Talk about paying to play. Three registered investment advisors were accused by the SEC of accepting cash payments from TD Waterhouse in return for putting client assets with Waterhouse.
The SEC announced in late September that it had fined TD Waterhouse $2 million for making “undisclosed cash payments” to three different independent registered investment advisors. The key word here is “cash.” TD Waterhouse allegedly — the firm neither confirms nor denies the allegations, as part of the settlement — paid the advisors various small amounts to make their mutual fund and equity transactions through Waterhouse's brokerage service platforms and house their clients assets with the firm.
“[TD Waterhouse] was aware that the payments created conflicts of interest, but they didn't know they weren't being disclosed,” says Sahil Desai, the SEC's chief enforcement attorney on the case. “We're holding them responsible for the advisors' failure to disclose the information.” The case is unusual because it marks the first time a broker/dealer has been fined for that reason: Not adequately monitoring whether its advisors are adequately disclosing relationships to clients. The difference, says the SEC: The cash.
“It's very unusual for a broker/dealer to be paying cash to get an advisor's business,” says Michael Dicke, deputy assistant district administrator for the SEC. “They recognized this was a dangerous area to be. We think a $2 million penalty sends a message to other broker/dealers that this is a dangerous area to be in, when you're paying cash to advisors.”
For registered investment advisors — professionals who have a fiduciary duty to put their clients' interests ahead of their own — this appears to be a serious breach of conduct. Whether such an incentive be paid in cash or in soft dollars, RIAs are obligated to disclose the arrangement to their clients, says Don Trone, president of the Foundation for Fiduciary Studies. “From a client's perspective, I think they're indifferent to what kind of payment it is,” Trone says. “Whether it's cash, whether it's a new Bloomberg terminal or whether it's a trip to the Bahamas, it has the same impact to clients. It presses on the inherent objectivity they expect.”
Of course, advisors do accept lunches, golf balls and all sorts of small gifts from fund or managed account wholesalers but those gifts must be $100 or less in value. And some asset managers and brokerages have even added to the NASD rules. Says one fund wholesaler, “I'm sure [cash payments] happened in the past. Now, you take a guy to lunch and it gets scrutinized.”
Dicke emphasized — while still pointing out that TD Waterhouse has “changed its policy” and is no longer allowing hard-dollar payments — that the issue was one of improper disclosure, not one of improper cash payments. But if that's the case, does a firm like, say, Edward Jones, now have to monitor every one of its advisors to make certain all payments are disclosed, or risk a hefty fine of their own?
No, says Mercer Bullard, securities law professor at University of Mississippi and president of Fund Democracy, a mutual fund customer advocacy group. Bullard says the disconnect comes from the notion of “disclosure.” “This is a blatant kickback we're talking about here, pure and simple,” Bullard says. “The SEC's current style of enforcement is to look for the disclosure violation as the easy prey so they can avoid the substantive question of whether this is legal.” In other words, it's the equivalent of busting Al Capone for tax evasion because it's easier to prosecute than actual bootlegging. Or, as Bullard puts it, “The SEC would say that if you went into someone's home and put a gun to their head and robbed them, you would be nailed for properly disclosing that you would rob them — not for actually robbing them.”
Bullard points out the large fine Waterhouse paid despite amounts that totaled less than $100,000 as proof that the violation was just not one of disclosure. Dicke says, “We don't enforce the NASD rules, but there are rules there; I am not personally an expert on them.”
The question then: Is “disclosure” becoming a buzzword catch-all for any regulatory intervention? What is illegal or improper, and what isn't? Are regulators taking shortcuts?
The case revolves around three independent broker/dealers: Kiely Financial Services in Greenville, N.C.; Rudney Associates in San Ramon, Calif.; and Brandt Kelly & Simmons in Southfield, Mich. (None of the firms returned calls for comment at press time.) The firms ranged from $95 million assets under management to $171 million, but the payments in question were no larger than $50,000. Two of the firms, Kiely and Rudney, have settled their cases, agreeing to pay back the money they received in interest and doling out “civil penalties” of $100,000 and $40,000, respectively. Brandt, according to legislators, “is being pursued in litigation”; the firm's principal, Kenneth Brandt, is accused of taking $7,500 from Waterhouse, which had been specifically earmarked to compensate clients for accrued fees for moving to Waterhouse, and pocketing it.
“We don't want the message of the case to be that broker/dealers have to police their investment advisors every day,” Dicke says. “The principle is that if you're a broker/dealer dealing with an investment advisor, if you get involved in a situation where it becomes clear to you that the advisors might be violating the law, then you have some sort of duty. To them, to yourselves and to the law.”