Regulators train a close eye on alternatives

SEC and Finra pledge increased attention to alts and complex products

Feb 2, 2014 @ 12:01 am

By Bruce Kelly

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Through broker-dealer examinations and issuing alerts of investment advisers' due diligence, the Securities and Exchange Commission is continuing its focus on how advisers sell or advise clients on alternative investments.

The SEC's spotlight on alternatives ranges from nontraded real estate investment trusts to hedge funds, according to industry executives, SEC officials and statements from the commission.

Last month, the SEC released its list of 2014 exam priorities, and those include “advisers who have never been previously examined, including new private-fund advisers.”

Private-fund advisers include those who manage unregistered funds such as hedge funds.


The SEC isn't alone in putting emphasis on alternative investments and so-called complex products.

On the Financial Industry Regulatory Authority Inc.'s annual list of exam priorities, issued last month, the industry's self-regulator included nontraded REITs, complex structured products, emerging-markets investment funds, mortgage-backed securities, long-duration-bond funds and municipal securities.

John Nester, SEC spokesman, declined to comment beyond the SEC exam priorities letter and the risk alert on advisers' due diligence of alternative investments.

There is no doubt that the SEC has recently put intense focus on broker-dealers and registered investment advisers recommending and selling alternative investments, including nontraded REITs.

Speaking on a panel last Tuesday at the Financial Services Institute Inc.'s annual OneVoice Broker-Dealer Conference in Washington, Kevin Goodman, the national associate director of the SEC's broker-dealer exam program, said registered representatives need advanced training when selling nontraded REITs.

Moderating an earlier panel, Paul Tolley, chief compliance officer of Commonwealth Financial Network, said the firm's 2012 to 2013 SEC exam focused on alternative investments “from start to finish,” with keen attention to due-diligence details.

Last Wednesday, the SEC issued a “risk alert” and said that its staff had noted shortcomings in due diligence at several of the advisory firms it examined.

Those deficiencies included “providing potentially misleading information in marketing materials about the scope and depth of due diligence conducted” and “having due diligence practices that differed from those described in the advisers' disclosures to clients.”

Another due-diligence shortcoming at RIAs was “omitting alternative investment due-diligence policies and procedures from their annual reviews, even though these investments comprised a large portion of certain advisers' investments on behalf of clients.”

Keith Robinson, a partner at Dechert, noted that the SEC's risk alert is geared more toward investment advisers who work with institutional investors such as pension funds that retail advisers.

He conceded, however, that such large managers are increasing efforts to create products to sell through broker-dealers to retail investors.

“The SEC is trying to shape industry behavior and set out markers for where minefields lie,” when advising clients to invest in alternatives, Mr. Robinson said.

“They want due diligence in sync more closely to adviser policies and procedures. They want to make sure that what you're telling clients you are doing is actually what you do,” Mr. Robinson said.

“If there's anything worse than not having a policy, it's having one and not following it,” he said.

Mr. Robinson also noted that in its risk alert, the SEC also gave praise to advisory firms, noting that due-diligence practices have improved at some firms.

Those improvements include advisers' “seeking more information and data directly from the managers of alternative investments” and “using third parties to supplement and validate information provided by managers of alternative investments,” according to the alert.

“The trends noted in the staff's risk alert demonstrate clearly that the adviser and alternative funds industries have implemented best-practice recommendations without a statutory or regulatory imposition of a requirement to do so,” Mr. Robinson said.

Meanwhile, the SEC is getting tough on broker-dealers and their sales of alternative investments, Mr. Tolley said.

The exam of Commonwealth included multiple interviews with staff members, including specific analysts at the firm who review products, he said at the FSI conference.

The SEC exam began with a focus on senior investors but quickly expanded to include alternative investments, Mr. Tolley said.

“It was a deep dive, and not something we have experienced before,” he said.

The SEC's exam was part of Commonwealth's broker-dealer/investment adviser review of dually registered firms, he said.

The last such exam for Commonwealth was in 2005 and 2006, Mr. Tolley said.

“I was pleased because I know how thorough and exhaustive we are on both sponsor due diligence and product due diligence, Mr. Tolley said.

The SEC's attention to adviser use of alternative investments is warranted, particularly as investment banks are flooding the market with products such as private placements and structured notes, said Chris Kelly, managing director of the Barclay Breland Family Office.

“With so many alternative investments, it feels like the Wild West is coming back,” he said.

Some wirehouse advisers Mr. Kelly speaks to “don't understand how structured products work,” he said.

Wirehouse advisers and private bankers particularly lack an understanding of the products' absence of liquidity, the products' “holdback” — or the amount withheld from payment until certain goals have been reached — or the wirehouse's or private banks' underlying involvement in the transaction.


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