One Bad Apple

Posted by Bill Prewitt, M.S., CFP® on 1 July 2009 | 0 Comments

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Investment Advisors managing over $25 million are subject to regulation by the Securities and Exchange Commission (SEC).  The general public has long relied on SEC oversight as an indication that regulated advisors are probably okay to invest with.  For its part, the SEC does not issue any such approval since they are acting as regulators.  Regulated advisors are required to make disclosures about how they operate, and bring to light any potential conflicts of interest that may exist in their advisory relationship.


The past year has undermined this sense of confidence.  The market meltdown exposed several investment advisors who were not operating in the best interests of their clients.  The most flagrant example was the Bernard Madoff affair.  It was a Ponzi scheme of vast proportions, creating an estimated loss of $50 billion.  The hoax was perpetuated for years by producing phony client statements.  Seemingly stable returns attracted more money, which was used to provide yet more “stable returns”.  Even after inspecting Madoff’s firm over a two-year period, the SEC was unable to connect the dots prior to the market meltdown.  Once the firm collapsed, the SEC came under a firestorm of scorn from both Congress and the public.  Right now the SEC is in a crisis management mode, but far reaching changes are underway that will impact financial advisors for many years to come. 


The Investment Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 are currently are the ruling legislation for investment advisors.  These Acts were a reaction to elements that caused the market crash of 1929, which led to the Great Depression.  It is likely that there will be future legislation matching the scope of the 1934 & 1940 Acts. 


The SEC makes field visits to advisors to make sure they are doing what they say they are doing on their disclosure documents (ADV 2 is a publicly available document that should be offered to the investor: if can also be found at then click on Investment Adviser Public Disclosure (IAPD) website which appears lower in the text).  They have announced that examination priorities are changing to detect significant infractions sooner, and focus on the procedures firms have in place to prevent such actions from occurring in the future.  Specifically, they are focusing in the areas of: portfolio management, safeguarding funds and securities, protecting non-public information, dually registered firms, ensuring adequate supervision, substantiating performance claims, and protecting senior investors. 


In light of recent events, there are several follow-up actions that the SEC has taken to restore confidence in the system.  There will be changes in examination frequency, with increased focus on identifying unregistered advisors and funds and unregulated products.  Firms will be targeted for examinations to verify the existence of client assets.  To this end, clients may be contacted directly by the SEC by mail (not by Internet) to request verification of assets reported by advisors and custodians.  They do not wish to unduly alarm clients or undermine the advisory firms; clients will be requested to cooperate so the SEC can verify that amounts being reported by advisors do exist. 

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