On Advice

In this Finra program, the eyes have it

A new initiative has the regulator looking at private placements more closely and in real time

May 11, 2014 @ 9:46 pm

By Bruce Kelly

The financial advice industry is becoming increasingly fascinated — some would say preoccupied — with robo-advisers.

Hardly a week goes by when at least one story doesn't appear in InvestmentNews or other media serving the financial advice industry exhorting advisers to either fear or embrace the robo-adviser, which is just a fancy name for online advice. Such websites and tools will make human advisers obsolete, one theory goes, forcing tens of thousands of financial advisers off the golf course and into the job market.

But advisers should not worry. In truth, online advice is not that scary and really is just a bunch of fancy financial planning software wrapped up in sophisticated, Silicon Valley marketing. Advisers will have more competition but prevail. After all, who wants to talk to the Terminator about money?

Always a few steps behind advisers they oversee, securities regulators are also adopting technology-based techniques to better understand the financial advice marketplace.

The Financial Industry Regulatory Authority Inc., the self-regulatory organization for broker-dealers and registered reps, is building a software robot of its own, called the Comprehensive Automated Risk Data System. It sounds kind of cool. Dubbed CARDS, the new program is an automated data collection system that would allow Finra to improve its monitoring of brokerage firms' customer accounts. 


Like robo-advisers, CARDS is eliciting fear and exasperation from the advice industry. Trade groups hate the CARDS proposal because it would increase expenses at broker-dealers, they claim. But it would also spur changes in the way firms do business.

That's why it's refreshing to learn of initial results and potential success of an oversight program recently started by Finra that relies on eyeballs rather than computers.

A new program that puts the spotlight on broker-dealers selling Reg D private placements has led to a number of potential enforcement cases, according to Joseph Price, senior vice president of corporate finance and advertising regulation at Finra.

The program requires member firms to file with Finra a copy of any private placement memorandum, term sheet or other offering document the firm used within 15 days of the sale of a Reg D offering. In 2013, the first full year of implemetation, Finra received 3,043 private placement filings.

"We've got numerous open enforcement cases already coming out of the program," said Mr. Price. "In the past, we've looked at the private placement memorandum as part of the process of broker-dealer exams. Now, we're looking at (the offerings) much more in real time."


Finra hired nine employees to track private placements, Mr. Price said, stressing that the new focus was being coordinated across an organization with 3,400 workers.

According to a 2012 Finra notice, the rule is part of its "multipronged approach to enhance investor oversight and investor protection in private placements."

Private placements are high-risk securities for accredited investors, defined as having $1 million in investible assets or two years of at least $200,000 in annual income.

The program is a welcome development after several years of fallout from Reg D failures. Regular readers know InvestmentNews' focus on these deals. The Big Three of private placements — Medical Capital Holdings Inc., Provident Royalties LLC and DBSI Inc. — each raised hundreds of millions of dollars through small to midsize independent broker-dealers.

Armed with due-diligence reports commonly paid for by the three private placement sponsors, the broker-dealers raised close to $3.5 billion in capital for the three private-placement syndicators. Each of the firms promised high yields just as investors began a frantic search for yield in 2006, 2007 and 2008.

The results were disastrous. DBSI, which sold real-estate-linked investments and private notes, declared bankruptcy in 2008. MedCap and Provident shut down in 2009 after the SEC charged them with securities fraud. Crushed by the cost of defending investors' arbitration complaints, many of the B-Ds that sold DBSI, MedCap and Provident products have shut down. Investors lost hundreds of millions of dollars.

It remains to be seen whether Finra's new effort can prevent such financial carnage. But collecting and reviewing private placement memorandums is paying off, Mr. Price said. The deals are typically small, with many looking to raise $5 million or less, but some are rife with red flags.

"We've seen examples of brokers raising money for issuers that have significant financial problems," Mr. Price said.

Another potential problem: Private placements that are contingency offerings, in which the product sponsor has made no effort to put aside some investor money in escrow before it is invested — a simple way to protect clients' cash.

"Brokers are learning that if they are not following contingency procedures, they get a call from Finra," Mr. Price said.

Private placements are for elite investors. When putting money into such deals, using eyeballs is still the best way to keep clients safe.


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