By Expert No. 361382 CFP, CTFA, CDFA
Abstract
Most people are quite familiar with Broker-Dealers — wirehouses such as Morgan Stanley Smith Barney or Merrill Lynch. The broker-dealer is essentially a sales organization that charges clients either a transactional commission or utilizes a fee in lieu of commission platform. The minimal threshold of “suitability” is the established standard for products offered to investors. Advice is considered incidental to investment.

 

Not so commonly known to the investing public, the Registered Investment Advisor (RIA) has significantly greater duties and obligations to their clients. Dependent upon factors such as assets under management, type and total quantity of clients, and number of States in which business is conducted, the RIA is registered at either the State or Federal level and is firmly established as a fiduciary under the Investment Advisers Act of 1940. Full and truthful disclosure of all material facts relative to the advisor/client relationship is required, including any conflicts of interest or practices that might affect the relationship. The client must be able to either consent to or reject such conflicts or practices. Investment advice is the product offered to the client and a fee is charged for the service.

I was recently engaged by Plaintiff’s Counsel in a wrongful termination case. Counsel stated that their client was fired by the employing RIA after bringing a series of compliance issues to the attention of the firm’s supervisory hierarchy. The RIA was the advisor to a family of open ended mutual funds, offered by an Investment Company under common ownership. My first task was to review a brief list of the client’s allegations and determine if the issues raised would be actionable by regulatory authorities as a matter of public policy.
The Plaintiff was in a position to observe and report questionable acts committed by a third party Service Provider that included:

  • Inaccurate application of front end loads to share holder accounts
  • Failure to accurately calculate Rights of Accumulation / Breakpoints
  • Placement of C class shares onto an RIA platform
  • Incorrect application of 12b-1 fees
  • Improper application of Contingent Deferred Sales Charges
  • Disclosure of client private information

The laws governing the Securities Industry are intended to identify matters of national public interest and establish standards of conduct to serve the best interests of the individual investor. I needed to determine whether fiduciary failure could have resulted in a loss of shareholder value in order to provide context for my client’s case.

The primary authorities I looked to were the Investment Advisers Act of 1940 (IAA) for the RIA’s duties and obligations, and the Investment Company Act of 1940 (ICA) for elements related to the open ended mutual funds.

The IAA requires RIA’s to adhere to a Code of Ethics (Rule 204a-1) that must reflect their fiduciary obligations and set forth their ideals for ethical conduct. A principal concept of the fiduciary relationship is to place the interests of the client first and foremost.  Rule 206 (4)-7 requires that compliance procedures be set in place that prevent, detect, and correct violations of the Act. The instructions for the RIA federal registration form ADV also specify the need for a formal Code of Conduct and Compliance Policies and Procedures.

Several of the violations the Plaintiff brought forward to their former employer were specifically cited within IAA Rule 206 (4)-7 as issues that must be addressed by an RIA’s formal compliance policies and procedures.

Under the ICA Rule 38a-1, fund boards are required “to adopt written policies and procedures reasonably designed to prevent the fund from violating the federal securities laws. The procedures must provide for the oversight of compliance by the fund’s advisers, principal underwriters, administrators, and transfer agents (collectively, “service providers”) through which the fund conducts its activities.”

In short, investors in the fund family would have suffered harm by failing to receive full share value for their monies at multiple points in the sales and service process, with errors compounding upon themselves. Both the RIA and Investment Company Board failed in their fiduciary duties to address the numerous, material compliance violations that were systemic, repetitive, and uncorrected. To me, this was indicative of a breach of public policy.

Furthermore, as a result of the compounding errors, individual investor performance could vary significantly from the composite portfolio results measured and submitted to the SEC under ADV and fund prospectus filings, as well as published in promotional materials distributed to the investing public. This could indicate that the RIA and Investment Company were engaged in false or misleading advertising practices.

After reporting this opinion to Plaintiff’s Counsel, I was engaged to look deeper into the case file and review the depositions of key RIA personnel. Counsel informed me that the RIA was taking the position that the material violations cited by the Plaintiff were, “simply clerical errors that did not matter,” because, “even if they were not fixed, it was not a compliance issue.” The very real impact to members of the investing public was completely brushed aside.

Amongst the most astounding revelations in the depositions were the consistent statements by the various Defendants wherein no one could say if the errors/violations had ever been investigated or resolved. It was disingenuous for such highly experienced, highly compensated management professionals (Chief Operating Officer, Chief Compliance Officer, Chief Executive Officer, et al) to claim ignorance of the regulatory obligations their positions required and justify their failure to act accordingly. Malice or intent is not a necessary component of non-compliance. Best effort is not the standard.

It was also untoward for them to denigrate the Plaintiff when the records indicated the Plaintiff was not only hired on the basis of special skills and expertise, but extraordinary compensation arrangements were made to pay “above band.” The fund Board even repeatedly commended the RIA for their skill in recruiting and retaining highly capable personnel.

By having access to a fuller complement of documents I was able to further erode the Defendants’ stance by substantiating and citing detailed regulatory violations found within:

  • Investment Advisers Act of 1940; IA Code of Ethics 204a-1, 204-2, Form ADV; 206(4)-7
  • Investment Company Act of 1940, Sections 12b-1; Rule 38a-1; 17j-1; Investment Company Governance (multiple sections); 18f; Advertising rules;
  • Securities Exchange Act of 1934, Sections 17; 17a; 15
  • FINRA: notice to members 03-47; ntm 02-85; ntm 03-68; ntm 05-68; Rule 2010; Rule 8210; Rule 6730; Rule 2232
  • NASD: 98-107; 03-50
  • Gramm Leach Bliley

It also became apparent the Defendants had failed to disclose the lengthy set of material violations to the SEC during an audit.

Prior to my deposition (at Plaintiff’s request) I produced a report outline that delineated the Defendants’ fiduciary and supervisory failures and provided context for the violations in terms of harm done to the investing public. A settlement was subsequently agreed upon before I was called to testify.

Expert no. 361382 is a consulting expert with over 11 years comprehensive financial advisory experience gained as a registered representative of national wire-houses.  Specializes in matters related to investment management by fiduciaries, trustees, personal representatives, and financial consultants, as well as adherence to SEC / FINRA standards of conduct for broker-dealers, registered investment advisors, and their representatives.  Emphasis on investment analysis and decision-making processes / modern portfolio theory; asset allocation, diversification, risk control / fiduciary standards, investment and spending policy statements / trust and estates; multigenerational strategies, charitable gifting, tax planning and sheltering.  Private practice focuses on recommending and implementing efficient wealth management and investment strategies for high-net-worth individuals and institutional investors.  Certified Financial Planner (CFP).  Certified Divorce Financial Analyst (CDFA).  Possesses Series 7, 63, 65, 31, Life, Variable, and LTC Licenses.  More than 10 years expert witness experience.  Consultations and depositions.– Consulting expert with over 11 years comprehensive financial advisory experience gained as a registered representative of national wire-houses.  Specializes in matters related to investment management by fiduciaries, trustees, personal representatives, and financial consultants, as well as adherence to SEC / FINRA standards of conduct for broker-dealers, registered investment advisors, and their representatives.  Emphasis on investment analysis and decision-making processes / modern portfolio theory; asset allocation, diversification, risk control / fiduciary standards, investment and spending policy statements / trust and estates; multigenerational strategies, charitable gifting, tax planning and sheltering.  Private practice focuses on recommending and implementing efficient wealth management and investment strategies for high-net-worth individuals and institutional investors.  Certified Financial Planner (CFP).  Certified Divorce Financial Analyst (CDFA).  Possesses Series 7, 63, 65, 31, Life, Variable, and LTC Licenses.