Due Diligence

Retired Janitor? Set An RIA Up!

As of last week, Wesley Snipes, Annie Liebovitz and Uma Thurman can be added to the long list of very wealthy people who have been duped by someone who is, legally, considered a fiduciary. Manhattan-based financial advisor Kenneth Ira Starr stole money from all three celebrities and many others for his own personal use in yet another Ponzi scheme, according to SEC charges. His RIA firm, Starr Investment Advisor, has been registered in New York and California since 2006, according to its form ADV. He had $1.2 billion in assets in 35 accounts.

The Starr case serves as a reminder that, while the fiduciary standard is a very valuable legal standard for financial advisors, it’s way too easy to violate—and it’s way too easy to become a fiduciary in the first place. This does not mean that applying the fiduciary standard to all financial advisors, including registered reps., is a bad idea, just that it’s not enough, on its own, to stop crooks. It’s especially pertinent today, as Washington hotly debates financial regulatory reform, with Congress attempting to reconcile distinct House and Senate bills before the July 4th recess. Extending the fiduciary standard to stockbrokers who provide retail financial advice is on the table, as is giving the SEC a lighter load of RIA oversight—raising the asset threshold for SEC versus state regulation to $100 million from $25 million.

“It would blow the American public‘s mind if they knew just how easy it is to become a Registered Investment Advisor,” says Zachary D. Gronich, CEO of RIA in a Box, an RIA consulting firm. “Right now, with $40, we could create an SEC-registered firm, claiming to have a half a trillion in assets, get approval, with a hedge fund attached, and it could hang out for a long time before the SEC caught up to you. They don’t even check out whether you have the assets you say you do until they come out and do an audit.” In fact, Bernie Madoff lied about his assets under management, among many other things. A lot of those “assets” he claimed to be managing had been passed on to other investors as returns or funneled into his own private accounts.

Even SEC officials admit it’s pretty easy to become an RIA. “Primary compliance is not on the front end of the commission,” says Bob Plaze, Associate Director for Regulation of the Division of Investment Management for the SEC. “Primary compliance is in the examination.” But RIA firms can evade examination for a decade or more, as the SEC only audits about 9 percent of the 11,000 RIAs in its purview every year. There is no fixed examination cycle. It’s risk-based, says Plaze, with the SEC determining when to audit firms according to disclosures on their forms ADV and prior examinations.

To set up an RIA, principals must pass the series 65 examination, which is administered by the states and has an 85 percent pass rate, and file a form ADV. ADV Part I discloses the number of employees you have, how you charge clients for your services, your assets under management, and then there are some disclosure questions about your past record and business affiliation and activities, as well as name, address, phone number and website address. But this information is barely verified, and the SEC only really checks out your record if you disclose that you have disciplinary events. If you don’t, no flags are raised and they don’t check. If you are registered in certain states, like New York, Minnesota and Wyoming, you do not even have to file a U4 for yourself, or any of your representatives.

“If you are representatives of an SEC-registered firm, in the state of New York, there is no registration mechanism for individuals, and therefore no requirements of any kind,” says Gronich. “There is no exam, no work experience requirement, no age requirement, no background check, no preliminary have-you-ever-stolen-money-and-been-caught requirement. They can give investment advice without having any securities license or registration.”

RIAs must also file a notice filing for applicable states, which lets that state know that you will be doing business there (typically, because you either have an office in the state, or have at least six clients in the state).

Raising the SEC oversight threshold to $100 million will help—for those RIAs with more than $100 million in assets, says Plaze. But not necessarily for those with $25 million to $100 million in assets. About 4,000 RIAs fall into this category, and will migrate to state securities regulation. It’s not clear how the states will deal with the increased oversight burden—most of them are strapped for resources as it is.

Maybe regulators should raise the bar for RIA registration, requiring passage of the rigorous CFP exam. But Plaze says that would shut out the little guys who serve middle-class investors. “How do you create an examination that is meaningful for the sophisticated guy, and the guy with 30 to 40 clients, who’s just helping them allocate their assets? There are philosophical issues here.”

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