On Advice

Is David Lerner still chomping on the proprietary product apple?

Firm once fined by Finra over nontraded REIT transactions is still pushing its own series of mutual funds

May 31, 2018 @ 11:50 am

By Bruce Kelly

Brokerage firms that sell lucrative proprietary products, such as mutual funds built and managed by company executives, face an inherent conflict of interest. It's a story that's as old as investing.

When a registered rep sells a client such a fund, the same question always comes up: Was the rep offering the stock or bond fund that best fit the customer's objectives, or did he sell it because the firm's management told him to move some product and generate some commission dollars?

Unfortunately, the brokerage industry allows registered reps, many of whom call themselves financial advisers, to sell products made and distributed by the house. Independent broker-dealers tout the fact that their reps don't sell proprietary products, but Wall Street banks have plenty of incentives for brokers to market and sell loans and lending products from mortgages to credit cards to their clients.

Polite company on Wall Street terms that brand of product pushing cross-selling.

The Department of Labor's fiduciary rule would have required firms to eliminate such conflicts in clients' retirement accounts. But an aggressive, pro-business Republican administration has been slashing regulations across industries, and the DOL fiduciary rule is all but dead.

A couple of weeks ago, this column focused on Waddell & Reed Financial Advisors, which looks like a relic because its business model relies on its brokers and advisers selling the parent company's proprietary, actively managed mutual funds.

Senior management has stressed that Waddell & Reed is moving forward with changing the broker-dealer to a more competitive model. That's industry jive for selling fewer in-house funds.

Another broker-dealer with a reputation for biting, or perhaps chomping from, the proprietary product apple is David Lerner Associates, a midsize Long Island firm with 138 brokers, six branches and $5.3 billion in client assets, which is well-known locally for radio ads that asked prospective investors to "Take a tip from Poppy," referring to Mr. Lerner, the firm's founder and chief executive.

A decade ago, David Lerner Associates was a proprietary product pushers' delight. It traded and sold municipal bonds, offered an exclusive line of nontraded real estate investment trusts called the Apple REITs, and also offered proprietary mutual funds under the Spirit of America brand.

That strategy didn't work out so well for the firm. In 2012, the Financial Industry Regulatory Authority Inc. ordered it to pay more than $3.7 million in fines and restitution for overcharging retail customers on sales of more than 1,500 municipal bonds and 1,700 collateralized mortgage obligation transactions.

Later that year, Finra ordered the David Lerner Associates to pay $12 million in restitution to clients who had purchased shares of a nontraded REIT called Apple REIT 10. Finra also fined Lerner more than $2.3 million for charging unfair prices on municipal bonds and CMOs.

Adding to the general ugliness, CEO David Lerner was fined $250,000 and suspended from the securities industry for one year, followed by a two-year suspension from acting as a firm's principal.

Six years ago, Finra focused on inadequate due diligence at the firm when it sold an Apple REIT and didn't bang on Lerner for the fees it charged for nontraded REITs, a notorious high-fee product.

A glance at David Lerner's website shows that the firm is no longer pushing illiquid REITs. But it looks as if it is still hawking muni bonds, claiming that the firm maintains its own "in-house Trading Department staffed by municipal bond specialists," and proprietary products, including six Spirit of America mutual funds.

And the mutual funds, which invest in a variety of sectors from energy to real estate, ain't cheap, according to fund tracker Morningstar Inc. It rates four of the six as having "high" fees, one as having "above average" fees, and the last "average" fees. And the funds are little better than mediocre in their collective performance, with the six averaging a little more than two-and-a-half stars out of the five stars possible under Morningstar's rating system.

High fees and mediocre performance? Sounds like a dream of a proprietary mutual fund for a broker to sell.

David Lerner Associates insists it has changed its ways. In a statement to InvestmentNews, the firm said that sales of proprietary products had declined to 38% of revenue for the 12 months ending in April, from an astounding 92% in calendar year 2011. That's a decline of 59%.

"To further enhance services for customers, David Lerner Associates has also dedicated substantial resources to enhance its technology, training, and staffing to ensure that the company continues to conduct business in a manner designed to comply with all applicable laws, rules and regulations," the company said.

Meanwhile, a David Lerner executive said the firm no longer trades bonds in-house. It has outsourced trading to a clearing firm and will update its website to reflect those changes, he said.

Sales of proprietary products, while "not necessarily bad," are "down dramatically," said the executive, who asked that his name not be used for this column. He added that the firm's mutual fund fees were in line with industry averages and approved by each fund's board, and the front-end loads on illiquid investment like energy private placements have also been cut.

The firm obviously has recognized that it needs to change to remain in the brokerage business. But change is hard, particularly if commissions are cut, thus making an impact on how brokers earn their living.

David Lerner Associates would be better off in the long run dumping proprietary products. Who needs the conflicts?

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