The Great Compliance Witch Hunt!

Things went from bad to worse for Greg Kinkead, a 10-year veteran advisor based in Las Vegas. In 2002, several months after switching wirehouses, Kinkead received five complaints on his previously spotless U4 form. None of the claims specified damages, and they were all denied. He's currently trying to get them expunged. The U4 Kinkead sustained in the wake of his departure are not uncommon. Many

Things went from bad to worse for Greg Kinkead, a 10-year veteran advisor based in Las Vegas. In 2002, several months after switching wirehouses, Kinkead received five complaints on his previously spotless U4 form. None of the claims specified damages, and they were all denied. He's currently trying to get them expunged.

The U4 “dings” Kinkead sustained in the wake of his departure are not uncommon. Many clean brokers jump firms, only to discover their old broker/dealer besmirched their U4s. In a business where client realtionships are at stake, things can get ugly very quickly.

Today, though, the stakes are higher. That's because, in this hypersensitive regulatory environment, the U4 action caused Kinkead's new b/d to start an investigation of its own into Kinkead's (and his partners') advisory business. In the end, his new firm's compliance department did find a violation — transfer forms for one client that were signed but not filled out. Generally, it's an infraction that results in a written reprimand and little else.

That is, before a host of scandals and a certain Martin Act-wielding attorney general from New York came along. Kinkead's new b/d compliance department kept digging. “They were questioning a transfer that had been made in my mother's account. They started looking at our top clients, asking about every aspect of the business. It was,” Kinkead says, “borderline harassment.”

In the spring of this year, Kinkead and one of his partners, Tom Galbraith, had had enough and left to start their own independent advisory, KG Financial Group. “It's become such a horrendous work environment to conduct basic business,” Kinkead says. “These attorneys' jobs are to hang some people in order to show their own bosses or the regulators that they're doing something.”

Kinkead's experience is not uncommon. In the wake of the industry's scandals — which exposed shoddy Wall Street research, accounting shenanigans, illegal fund trading schemes, fund breakpoint failures and questionable mutual fund sales practices — complaints against brokers hit an all-time high of 8,945 in 2003. Through April 2004, 2,988 cases have been filed, which would be just a 4 percent decline from the same period a year ago.

In the spring of 2003, SEC Commissioner Paul Atkins said: “During the past six months, the SEC has engaged in its largest rulemaking period since its inception.” It has only continued to spread: The SEC is in the midst of a complete examination of how funds are sold and how firms and their brokers are compensated. The NASD is currently investigating the appropriateness of fee-based accounts (see story on page 28) and variable annuities sales. Perhaps more worrisome, the NASD has also proposed a rule that would ramp up supervision of reps with three or more complaints on their U4s.

While b/ds have always had supervisory responsibility over reps, the added scrutiny from outside regulators is reaching fever pitch. “It's intense,” says James Gorman, head of Merrill Lynch's global private client group. “It's got us all on our toes.” Reps look over their shoulders at branch managers, who see complex managers, district directors, the legal department, compliance officers and firm CEOs, who, themselves, are cringing in anticipation of the federalés tapping them on the shoulder.

As a result, transgressions that were previously considered insignificant are now treated much more seriously. “Firms are quicker to either discipline or part company with brokers over issues that a couple of years ago might not have resulted in much, or at most, an informal sit-down,” says Donald Davidson, a partner at Bingham McCutchen in New York. “Clearly, it's a much tougher environment.”

A Bull Market in Regulations

Bear markets tend to inspire scrutiny. (The SEC was born out of Congressional investigations into the origins of the 1929 crash, after all.) New York Attorney General Eliot Spitzer's investigations uncovered all kinds of sketchy — and some illegal — practices that could only be hidden by a raging bull market. But the party is over: Name a large financial services company, and it's likely they've paid millions of dollars in fines, from illegal late-trading and malodorous market-timing arrangements to questionable mutual fund sales practices.

Now that the SEC and other regulators have been embarrassed into action, advisors say scrutiny is becoming overbearing. Consider this: Between 1998 and 2002, the NASD filed for 12 rule amendments with the SEC that would alter or enhance some form of regulation of b/ds. In 2003 alone, it filed for an additional 12. Already through the end of May of this year, the self-regulatory body has filed an additional 12 rules. “The rules by themselves are not bad,” says Nancy Lininger, founder of The Consortium, a compliance and marketing consulting firm in Camarillo, Calif. Lininger points to added disclosure requirements related to annuities and mutual fund breakpoints, in particular, as needed. “But the pace is way too fast to comprehend. It's harder for advisors to talk to clients and make investments, and then with the regulatory requirements, run their businesses correctly.”

It's not just individual producers who are affected; firms now have to deal with systemic changes, including new paperwork to handle mutual fund point-of-sale disclosures, business continuity plans, breakpoint disclosures and CEO certification of ongoing reviews of internal compliance procedures. If some in Congress have their way, 12b-1 fees, soft-dollar, revenue-sharing and directed brokerage arrangements will go away, turning the industry on its head.

How are firms coping? They're spending money. Robert Iati, analyst at Tower Group in Needham, Mass., estimated Patriot Act-related spending would amount to $700 million over the next three years. He says compliance spending is about 7 percent to 10 percent of securities firms' budgets now, up from about 5 percent a few years ago, and at some firms, as much as 12 percent to 13 percent. “Compliance spending, as related to the middle and back office, was about $1.5 billion in the U.S. in 2003, nearly a 7 percent increase over the previous year,” Iati says.

Every Breath You Take

But firms are also coping by tightening the screws. For branch managers, the tenor of troubleshooting has changed. Customer complaints delivered orally aren't being solved with a calming phone call anymore.

“It used to be, as a branch manager, I got a call, I'd deal with it and clean it up,” says a manager at one regional firm. “Now, if the rep's shoelace was tied wrong, and it's verbalized to me, I have to write it up and send a response to the client, ‘Yes, we recognize the rep had the wrong shoelace at the meeting.’ I used to be allowed to diffuse things and talk clients off the ledge, but not anymore.”

It could get worse for BOMs. A pending NASD proposal would require enhanced supervision of any rep with three complaints or more on his U4 received within a span of five years. A number of the large b/ds were opposed to this rule, despite the seemingly small number of people this would affect — just 2,751 were subject to three or more complaints or arbitrations.

“There was a tremendous amount of pushback,” says Marc Menchel, executive vice president and general counsel at the NASD. “Some didn't like the way we cut the parameters. Some said we should leave heightened supervision to the firms and not dictate standards, but the current environment doesn't argue in favor of that.”

The “current environment” has made firms skittish to talk about compliance. None of the five wirehouses responded to a request for comment on this issue. Those who did said they wouldn't hire a rep with three or more dings on his U4 anyway. Don Runkle, associate director of compliance at Raymond James Financial Services, says even a rep with one complaint undergoes a review — and the chances are very slim they'd hire someone with three complaints. (Currently, just 3.3 percent of reps have at least one complaint, says the NASD.)

Recent rule changes also make those complaints — even unfounded ones — more difficult to expunge from a broker's record. This deadly combination has made firms more conservative in their hiring practices. This could hurt otherwise honest reps looking to move who received a bunch of complaints as a result of a problem with a particular product.

“You're probably going to put some reps, who are otherwise good reps, in a difficult situation in terms of who is going to hire them,” says Laurie Lennox, director of compliance at Commonwealth Financial, before adding that recruiters for the firm don't show them candidates with “anything of significance,” because “there's no way to defend yourself from a failure to supervise [complaint]. You're on notice from the get-go.”

Then again, the industry's bad eggs have proved that stringent supervisory safeguards are necessary. Remember the case of Lehman Brothers broker Frank Gruttadauria, a superstar who was in fact a clever thief, stealing millions from clients by faking clients' mailing addresses and handling accounts with a portable computer? He wasn't caught until he deliberately gave the game away. And Merrill Lynch took three years to react to two dozen complaints against broker Joel Cessna, finally firing him very recently.

There are now cases in which firms have fired reps over allegations of market-timing abuses — when a lack of supervision, or, in some cases, willful disregard by senior management was to blame. “I think there's enough regulation in place, but I don't think the supervisors are doing their job,” says New York-based attorney Jacob Zamansky, who represents investors. “They're ignoring supervision, particularly for large-producing brokers at the expense of clients.”

According to the NASD, the nature of complaints that have increased most dramatically are those that would indicate systemic abuse: Negligence complaints are up 54 percent from 2001 to 2003; failure to supervise, up 64 percent; and complaints for breach of fiduciary duty have risen 61 percent.

A Proactive Paradigm

Don't expect the government's crack down on sales practices and disclosure issues to slow. In November the NASD began to question the appropriateness of fee-based accounts to certain buy-and-hold clients (see page 28).

Besides the NASD's various ongoing investigations, don't forget about the scope of the Anti-Money Laundering provisions of the Patriot Act. To handle the new responsibilities, larger firms have increased the importance of the chief compliance officer. In the past, that person would have reported to the CFO but now they're becoming increasingly involved with the firms' board of directors and meeting directly with CEOs.

But the very nature of regulation suggests that firms are always going to have to react to what regulators are doing. In that case, look out.

“Over the last couple of years, we have been determined to become much more proactive in getting at impermissible, unwarranted or unethical conduct than before,” the NASD's Menchel says. “There has been a real sea change in the quantity and nature of regulation; I don't think it's going to abate.”

While some b/ds complain of a “bull market” in regulatory action, others see it differently. “We're not even close to overregulating. The history of NASD regulation has always been to err on the side of leniency,” says John Coffee, a professor at Columbia Law School. “For the first time the NASD has become proactive in that it seeks out cases as opposed to just responding to complaints.”

For the individual, it means greater vigilance in protecting one's flank. Kinkead, in addition to rebuilding his business, is also taking the Series 24 exam, the supervisory accreditation, to prepare for any compliance situations. He also plans to bring in an expert who grasps the consequences of the regulations.

“We will absolutely have someone who understands every regulation,” Kinkead says. “My father used to tell me that you knew you were okay if you could look yourself in the mirror and know you're doing a good job. But in this environment, that's not enough.”

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