, family members, and fraudsters, all accounts of senior investors should be on heightened supervision.  Today’s supervisory systems can easily add age-based triggers for exception reports.  Indeed, because age is a hard number and not subject to debate (such as the suitability of certain investments) this should be a trivial red flag to implement.

There can be no excuse for failing to supervise the accounts of senior investors.

__________

Notes:

[1]      “Caring for Aging Parents, With an Eye on the Broker Handling Their Savings”; Tara Siegel Bernard; The New York Times; August 24, 2018; Available at: https://www.nytimes.com/2018/08/24/business/brokers-excessive-trading-retirement.html?login=email&auth=login-email; Accessed August 27, 2018.

[2]      CRD of Trevor Rahn; Available at: https://files.brokercheck.finra.org/individual/individual_2196155.pdf; Accessed August 27, 2018.

[3]      Deutsche Bank Securities Inc., v. Trevor Rahn; Case No. CV13-5534 RGK (VBKx).  Mr. Rahn attempted to have the arbitration decision to award Deutsche Bank the $748,011 vacated.  His claim was denied.

 

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Topics: fraud, Senior Investors, supervision, Protecting Senior Investors, Elder Abuse, dementia, Alzheimer's, financial exploitation

FINRA's Proposed Changes to the Churning Rule

Posted by Jack Duval

May 29, 2018 8:03:39 AM

Accelerant - FINRA - Churning - Quantitative Suitability - Jack Duval

On April 20, 2018, FINRA issued Regulatory Notice 18-13 – Quantitative Suitability, requesting comments on amendments to Suitability Rule 2111.  This is the first FINRA response to SEC Regulation Best Interest.  In it, FINRA is trying to square the existing suitability rule with a new proposal in SEC Regulation Best Interest.[1]  (My writings on SEC Regulation Best Interest can be found here.)

Proposed Changes to FINRA Suitability Rule 2111.05(c) – Quantitative Suitability

The proposed changes would be made to the Supplementary Material to Rule 2111 dealing with quantitative suitability found in under section .05(c).  In short, section .05(c) would be amended to "remove the element of control that currently must be proved to demonstrate a violation (of the suitability rule) ..."[2]  What would remain are "… the obligations to prove that the transactions were recommended and that the level of trading was excessive and unsuitable in light of the customer's investment profile."[3]

The comment period expires on June 19, 2018.

According to FINRA, it is removing the control element from the rule because it is unnecessary.  FINRA writes (from the enforcement action perspective):[4]

The inclusion of the control element has its historic roots, in part, in the perceived need to ensure that the culpability for excessive trading rested with the party responsible for initiating the transactions in actions brought pursuant to the antifraud provisions of the federal securities laws.  That concern is not present under FINRA's suitability rule.  Because FINRA must show that the broker recommended the transactions in order to prove a Rule 2111 violation, culpability for excessive trading will still rest with the appropriate party even absent the control element.

... FINRA's suitability rule will continue to require FINRA to prove that the broker recommended the transactions and that the transactions were excessive and unsuitable in light of the customer's investment profile.

… The control element is an unnecessary layer of proof regarding the identity of the responsible party (i.e., the party initiating the transactions) and does not in any way touch on the proof needed to establish the underlying, substantive misconduct (i.e., the excessive trading activity inconsistent with the customer's investment profile.)  (Emphasis in the original, notes omitted)

Defining Churning

Churning is the effectuating of a trade for the sole purpose of generating a commission.  It can be for one transaction and does not have to be for multiple transactions, although the high transaction version is far more common.  (My previous post on churning can be found here.)

Critically, the level of activity and costs associated with the trading strategy must be judged against the individual client's profile, investment objective, risk tolerance, and involvement.  FINRA writes:[5]

Although no single test defines excessive activity, factors such as turnover rate, cost-to-equity ratio or the use of in-and-out trading may provide a basis for a finding of excessive trading.  A turnover rate of six or a cost-to-equity ratio above 20 percent generally is indicative of excessive trading.  However, lower ratios have supported findings of excessive trading for customers with very conservative investment objectives, while somewhat higher ratios have not supported findings of excessive trading for some customers with highly speculative investment objectives and the financial resources to withstand potential losses.

Most clients are buy-and-hold type of investors with moderate risk tolerances.  In these cases, even low levels of turnover and cost/equity ratios can be indicative of churning.  For example, I have seen such clients churned in portfolios laden with structured products.  These products were tax-inefficient and resulted in costs of 1.5 to 2 percent per year, when publicly traded equivalents would have cost a small fraction of that.

Alternately, a client with a speculative investment objective that wanted to trade actively (especially with only a portion of her assets) could have much higher turnover and cost/equity ratios without them be indicative of churning.

Another indicator is the level of commissions being assessed on each trade.  Is the broker charging full freight commissions (even if only on the buys)?  If so, this is more likely to be abusive than a broker charging firm minimum (or heavily discounted) commissions on each trade.

Ultimately, the assessment of any recommended investment strategy will be based on its comportment with the client's investment objective, risk tolerance, and overall profile.

Very few investors want to actively trade.  Most have no interest in the markets and even fewer have the leisure time to devote to following individual securities on a tick-by-tick basis.

These types of clients give their money to an investment professional and pay that professional to manage the money for them.  If speculative trading develops in these accounts, it is likely to be churning, even at low levels of turnover and cost/equity ratios.

Where an investor chooses a speculative trading strategy and knowingly takes the risks and is willing to pay the costs (which can add up quickly, even at low commission levels), that is their right.

Unfortunately, most speculative trading strategies don't work.  The investor is up against buildings full of computer servers engaged in algorithmic trading strategies that get the price data faster, and process their trades nearly instantaneously, before the client can even start typing in an order.[6]

Supervision

As always, broker-dealer supervisors will need to monitor accounts for churning.  These efforts should trigger red flags for accounts with high turnover and cost/equity ratios, those with a significant amount of the client's investable assets involved in the trading, those with large amounts of losses, and those where the trading does not comport with the client's profile.

Almost all compliance systems today can monitor for these triggers and generate exception reports for supervisors on an automated basis.

_______

Notes:

[1]      SEC Regulation Best Interest; Release No. 34-83062; Available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf;  Accessed May 24, 2018; 150.  “… Regulation Best Interest would include the existing ‘quantitative suitability’ obligation, but without the ‘control’ element.”

[2]      FINRA Regulatory Notice 18-13 – Quantitative Suitability; April 20, 2018; 1.  Available at: http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-18-13.pdf; Accessed May 24, 2018.

[3]      Id.

[4]      Id. at 3-4.

[5]      Id. at 3.

[6]      See Michael Lewis’ Flash Boys: A Wall Street Revolt explaining how algorithmic traders are scalping even the largest institutional investors.

 

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Topics: FINRA, supervision, Quantitative Suitability, Churning, turnover ratio, cost/equity ratio

Premeditated "C" Share Churning at Morgan Stanley?

Posted by Jack Duval

Apr 5, 2018 10:06:49 AM

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On March 29, 2018, AdvisorHub broke a story about Morgan Stanley’s decision to convert all Class "C" mutual fund shares held for six or more years into load-waived "A" shares.  This is a beneficial move for clients, who will see their funds expenses ratios cut by about 1.5 percent.

Morgan Stanley brokers were not pleased with the move, which will reduce their 12b-1 fees from one percent to 25 basis points.

Some of them vowed to churn their clients in order to avoid the conversion.  (This was not an April Fool’s joke.)

Understanding “C” Share Mutual Funds

In theory, “C” shares are designed for clients who will be relatively short-term holders and want to avoid the front-end load on "A" shares and the back-end load on "B" shares.

In reality, they are an anachronistic holdover from the mid- to late-90's.  Back then, broker-dealers where trying to grow their fee-based business and saw "C" shares as a way for transactional brokers to become more annuitized.

Today, clients can get the same investment exposures at a fraction of the costs of "C" shares in ETFs, which are also much more tax-efficient.

The truth is that "C" share funds shouldn't be held for six years, and probably not at all.  Clients would be much better off in ETFs.  “C” shares have a full one percent 12b-1 fee charged annually to the customer in addition to the management fee and other expenses.  They are extremely high-fee and in almost all cases should be avoided.

Some "C" share mutual funds from other companies convert into "A" shares after 10 years, but again, 10 years in a “C” shares is unsuitable.

For a more detailed take on fees, see The Tyranny of High Fees blog post from our sister company, Bantam Inc.

Premeditated Churning                 

In what hopefully has Morgan Stanley CEO James Gorman losing sleep at night, AdvisorHub wrote:[1]              

Several Morgan Stanley brokers told AdvisorHub that they plan to "flip C shares, selling out of one fund into another's similar share class as they approach conversion date so that they can continue collecting the higher so-called 12b-1 fee, or trail.                                                  

"Losing 75 basis points on every six-year-old share on my team's book will cost us $300,000 in gross and $120,000 in commissions," lamented one broker, who said the team expects to "flip til the cows go home."

These brokers would be selling the "C" share funds before they convert into "A" shares, thus continuing the one percent 12b-1 fee instead of having it reduced to 25 basis points.          

This would be an unabashed churn of client accounts, and after a nine-year bull market, one that would likely have serious adverse tax consequences for the clients.

Belden Decision                       

The SEC has considered share class issues long ago and has clearly stated their position.  The share class most advantageous to the client must be purchased, or in this case, held.                      

In Belden, the SEC found that a broker buying "B" shares for a client who could have purchased load-waived "A" shares because of the amount to be invested, was violative of FINRA rules.  The Commission’s opinion stated:[2]

As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests.  The test for whether Belden’s recommended investments were suitable is not whether Book acquiesced in them, but whether Belden’s recommendations to him were consistent with Book’s financial situation and needs.

FINRA concurs:[3]

NASD (now FINRA) construes Belden as supporting the principle that the manner of purchase of a recommended security by an associated person, where that security otherwise would be suitable based on the investor’s investment objectives, risk tolerance, and financial means, can render that recommendation unsuitable, and therefore violative of 2310 (now 2110), if there is an alternative basis upon which the security can be purchased to the pecuniary advantage of the investor.  (Emphasis added)

There is no way the selling of "C" shares to prevent them from converting into load-waived "A" shares can be in the customer’s best interest.

Supervision

Churning is the effectuating of any trade for the reason of making commissions.  Many churning claims involve high turnover (trading) of securities in a client account.  However, churning does not have to involve a series of trades.  Indeed, it can be one trade.

In the event a registered representative sells a “C” share fund before its conversion to a load-waived “A” share, it would constitute a one-trade churn.

Morgan Stanley supervisory systems should be able to flag any "C" share trades that occur close to a conversion, however, some brokers may preemptively sell "C" shares when they are further away from the six-year marker.

These will also be churns, but will very likely not be flagged.

Morgan Stanley supervisors should closely monitor all “C” share transactions for abuses.

_______

Notes:

[1]       Jed Horowitz; Morgan Stanley to Squeeze Mutual Fund Sales Compensation; AdvisorHub; March 29, 2018; Available at: https://advisorhub.com/morgan-stanley-to-squeeze-mutual-fund-sales-compensation/; Accessed April 4, 2018.

[2]       See Wendell Belden, Exchange Act Release No. 47859; May 14, 2003.

[3]       NASD NTM 03-69; Fee-Based Compensation; November 2003; 746 at footnote 5.

 

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Topics: FINRA, supervision, C Share, Securities Exchange Commission, Morgan Stanley, Churning, Wendell Belden

Protecting Senior Investors - 2nd Circuit Decision

Posted by Jack Duval

Mar 20, 2018 8:04:09 AM

 

Accelerant - Protecting Senior Investors.png

This blog post continues a series I began in 2012 highlighting regulatory efforts to protect senior investors.  (My previous blog posts on protecting senior investors can be found here.)

A recent 2nd Circuit decision is of interest to Broker-Dealers (“BDs”) implementing policies and procedures necessary to protect senior investors.

In brief, Claimant Alba T. Pfeffer filed a FINRA arbitration claim against Wells Fargo Advisors, LLC (“WFC”) and its Registered Representative Andre Mirkine.  The claim was based upon WFC and Mirkine’s refusal to transfer money from a trust account of Claimant Pfeffer’s husband that benefited their children to a trust account that benefited only Claimant Pfeffer.

“Mirkine explained that he did not transfer the assets because he became concerned following conversations with Mr. Pfeffer and Mr. Pferrer's son that Mr. Pfeffer was not competent and was being unduly influenced by Mrs. Pfeffer.  After receiving two letters from physicians opining that Mr. Pfeffer was not capable of making financial decisions, Wells Fargo froze both trusts."[1]

The FINRA arbitration panel denied all of Pfeffer’s claims.  Pfeffer then attempted to have the district court vacate the award and was there also denied.  Finally, Pfeffer appealed the district court’s decision to the 2nd Circuit Court of Appeals, which affirmed the district court’s ruling.[2]

There are a number of interesting items in the 2nd Circuit’s decision.

Refusing to Transfer Client Funds

Primarily, the decision to affirm the district court's denial of the vacature claim should bolster BDs in their efforts to protect senior investors.  It appears that WFC broker Mirkine and WFC supervisors did their job well by making a decision that would leave them open to potential litigation - refusing a request from an account holder to transfer money.[3]

This goes directly to FINRA Rule 2165 - Financial Exploitation of Specified Adults, which "provides a safe harbor for a member to place a temporary hold on a disbursement of funds or securities from the account... if the member reasonably believes that financial exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted."[4]

Manifest Disregard of the Law and Evidence?

Secondarily, the 2nd Circuit wrote:[5]

"On appeal, Mrs. Pfeffer argues that the award was procured by undue means, evident partiality, and misconduct because the Panel was intimidated by defense counsel and refused to consider relevant evidence.  She alleges that the Panel exhibited manifest disregard for the law and facts…

This Circuit does not recognize manifest disregard of the evidence as proper ground for vacating an arbitration panel's award and will only find a manifest disregard of the law where there is no colorable justification for a panel's conclusion."  (Emphasis added)

The 2nd Circuit found that the FINRA panel did not disregard evidence.  However, the fact that manifest disregard of evidence is not proper ground for vacating an award is bracing.

Finally, the 2nd Circuit sets the “manifest disregard of the law” standard so low at “no colorable justification” that it would seem highly remote to meet it.

Supervision

While it is no trivial matter to stop client distributions, supervisors should take quick action to stop suspect activity and to seek input from medical professionals and, if necessary, make referrals to law enforcement.

----------

Notes:

[1]       United States Court of Appeals for the Second Circuit; Summary Order; Alba T. Pfeffer Plaintiff-Appellant v. Wells Fargo Advisors, LLC, et al. Defendants-Appellees; 17-1819-cv; February 15, 2018; 3.  Available at: http://caselaw.findlaw.com/us-2nd-circuit/1889422.html; Accessed March 20, 2018.

[2]       Plaintiff Pfeffer was pro se for all three proceedings.

[3]       The FINRA panel denied Respondent Mirkine’s request for expungement of his CRD records and applied all forum fees to Respondent WFC.  This could indicate the Panel’s displeasure with some aspect of Respondent’s actions, however, without a reasoned award this is speculation.  See FINRA Award at: https://www.finra.org/sites/default/files/aao_documents/15-00294.pdf; Accessed March 20, 2018.

[4]       See FINRA Rule 2165 FAQs; Available at: http://www.finra.org/industry/frequently-asked-questions-regarding-finra-rules-relating-financial-exploitation-seniors; Accessed March 20, 2018.

[5]        See Supra Note 1 at 4-5.

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Topics: fraud, Senior Investors, supervision, Protecting Senior Investors, Elder Abuse, dementia, Alzheimer's, financial exploitation, 2nd Circuit

Protecting Senior Investors - Nationwide Elder Fraud Sweep

Posted by Jack Duval

Feb 27, 2018 7:49:13 AM

Accelerant - Senior Investors DOJ Image-1.jpeg 

This blog post continues a series I began in 2012 highlighting regulatory efforts to protect senior investors.  (My previous blog posts on protecting senior investors can be found here.)

On February 22, 2018, the Justice Department announced a nationwide sweep that resulted in over 200 criminal charges for financial crimes targeting the elderly.

Attorney General Jeff Sessions was quoted, saying:

The Justice Department and its partners are taking unprecedented, coordinated action to protect elderly Americans from financial threats, both foreign and domestic... Today's actions send a clear message:  we will hold perpetrators of elder fraud schemes accountable wherever they are.  When criminals steal the hard-earned life savings of older Americans, we will respond with all the tools at the Department's disposal - criminal prosecutions to punish offenders, civil injunctions to shut the schemes down, and asset forfeiture to take back ill-gotten gains.

Today is only the beginning.  I have directed Department prosecutors to coordinate with both domestic law enforcement partners and foreign counterparts to stop these criminals from exploiting our seniors.

The Perpetrators

As I have written about before, many of the perpetrators were known to the victims.  The DOJ press release gave this description:

The actions charged a variety of fraud schemes, ranging from mass mailing, telemarketing and investment frauds to individual incidences of identity theft and theft by guardians.  A number of cases involved transnational criminal organizations that defrauded hundreds of thousands of elderly victims, while others involved a single relative or fiduciary who took advantage of an individual victim.  (Emphasis added)

While few crimes could be more heinous than those targeting senior investors, those perpetrated by guardians, relatives, or fiduciaries would qualify.

Supervisory Implications

The financial abuse of senior investors is not an isolated problem.  The DOJ press release stated that the schemes undertaken by the alleged criminals caused more than $500 million in losses to over a million victims.  

These sweep results should be a call to action to broker-dealers, RIA firms, and banks across the country to raise their supervisory oversight of senior investors accounts.

In the past, there has rightfully been significant focus on cases that involve senior investors with Alzheimer's or dementia.  However, unsophisticated and wholly trusting senior investors, who do not have the wherewithal to question recommendations, can also be subject to abuse by unscrupulous advisors.

Compliance and supervisory personnel at all financial firms need to be aware of the potential for abuse and should have special policies and procedures in place to monitor the activity in the accounts of senior investors.  At a minimum, these policies and procedures should detect financial fraud such as: unnecessary trading, unsuitable investments, and suspicious withdrawals.

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Topics: fraud, Senior Investors, supervision, Protecting Senior Investors, Elder Abuse, dementia, Alzheimer's, financial exploitation, Justice Department

Volatility-Linked Products - Complexity Risk Strikes Again

Posted by Jack Duval

Feb 6, 2018 10:41:24 AM

This blog post continues a series exploring volatility-linked exchange-traded products.  Our previous posts can be read here, here, and here.

The VIX S&P 500 volatility index ripped higher by 115 percent yesterday.  This effectively destroyed most, if not all, inverse VIX ETPs.

Common sense will inform that if an index increases by more than 100 percent, an investment vehicle designed to give the opposite (inverse) performance should decline to zero.  (In most cases, if an investment doesn't use leverage, a potential loss is limited to 100 percent.)

Indeed, experience is now bearing this out.

VelocityShares Inverse VIX Short Term ETNs (XIV)

The XIV ETN halted trading yesterday and fund manager Credit Suisse is almost certain to close the fund.

The prospectus language allows Credit Suisse to shutter the fund if the Intraday Indicative Value is equal to or less than 20 percent of the prior day's Closing Indicative Value (among other reasons).  That has happened.

Table 1: XIV Indicative Value

XIV - Indicative Value.gif

Source: Bloomberg

The XIV Indicative Value collapsed from 108.37 to 4.22, a 96 percent decline, and well under the 20 percent threshold.

The difference in the XIV price and indicative value was widening over the past few days of the market selloff, and then blew out yesterday.

Chart 1: XIV Price and Indicative Value

XIV Price v. XIV Indicative Value Chart.gif

Source: Bloomberg

Unfortunately, a significant amount of hot money had been flowing into this ETN due to it's returns over the past few years.  The XIV market cap was just off its all-time high, at $1.48B yesterday.

Chart 2: XIV Historical Market Cap

XIV Market Cap Chart.gif

Source: Bloomberg

A Bitter Irony

In a classic example of complexity risk, investors who bought the XIV at the close yesterday (thinking that the VIX had risen too far, too fast), will be wiped out, just like longer term holders.

As of this writing at 10:20am, the XIV is down 31 percent, meaning that those buyers would have been directionally correct, but will suffer virtually complete losses anyway with no chance to get out.

Suitability and Supervision of Volatility-Linked Products

For years, investors have been seeing their principal destroyed as unknowing advisors bought and held inverse and leveraged ETPs.  Indeed, the XIV prospectus (PS-16) gives this warning:

Screen Shot 2018-02-06 at 9.16.52 AM.png

Advisors putting their clients into inverse and leveraged ETPs should have known about the risks of long-term holding and the risk of complete overnight ruin.

Likewise, firms that allowed their advisors to sell these products should have implemented special training for them.  Furthermore, specific policies and procedures should have been written to insure these products were only utilized in speculative accounts, and for sophisticated investors, who were aware of, and accepted the risk of, total loss.

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Topics: suitability, supervision, Complex Investments, Complexity Risk, volatility-linked products, XIV, VelocityShares Inverse Short Term ETN

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