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Naughty Or Not: SEC to Contact Your Clients

Naughty Or Not: SEC to Contact Your Clients

In an effort to catch future Madoffs before they strike, the SEC would like to ask your clients a few questions. Over-the-top government meddling or simply a good idea?

The SEC recently let it be known that in order to prevent would-be fraudsters like Madoff, it would be expanding the list of people and entities from which it gets its information. Key to the SEC's new strategy? The investment advisor's most important asset: his clients.

The meticulousness of Bernard Madoff's fraud exposed the weaknesses of relying on investment advisors and their custodians to verify assets. Madoff acted as the custodian but he — probably with the help of others — forged client statements, creating bogus transaction “dupes” and statements. And he got away with it for nearly two decades. Therefore, in a March 9 letter to various industry organizations, the SEC announced it was widening its examination net. “In recent months, the Commission's examination staff has determined that, in order to perform a valid verification of assets, the staff must request independent confirmation of investor assets from various third-parties.”

As part of its routine examination process going forward, the SEC will be asking a sampling of clients of the investment advisors it is examining to confirm account balances as well as if contributions and withdrawals from a given period of time are correct and were authorized, according to the SEC's letter. The news has angered many advisors and other industry participants who argue that not only would that be an unwarranted intrusion, but that it will cause many clients to panic and further taint the profession and its participants' image post-Madoff.

Hello Mr. Jones, This Is The SEC

Gene Gohlke, associated director of the SEC's Office of Compliance Inspections and Examinations (OCIE), and the author of the March 9 letter, says checking custodian statements against advisor statements to see if the two match up doesn't cut it anymore. In fact, it never did, as the Madoff scam showed. Gohlke explains: “If clients are adding money to their accounts but the advisor is skimming off some portion of that as it comes in and passing the rest to the custodian, the custodian won't know,” says Gohlke. And if the advisor then forges custodian statements, the client won't know either. “Without the client/custodian two-way confirmation, we won't catch that,” he says.

Others regard contacting advisory clients as akin to police randomly selecting a house to enter and searching it — without a warrant or suspicion of criminal behavior. Garry Clemmons, owner and senior portfolio manager for Texas Capital Management, an RIA in Baytown, TX, recently spoke at the Investment Advisor Association's compliance conference in Washington, D.C., about business continuity planning — he lost his physical office to Hurricane Katrina — but he says the SEC's new plan to contact clients dominated advisor thoughts and conversations. “I don't believe it's the place of the SEC or FINRA to call clients if there's no reasonable reason,” says Clemmons. “If they suspect something, that's different. But don't come into my house and shuffle through to see if there's something there.”

Attorneys who spoke with Registered Rep. have mixed feelings about the SEC's new examination procedures. Harry Weiss, a partner with WilmerHale, a law firm in Washington, D.C., who also spoke at the IAA Conference, thinks it's “an easy step” for the SEC to improve its effectiveness. But he sympathizes with advisors like Clemmons. “I think the SEC has an obligation to contact clients in such a way that it doesn't disturb the relationship between client and advisor,” Weiss says.

Gohlke says the SEC is well aware of the fear that a poorly worded letter — and it will be a letter, at least at first — could have on clients. The SEC has suggested that advisors prepare clients for potential contact by including its March 9 letter in client communications, or some other disclosure, explaining the “routine” nature of SEC examinations. Karen Barr, the IAA's General Counsel, would like the SEC to do investment advisors a favor by postinga notice on its own website so clients can verify it from an official source. According to Weiss, some advisors have suggested the SEC allow advisors to warn clients when the SEC will be contacting them so that they can reassure them. But Weiss thinks that could create more problems for the advisor. “There's a worry that later on the advisor could be seen as trying to influence the outcome of the examination,” he says.

Stephanie Monaco, a partner with Mayer Brown in Washington, D.C., says she trusts the SEC will do its best to be sensitive, and she also understands the difficult balance the regulator is trying to maintain — ensuring investor protection while not harming the client/investment advisor relationship. But Monaco reckons human nature is what it is and, therefore, clients will be alarmed no matter what. Not only because the SEC is investigating their advisor, but because they're being contacted by the Feds, period. “It's not a reach to imagine a client thinking, ‘What if they contact the IRS?’” says Monaco. As a result, she expects a “high degree of unresponsiveness” from queried clients — a guess that the SEC's Gohlke concedes is “very probable.”

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