Consumer Protection

Accredited Investor Definition Revisited By SEC Part I

November 20, 2014 | by Staff Attorney

According to an InvestmentNews article, the Securities and Exchange Commission (SEC), for the first time in 32 years, is revisiting the idea of who should qualify as an accredited investor to be eligible to invest in private placements. The current accredited-investor standard limits private placement purchases to individuals who earn at least $200,000 annually or have a net worth of $1 million after excluding the primary residence. Recently, the SEC recommended considerable revisions on who should make to the definition of an accredited investor in order to broaden the potential pool and strengthen verification that they qualify.

Under the Dodd-Frank reform law, the SEC must review the accredited investor definition every four years. Under the current rules, about 8.5 million investors currently qualify. The Investor Advisory Committee (IAC) was also established by Dodd-Frank to represent retail investors to the SEC to propose rule recommendations.

The committee stated that relying on income and net worth oversimplifies the analysis of who has the wealth and liquidity to withstand the risks of private offerings. For instance, the thresholds fail to provide adequate protection for investors whose net worth is based on an accumulated retirement savings, illiquid holdings, or maybe a lump sum settlement from a lawsuit that is supposed to replace income.

SEC Rejects Bids by Funds to List Nontransparent ETFs

November 19, 2014 | by Staff Attorney

In a rare move of true consumer protection, the Securities and Exchange Commission (SEC) denied applications by fund managers BlackRock Inc. and Precidian Investments to offer nontransparent exchange-traded funds (ETFs) to investors by stating that such products were not in the public’s interest. The SEC stated that the proposals could inflict substantial costs on investors, disrupt orderly trading, and damage market confidence in trading of ETFs.

The fund managers have argued that opening up actively managed ETFs to full transparency would lead to front running, a strategy where other investors trade ahead to gain a benefit. As a result, the funds argue that their trading strategies are rendered obsolete by the market’s knowledge of them. Thus, the solution the industry devised was to deprive the investing public of disclosure of fund holdings.

However, the SEC said that daily transparency is necessary to keep the market prices of ETF shares at or close to the net asset value per share of the ETF. But as usual, the industry losses a battle but will eventually win the war. Others funds such as American Funds, T. Rowe Price Group Inc. and Eaton Vance Corp. all have applications pending for similar nontransparent ETFs where the SEC could rule on various alternative proposals. In addition, Precidian’s chief executive, Daniel J. McCabe, told InvestmentNews he believed the SEC’s objections can be worked though and that it will merely take longer to get approval because the funds are not standard.

UBS Puerto Rico Fined $3.6 Million and to Pay $1.7 Million in Restitution to Customers of its Bond Funds

November 6, 2014 | by Staff Attorney

On October 9, 2014, Puerto Rico’s Office of the Commissioner of Financial Institutions (OCFI) has settled its claims with UBS Financial Services Incorporated of Puerto Rico (UBS Puerto Rico) over UBS’s sale of closed-end mutual funds in Puerto Rico. The OCFI conducted a routine examination from October 15, 2013 through June 27, 2014. The examination of UBS Puerto Rico was conducted to determine if the firm complied with the Puerto Rico Uniform Securities ACT Regulation No. 6078.

The OCFI interviewed a sample of clients and examined whether certain former and current UBS Puerto Rico brokers either (i) recommended that, or (ii) permitted certain clients to, use non-purpose loans through UBS Bank USA to purchase securities in UBS brokerage accounts during the 2011-2013 period in violation of the customers’ loan agreements and UBS Puerto Rico policies.

The OCFI determined that for some clients, such a practice was unsuitable based on the customers’ financial objectives, risk tolerance and needs, and that UBS Puerto Rico brokers may have induced clients through the misrepresentations or omissions of material facts.

FINRA Declines Rule Requiring Brokerage Firms To Carry Insurance

November 5, 2014 | by Staff Attorney

According to a recent report, the Financial Industry Regulatory Authority (FINRA) has decided it cannot force firms to carry insurance for payment of awards granted by arbitration panels on behalf of investors who have lost money.

As a background, every investor who opens a brokerage account with an investment firm agrees to arbitrate their dispute before the FINRA. Even if an investor did not open an account with a brokerage firm the claim can still be arbitrated under the industries rules. FINRA is the investment industries self-regulatory organization for all brokerage firms operating in the United States, overseeing approximately 4,700 brokerage firms and 635,000 registered representatives. FINRA both enforces its own rules through regulatory actions and administers an arbitration forum for securities disputes.

Our firm has noticed a recent trend where small and even mid-sized firms fail to keep sufficient funds on hand to pay investors due to misconduct at the firm. These smaller firms sometimes fail to enact proper supervisory procedures and regulatory controls to prevent their brokers from engaging in wrongful conduct. Sometimes these firms simply do not have the resources to properly engage in the securities business lines they attempt to engage in. As a result investors are harmed and due to their small size, cannot be compensated. In 2012, brokerage firms failed to pay $50 million in awards to customers. In 2011, the number of unpaid awards totaled $51 million.

SEC Cracks Down on Wrap Accounts to Prevent “Reverse Churning”

October 6, 2014 | by Staff Attorney

A recent InvestmentNews article explored The Securities and Exchange Commission’s (SEC) attempts to prevent conflicts of interest at registered investment advisers, a breach of their fiduciary duties, by focusing on potential misuse of popular flat-fee wrap accounts. The use of these accounts have given rise to claims of “reverse churning.” As we previously reported, “churning” is excessive trading activity or in a brokerage account. Churning trading activity has no utility for the investor and is conducted solely to generate commissions for the broker. By contrast “reverse churning” is the practice of placing investors in advisory accounts or wrap programs that pay a fixed fee, such as 1-2% annually, but generate little or no activity to justify that fee. Such programs constitute a form of commission and fee “double-dipping” in order to collect additional fees.

The SEC is looking into the practice by which clients pay an annual or quarterly fee for wrap products that manage a portfolio of investments. Investment advisors who place clients in such programs already charge fees based on assets under management (AUM) and the money management charges for wrap products are in addition to the AUM fee. According to InvestmentNews, the assets under these arrangements totaled $3.5 trillion in 2013, a 25% increase from 2012. Included in these numbers include separately managed accounts, mutual fund advisory programs, exchange-traded-fund (ETF) advisory programs, unified managed accounts, and two types of brokerage-based managed accounts.

Reverse churning can occur under these arrangements if there’s too little trading in the accounts in order to justify the high fees. In August, the SEC’s scrutiny of these products came to the forefront with the agency’s victory in a court case that revolved in part around an adviser’s improperly placing his clients into wrap programs. A jury decided in the SEC’s favor against the advisory firm Benjamin Lee Grant that the SEC argued improperly induced clients to follow him when he left the broker-dealer Wedbush Morgan Securities to his advisory firm, Sage Advisory Group.

Regulators On the Look Out for “Reverse Churning”

October 4, 2014 | by Staff Attorney

It is relatively easy to grasp the concept of excessive trading activity or “churning” in a brokerage account. Churning trading activity has no utility for the investor and is conducted solely to generate commissions for the broker. Churning involves both excessive purchases and sales of securities and the advisors control over the account. But regulators are also looking at another growing trend referred to as “reverse churning.” According to the Wall Street Journal (WSJ) the Securities and Exchange Commission (SEC) states that “reverse churning” is the practice of placing investors in advisory accounts that pay a fixed fee, such as 1-2% annually, but generate little or no activity to justify that fee. Regulators are watching for signs of “double-dipping” whereby advisers generate significant commissions in an investor’s brokerage account and then moves the client into an advisory account in order to collect additional fees.

As a background there are many standalone brokerage firms and investment advisor firms where the option does not exist for a client to be switched between types of accounts. However, there are also many dually registered firms which are both broker-dealers and investment advisers. These firms, and their financial advisors have tremendous influence over whether a customer establishes a brokerage or investment advisory account. In the WSJ, the SEC was quoted as saying that “This influence may create a risk that customers are placed in an inappropriate account type that increases revenue to the firm and may not provide a corresponding benefit to the customer.”

However, dumping a client account into an advisory account after the broker ceases trading is only one strategy that should be included in the category of “reverse churning.” There are many other creative ways that brokers can generate excessive commissions for themselves while providing no benefit to their clients. For example, if a broker recommends a tax deferred vehicle, such a as a variable annuity, in an IRA account there is no additional tax benefit for the client. While the recommendation would not result in excessive trading, the broker would earn a huge commission for an investment that cannot take advantage of one of its primary selling points.

SEC Releases Alert Warning Investors About Affinity Fraud

August 21, 2014 | by Staff Attorney

The SEC’s Office of Investor Education and Advocacy issued a Investor Alert to help educate and warn investors about the dangers of affinity fraud. Affinity fraud is a common type of securities fraud that preys upon members of a group or community such as members of certain religions or ethnic communities. Affinity frauds involve either fake investments or extremely risky investments that are conducted outside regular securities channels. The fraudster will typically lie about important details such as the risk of loss, the track record of the investment, or the background of the investment.

Many affinity frauds turn out to be Ponzi schemes. In a Ponzi scheme new investors money goes to pay earlier investors to create the illusion that the investment is succeeding all the while the fraudster skims large amounts of the funds for his or her personal use. When the fraudster’s supply of new investor money runs out and current investors seek payment the scheme collapses. Fraudsters use many legitimate investment sounding vehicles and names to mask their schemes. For example, the fraudster may tell investors that they are investing in real estate, options, precious metals, or employing leverage or other sophisticated investment tools to increase returns.

In order to carry out affinity frauds, the fraudster will be a member of the group they are trying to defraud such as a particular denomination or church. However, any close knit community or group such as an ethnic group, immigrant community, or racial minority will work. Fraudsters may also prey upon members with other commonalities such as teachers, union members, or military servicemen. The key to affinity fraud is that the fraudster can target the group and built up a high level of trust and confidence through the affinity connection to convince them to trust the fraudster with their life savings.

Business Development Companies (BDC) – Investment Risks to Be Aware of – Part II

August 20, 2014 | by Staff Attorney

In our prior post we recently highlighted, the rising popularity of non-traded business development companies (BDCs). BDCs may be one of the latest and greatest products that Wall Street is promoting that will provide outsized yield with less risk. As usual, these “new ideas” end with brokerage firms making lots of money and investors suffering the consequences.

BDCs make loans to and invest in small to mid-size, developing, or financially troubled companies. BDCs now fill the role that many commercial banks left during the financial crisis to lend to those companies with questionable credit. While BDCs are not new products, until very recently investors had only publicly traded closed-end funds that acted like private equity firms to invest in. These funds are risky enough. During the last downturn some of the publicly traded funds fell by 60%, 70% or more.

Like their non-traded REIT cousins, non-traded BDCs utilize a non-traded REIT-like structure and promote very high yields of 10% or more. There are some differences between BDCs and REITs, BDCs are regulated under the 1940 Act that governs mutual funds. There is also a big difference in valuation. BDCs are valued quarterly while non-traded REITs publish their valuations no later than 18 months after the offering period.

Business Development Companies (BDC) – The Next Risky Wall Street Cash Cow?

August 19, 2014 | by Staff Attorney

Since the financial crisis, the product development squad on Wall Street has been hard at work putting new spins on old ideas. The usual plan is merely to rebrand an old idea with a new label and convince investors looking for the latest and greatest product that the investment will provide outsized yield with less risk. It’s no coincidence that these new ideas make lots of money for the brokers selling them.

Enter the non-traded business development companies (BDCs). Now that many regulators and investors have begun to wise up and sour on the high commission and uncertain return approach offered by non-traded REITs, BDCs have entered into the fray as the non-stock market, non-real estate, high yield alternative. However, BDCs appear to be just as speculative – likely even more so – and inappropriate for most investors as non-traded REITs with many of the same failings such as obscenely high up-front fees, limited liquidity, and reliance on leverage to juice returns.

BDCs make loans to and invest in small to mid-size, developing, or financially troubled companies. BDCs have stepped into a role that many commercial banks left during the financial crisis due to capital raising requirements. In sum, BDCs lend to companies that may not otherwise get financing from traditional sources. While BDCs are not new, until very recently the market has been served by publicly traded closed-end funds that act like private equity firms. Just like the market was served just fine by publicly traded REITs before the non-traded variety showed up on the scene. One would think that the publicly traded BDCs provided high enough returns and were risky enough for even the most speculative investor considering that during the last downturn some of the funds fell by 60%, 70% or more. But greed is good.

Bank Loan ETFs – Buyer Beware

July 11, 2014 | by Staff Attorney

A recent statement by BlackRock Inc (BlackRock) Chief Executive Larry Fink concerning leveraged exchange traded funds (Leveraged ETFs) has provoked a chain reaction from the ETF industry. Fink runs BlackRock, the world’s largest ETF provider. Fink’s statement that structural problems with Leveraged ETFs have the potential to “blow up the whole industry one day” have rattled other ETF providers – none more so than those selling bank loan ETFs. Naturally, sponsors of Leveraged ETFs, a $60 billion market, called the remarks an exaggeration.

As a background, leveraged ETFs use a combination of derivatives instruments and debt to multiply returns on an underlining asset, class of securities, or sector index. The leverage employed is designed to generate 2 to 3 times the return of the underlining assets. Leveraged ETFs can also be used to return the inverse or the opposite result of the return of the benchmark. While regular ETFs can be held for long term trading, Leveraged ETFs are generally designed to be used only for short term trading – sometimes as short as a single day’s holding. The Securities Exchange Commission (SEC) has warned that most Leveraged ETFs reset daily and FINRA has stated that Leveraged ETFs are complex products that are typically not suitable for retail investors. In fact, some brokerage firms simply prohibit the solicitation of these investments to its customers, an explicit recognition that a Leveraged ETF recommendation is unsuitable for virtually everyone.

Despite these dangers, bank loan Leveraged ETFs may be an easy sell to investors. Investors in fixed income instruments are compensated based upon the level of two sources of bond risk – duration risk and credit risk. Duration risk takes into account the length of time and is subject to interest rate changes. Credit risk evaluates the credit quality of the issuer. For example, U.S. Treasury’s have virtually no credit risk and investors are compensated based on the length of the bond. At the other end of the safety spectrum are low rated floating-rate debt – what bank loan Leveraged ETFs invest in. These funds are supposed to reset every 90 days in order to get exposure to the credit side but not take on much duration risk.