Risky alt investments being probed

The sweep investigation of 15 brokerage firms initiated last week by Massachusetts is a clear message to the advice industry that regulators are hot on the lookout for risky alternative investments being sold to investors, especially senior citizens.

Regulators are concerned that seniors, desperately looking for higher returns than they can earn from traditional bank products, may not fully understand these investments, some of which can tie up investors’ money for years.

“Alternatives are one of [state regulators’] biggest focuses right now because there’s been such an explosion in them,” said A. Heath Abshure, president of the North American Securities Administrators Association Inc. and Arkansas’ securities commissioner.

“Right now, what we have are senior citizens who rely on a certain level of yield to pay day-to-day living expenses,” he said. “They’re scared of the stock market, [but] they’re saying “Come hell or high water, I need 7%,’ and the only thing that purports to give them that are these alternative investments.”

Massachusetts subpoenaed the firms, demanding information on sales in the past year of nontraditional products such as oil and gas partnerships, private placements, structured products, hedge funds and tenant-in-common offerings to state residents 65 or older.

“These products are gaining some popularity, I think, because people are frustrated by low returns on their investments, and they’re reluctant to return to the equity markets,” said William Galvin, Massachusetts’ secretary of the commonwealth. “They’re especially attractive for older people.”

The targeted firms are Bank of America Merrill Lynch, Charles Schwab & Co. Inc., Commonwealth Financial Network, Fidelity Brokerage Services LLC, ING Financial Partners Inc., Investors Capital Corp., LPL Financial LLC, Meyers Associates LP, MML Investor Services LLC, Morgan Stanley, Signator Investors Inc., TD Ameritrade Inc., UBS Securities LLC, Wells Fargo Advisors and WFG Investments Inc.

The complexity of some nontraditional investments is a big issue for regulators, said Terry Lister, chief regulatory officer with Waddell & Reed Financial Inc., which recently went through two senior-related sweeps initiated by state regulators.

A new wrinkle for regulators is finding out how well advisers themselves understand the complicated products that they are selling, he said.

“The regulators take the position that advisers don’t understand these products, so how can they explain them to a senior?” Mr. Lister said.

Waddell & Reed doesn’t sell illiquid alternatives, he said.

FINRA CRACKDOWN

State regulators aren’t the only ones cracking down on alternatives.

The Financial Industry Regulatory Authority Inc. warned members last January in its annual exam priorities letter that it was “particularly concerned about sales practice abuses [and] yield-chasing behaviors” that might lead investors into unsuitable complex products.

Products under scrutiny by Finra this year include business development companies, structured products, nontraded REITs and private placements.

“Finra grinds us on structured notes and commodity-linked notes,” said the president of another broker-dealer, who asked not to be identified.

His firm recently finished a Finra exam that included multiple requests about structured products, he said.

Finra examiners also are armed with a tougher suitability rule, revised a year ago, that requires broker-dealers and registered representatives to have a reasonable basis to think that a recommendation is suitable.

Additionally, Finra has more information about specific private placements being sold by broker-dealers, thanks to a rule that went into effect in December. That rule requires firms to file private-placement offering documents with the regulator.

In March, some broker-dealers were hit with a Finra sweep letter asking for information on sales to clients over 65, including the top products purchased, commissions earned on sales, marketing methods, use of senior designations and training.

Similarly, Massachusetts last week demanded the names of senior investors who purchased nontraditional products, the commissions generated, how the sales were reviewed, and all relevant compliance, training and marketing materials.

Its latest action is a follow-up to a series of nontraded-REIT cases.

In May, the commonwealth settled with Ameriprise Financial Services Inc., Commonwealth Financial, Lincoln Financial Advisors Corp., Royal Alliance Associates Inc. and Securities America Inc. The five firms agreed to pay a total of $6.1 million in restitution to investors, and fines totaling $975,000.

In February, Massachusetts settled a case against LPL, which agreed to pay at least $2 million in restitution and $500,000 in fines related to the sale of nontraded REITs.

“We found out that in the REIT cases, people didn’t know what they were investing in,” Mr. Galvin said.

Mr. Abshure worries that more investors will get into private deals.

Action last week by the Securities and Exchange Commission to allow hedge funds and other issuers of private placements to advertise their offerings will lead to more unsuitable sales of illiquid products, he said.

Seniors may see a “slick infomercial or website saying, “We’ll guarantee a 10% return,’ and they can buy directly from the issuer,” without any due diligence by a broker-dealer, Mr. Abshure said.

Sales would be limited to accredited investors, but state regulators and other critics contend that oversight will be lacking without tougher investor protections.

“Once you get a broad-based [exposure], you’re inviting more people in,” Mr. Galvin said.

Advertising will “certainly make the public aware of [alternative products], and included among those will be unsophisticated investors,” he said.

Related Topics: American Funds Distributors, Financial Industry Regulatory Authority, North American Securities Administrators Association Inc (NASAA)