Breaking away for the wrong reason

Regulators are concerned that brokers are jumping into the RIA channel to take advantage of a lax regulatory climate

Sep 27, 2015 @ 12:01 am

By Mason Braswell

Adviser Sean Meadows was sentenced to 25 years in prison in June for stealing $10 million from clients. In August, Jacob Cooper was fined $2.8 million and also barred from the securities industry for putting his clients' money into investments that paid him undisclosed kickbacks.

Aside from running afoul of law enforcement or regulators, the advisers have another thing in common: both left the brokerage industry to become registered investment advisers. As more brokers leave the highly regulated broker-dealer industry for the less regulated world of RIAs, concern is growing that investors increasingly may be at risk.

While no one is saying that breakaway brokers are more inclined to violate the law than others in the overall advice industry, at the same time few dispute that the RIA industry has less regulatory oversight than the brokerage business.


“It looks like it's very easy for brokers to leave a brokerage firm and go do their own thing,” said Barry Lax, a lawyer who is currently representing ex-Yankee catcher Jorge Posada in a civil lawsuit against his former advisers. “If they have the client base, there's no reason for them not to do it, and there's no check, really, on these guys.

While the actual number of brokers leaving the industry to become investment advisers is hard to come by, and the total number of brokers still far outstrips the number of advisers, the RIA industry is growing at a much faster clip than the brokerage industry.

Between 2012 and 2014, the number of registered brokers rose 1% to around 371,000 while the number of advisers who were registered only as RIAs jumped 17% to around 46,000, according to the Financial Industry Regulatory Authority Inc. Most advisers say that the RIA model is growing because the fiduciary standard they adhere to — working in the “best interests” of clients — is better for the investing public than the suitability standard of the brokerage industry. But Susan Axelrod, executive vice president of regulatory operations for Finra, warns that it is also creating risks for investors because of a lack of oversight.

Large RIAs, those with more than $100 million in assets under management, are examined, on average, once every 10 years by their primary regulator, the Securities and Exchange Commission. Forty percent of RIAs have never been examined. Smaller RIAs are regulated by states and the frequency of exams differs from state to state. Broker-dealers, by contrast, are examined once every two to four years by Finra, their primary regulator.


The SEC has acknowledged that RIAs should be examined more frequently, but claims that it does not have enough examiners. It has tried to get additional money to hire more, but Congress has not given the agency the funds.

Commenting on the flight of brokers to the independent channel at an industry conference in April, Ms. Axelrod conceded that some of it is a result of a preference by clients who want to deal with RIAs instead of brokers.

“But there is some regulatory arbitrage as well,” she said. “Why would you want to be examined frequently and have personal activity questionnaires [from Finra] when you can sit back for 10 years [without being examined]? It's really important that we recognize that having a lot of folks out there who haven't been examined over a long period of time — with lots of assets moving in — that's a space that regulators and the industry should care deeply about.”

Ms. Axelrod's comments echoed similar remarks from SEC Commissioner Daniel Gallagher, who last year expressed concern that enforcement statistics were skewed higher for broker-dealers because the SEC was not able to police RIAs as effectively.

“In reality, there are plenty of repeat offenders at investment advisory firms who are engaging in misconduct,” he said in May. “We're just not finding them as quickly because the SEC allocates a disproportionate amount of resources to policing the activities of broker-dealers when compared to those we expend policing investment advisers.”

While there is no evidence that there is more misconduct among RIAs than brokers, even RIA executives concede they have their fair share of troublemakers.


“The anecdotal evidence is endless,” said Michael Maurer, a former wirehouse manager who founded an independent firm, Steward Partners Global Advisory. “Left unchecked, people start to make slippery-slope arguments for why something is good for clients.”

Mr. Meadows, whose crimes occurred between 2007 and 2014, told clients he would invest their money in bonds, real estate or other investments and promised 10% returns, according to the original complaint. Instead, the money went to pay Mr. Meadows' salary, make payments to his spouse, pay credit card bills, travel to Las Vegas for gambling trips and make “numerous payments totaling over $100,000 to adult entertainment establishments,” prosecutors said. He had worked at several independent broker-dealers until 2006, when he left the brokerage industry and started his own registered investment adviser, Meadows Financial Group.


Mr. Cooper left the brokerage industry in 2005 and registered his RIA, Total Wealth Management, the next year. The firm amassed around $100 million in assets over the years, thanks to the popularity of a radio show Mr. Cooper hosted. He was accused of placing most of that money in investments in which he had revenue-sharing agreements that were unknown to investors. At least one of the investments turned out to be a Ponzi scheme and another was in a coffee shop chain that was believed to have been insolvent since its inception, according to the SEC.

Earlier this month, the SEC charged another radio host and adviser, Dawn Bennett, with fraud, saying that she had inflated her firm's assets under management and exaggerated its investment returns. The SEC said that she had claimed to have more than $2 billion in assets, but in reality never managed more than $407 million. Ms. Bennett also allegedly touted the firm as having highly profitable investment returns and said that those returns put the Bennett Group Financial Services in the top 1% of firms in the world, the SEC said. Ms. Bennett left her broker-dealer, Royal Alliance Associates Inc., in 2009 to start her RIA. An administrative law judge will hear her case at a later date.

“We have been vocal publicly and with policymakers that this is one area we see eye-to-eye with our brethren on the brokerage side of the business that advisers need to be examined more frequently,” said Skip Schweiss, managing director of adviser advocacy and industry affairs at TD Ameritrade's RIA custody unit, which has around 5,000 RIA clients. “It's good for consumer protection and investor protection, and good for the industry to instill stronger confidence.”

Mr. Lax, the lawyer representing Mr. Posada and his wife, alleges that their former advisers placed the Posadas in unsuitable investments that cost them nearly $11.2 million. The advisers, Juan Carlos Collar and Anthony Fernandez, are former Merrill Lynch & Co. brokers, who left in 2005 to start their own RIA, Quantum Family.

“They go from Merrill Lynch, which has a compliance system and supervisory system, to an RIA,” Mr. Lax said. “And a lot of what they do is provide services — complete services like a family office — so they manage their taxes and accounts, and pay checks, and if you earn their trust, then the sky is the limit.”

An attorney for Mr. Posada's advisers, Gustavo Lamelas, has denied the Posadas' claims and has filed a motion to dismiss their lawsuit. He has said that the Posadas had requested some of the investments and were a “casualty of the financial crisis.”

“Quantum categorically denies the Posadas' scandalous and unfounded allegations,” Mr. Lamelas wrote in a statement. “[Mr.] Collar and [Mr.] Fernandez at all times diligently worked in good faith to pursue the Posadas' goals and to protect their interests. All investments were disclosed fully and constantly to the Posadas, and expressly authorized by the Posadas, in writing.”


The RIA industry has plenty of defenders who argue that overall the principles-based regulations that apply to RIAs are just as stringent or even tougher than Finra's rule-based system.

Most RIAs are adhering to those standards, and made the move specifically for that reason, executives at custodians and others in the industry say. RIAs who do not follow the rules aren't proof of the trend as much as they are confirmation that bad actors can exist in every industry, they say.

“I don't think it's appropriate to call out RIAs as having committed more bad acts than broker-dealers,” said Mark Tibergien, who heads Pershing's RIA custody unit. “It's a small percentage of the total, and the good news is that regulators are doing a much better job of capturing RIAs and broker-dealer reps who are violating laws. And there are plenty of examples of brokers leaving broker-dealers to go to other broker-dealers.”

Other RIA defenders argue that investment advisers don't actually hold any client funds in custody.

But in most cases, custodians have no obligation to keep watch over all the activities of their RIA clients or to take responsibility if an RIA directs client funds to a private placement. In addition, when things do go downhill, the custodian, unlike a broker-dealer, which is liable for supervision, usually bears no responsibility to repay investors. In cases of smaller RIAs, who do not have insurance, clients usually find it difficult to get their money back, Mr. Lax said.

“Eventually a reputable custodian or clearing firm does kick those guys out when they start to see things going downhill,” Mr. Lax said. “But it's usually too late.”


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