How to Prevent Investment Adviser Fraud

Disclosure is key to avoiding accusations.

SECTION 206 OF THE INVESTMENT ADVISERS ACT OF 1940 provides guidelines for investment advisers on what constitutes fraud.

THE SUPREME COURT HAS HELD THAT THE ACT imposes a fiduciary duty on investment advisers to act in the best interest of their clients by fully disclosing all potential conflicts of interest.

INVESTMENT ADVISERS SHOULD REVIEW CAREFULLY SEC and other disclosure requirements to ensure they clearly understand potential conflicts.

INVESTMENT ADVISERS SHOULD REVIEW ALL SEC FILINGS, client marketing materials and other significant documents to ensure that they have appropriately disclosed all potential conflicts.

Brian Carroll, CPA, is special counsel with the SEC in Philadelphia and an adjunct professor at Rutgers University School of Law, Camden, N.J.

The U.S. Securities and Exchange Commission disclaims responsibility for any private publication or statement of any commission employee or commissioner. This article expresses the author’s views and does not necessarily reflect those of the commission, the commissioners or other members of the staff.

raud is still in the headlines and on the minds of investors. Over the past few years, investors have grown discouraged with accounts of fraud occurring in trusted sectors of American business, including the financial services industry. Except for large investment advisers implicated in the mutual fund trading scandals (see “ The Mutual Fund Trading Scandals, JofA , Dec.04, page 32), the investment adviser profession has thus far avoided accusations of widespread fraudulent practices and the legislative scrutiny that ensues. This record, however, provides little comfort to an investment adviser firm when the SEC or a state agency starts a fraud investigation or files a fraud enforcement action. This article seeks to explain briefly the current legal framework defining fraudulent conduct and what an investment adviser firm can do to avoid accusations of fraud. In particular, it describes how an adviser may commit fraud by failing to disclose adequately potential conflicts of interests with clients, as opposed to affirmative misrepresentations to clients.

Above all else, investment adviser services are based on trust between the adviser and its clients. An adviser cannot survive without this trust, and nothing jeopardizes it more quickly than government accusations of fraud. Putting aside the enormous financial cost of defending against fraud accusations and the possibility of paying a civil money penalty in a negotiated settlement, fraud investigations test personal and professional reputations, client relations and the ability to generate professional referrals. Given these risk factors, it pays for every investment adviser to understand what constitutes fraud under the Investment Advisers Act of 1940. Stepping too close to the line, even inadvertently, can be very costly.

In the Client’s Best Interest

“Fundamental to the Advisers Act is an adviser’s fiduciary obligation to act in the best interest of its clients and to place its clients’ interest before its own.”

Source: Letter from the SEC’s Office of Compliance Inspections and Examinations to registered investment advisers, 2000.

The Investment Adviser Act of 1940 is the primary federal legislative authority governing SEC-registered investment advisers. It was enacted to eliminate unethical and fraudulent adviser business practices that contributed to the stock market crash of 1929. Certain provisions of the act apply to all investment advisers, regardless of whether they are required to register with the SEC (see “ SEC Jurisdiction Over Investment Advice, JofA , Aug.01, page 32). Of these provisions, two antifraud subsections of section 206 of the act stand out. These subsections say that it is unlawful for an investment adviser using interstate commerce (U.S. mail or other instrument) to employ any device, scheme or artifice to defraud any client or prospective client; or to engage in any transaction, practice or course of business that “operates as a fraud or deceit upon any client or prospective client.”

Although remarkably broad, neither subsection is self-explanatory. For example, both use the word any to describe the means for acting fraudulently or deceitfully (device, scheme, artifice, transaction, practice or course of business), though not one of these means is defined. Nonetheless, common sense dictates that the intent was to proscribe certain categories of conduct, such as intentionally making material misstatements about the firm’s investment performance return to lure clients, receiving a bribe to tout a clearly worthless stock, intentionally overcharging clients or stealing client assets. This type of traditionally fraudulent conduct, where a fiduciary affirmatively acts against the interest of its client, falls within a plain reading of the provisions. On the other hand, the complete story is not so obvious from an initial reading, and judicial interpretations of the provisions have clarified their reach.

The Fraud of Incompetence
By Clark Blackman II

T he CPA profession has a long history of dedication to the public interest and a belief that the profession’s members should embrace the basic principles of honesty, integrity, objectivity, competency and, perhaps most important, putting the public’s interest ahead of their own.

As an investment adviser who has maintained a CPA designation primarily for the pride and prestige associated with being a member of an elite group of “bean counters,” I believe nothing is more important than that we CPAs not lose sight of what has brought us here: the awesome responsibility of helping our clients with a level of independence, objectivity, competence and caring that goes beyond that which is expected.

Investment adviser fraud has two causes. The obvious one is greed. The more worrisome one within our profession is ignorance. In truth, greed is everywhere and dishonest professionals are a risk in every profession. But it is the insidious nature of incompetence that our profession needs to guard against most.

Every member of the AICPA swears to abide by an oath of professional conduct that includes “competency.” Today the greatest risk to the long-term viability of the CPA’s standing as “most trusted” adviser is the investment adviser who doesn’t have a complete and thorough understanding of the 27 basic practices required of any fiduciary providing investment advice (see “ Resources ”).

Make no mistake, you will be deemed a fiduciary in most instances where you hold out to be a CPA, regardless of how you are compensated.

CLARK BLACKMAN II, CPA/PFS, CFA, CIMA, is managing director and chief investment officer for Investec Advisory Group, LP, Houston. His e-mail address is .

Although both provisions were written to cover a wide variety of facts and circumstances, the Supreme Court’s decision in SEC v. Capital Gains Research Bureau, Inc. established an expansive legal framework for defining them. Consistent with Congress’s purpose in passing the act, the Court first determined that the investment adviser serves as a fiduciary to its clients, though the term never appears in the act. Under this fiduciary duty, an investment adviser was held to have “an affirmative duty of utmost good faith and full and fair disclosure of all material facts.” The Court went on to note that in enacting these provisions Congress intended to “eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which was not disinterested.” Consequently, the Court viewed the act as “directed not only at dishonor, but also conduct that tempts dishonor.”

Within this framework, the Court held that the “fraud or deceit” language of section 206(2) should not be interpreted narrowly or technically. Instead it should be construed broadly and remedially to cover instances where an adviser failed to disclose to the client all material facts, including an adviser’s conflicts of interest with its client.

For example, the Court held that the investment adviser violated this duty by “scalping.” This occurred when the adviser bought a security that it eventually recommended to clients, then bought the same security for clients (thereby driving up the price), and finally sold its shares at a profit. In doing so, the adviser had failed to disclose to its clients all the material facts surrounding this investment recommendation—namely, the adviser’s conflict of interest when it recommended a stock not as a disinterested adviser, but as part a scheme to profit personally.

The Court also made it clear that under section 206(2) the SEC may charge a violation even though it did not establish that a client was actually injured as a result of the failure to disclose, nor that the adviser intended to injure the client. In light of this interpretation an adviser’s failure to disclose material facts, including material conflicts of interest with its clients, could constitute a violation.

Not surprisingly, other courts have followed this lead by holding that an adviser may violate the act through either a material misrepresentation or an omission. In essence, an adviser must take reasonable care to avoid misleading clients by disclosing material conflicts of interests to its clients and prospective clients.

By taking this “conflicts-disclosure” approach, the Court effectively clarified the plain meaning of section 206. But because of its ambiguity, the approach has proven troublesome for investment advisers. Without an explicit statutory reference, an unaware investment adviser can easily stumble into trouble by failing to understand its duty to disclose material conflicts. Indeed, in light of the Court’s interpretation, the watchword is disclosure , and more disclosure.

Typically, in determining whether a violation of the Investment Adviser Act has occurred, the SEC staff reviews what the adviser has disclosed to its clients and what should have been disclosed. In addition to considering whether all facts related to the conflict were disclosed adequately, the SEC staff also weighs other factors when deciding whether to refer the matter for investigation. (See “ Factors Influencing Referral to Division of Enforcement, ” below).

Factors Influencing Referral to Division of Enforcement

M any SEC enforcement investigations start when the agency staff finds suspicious conduct during an examination of an investment adviser (see “ When the SEC Knocks, JofA , Aug.02, page 35). The examination staff may refer its findings to the SEC’s Division of Enforcement for investigation to determine whether the adviser violated section 206 of the act or another federal securities statute. Here are the questions the SEC considers:

Does it appear that fraud has occurred?

Were investors harmed?

If the conduct does not include fraud, is it serious (ongoing, repetitive, systemic or severe)?

Did the adviser apprise the SEC of the conduct and take meaningful corrective action?

Is the conduct of a type or degree that is most appropriate for the SEC, rather than another government regulator, to handle?

Is the activity in a particular area that the SEC wants to emphasize, such as emerging types of wrongdoing?

Did the adviser profit from the conduct?

Did the adviser appear to act intentionally?

Is the conduct recidivist in nature?

Were the firm’s supervisory procedures inadequate?

Source: “Financial Services Institute: First Annual Public Policy Day,” a speech by Lori Richards, director, SEC Office of Compliance Inspections and Examinations, October 13, 2004.

To make this decision, the SEC staff relies in part on one of the most important disclosure vehicles: the adviser’s Form ADV. Part I of Form ADV must be filed with the SEC and Part II provided to clients at the start of every adviser-client relationship. Form ADV requires the adviser to explain fundamental aspects of it operation, such as its affiliated businesses, client referral arrangements, brokerage arrangements, adviser fees and billing, trade allocation policies, whether it receives any economic benefit from a nonclient source, professional qualifications, investment strategy and the like. Along with other disclosure documents, such as marketing and advertising materials and the investment advisory services contract, Form ADV creates a disclosure benchmark against which the adviser’s actual conduct is compared to determine the adequacy of the disclosures.

Trouble often starts when the adviser says one thing in its Form ADV but then deviates substantially from this disclosed practice by engaging in conduct that benefits the adviser or some preferred client. For example, the SEC has initiated fraud charges against advisers based on their undisclosed security trading practices. It is not uncommon for an adviser to disclose to clients that its securities purchases or sales for clients will generally be executed in a single block trade at a uniform price and allocated equally among clients participating in the trade on a pro rata basis. Depending on market conditions, however, the adviser may not be in a position to purchase the same security for all clients at the same price. Instead, it may have to purchase the security over several days at different prices. According to the adviser’s disclosures, each client should receive a pro rata allocation of the security purchased at the various prices. But seeing an opportunity to favor certain clients, the adviser may allocate all of the more favorably priced shares to clients with a history of referring other clients or with more assets under management. In so doing, the adviser has violated its fiduciary duty by failing to disclose adequately the facts surrounding this conflict of interest. (For another example, see “ A Case of Fraud. ”)

A Case of Fraud

I n a recent enforcement action, the SEC alleged that an investment adviser had failed to disclose adequately its brokerage arrangement with a broker-dealer in violation of section 206 of the Investment Adviser Act.

The adviser informally arranged for registered representatives of broker-dealer firms to refer clients to it. In return, the adviser placed the securities trades of those clients with the referring representatives. The commission rate charged by these referring representatives was more than three times the rate charged by nonreferring brokers. The adviser failed to disclose to its clients this potential conflict of interest, and the fact that less-expensive brokerage arrangements were available and were used for nonreferred clients. Without admitting or denying the charges, the adviser consented to an SEC enforcement action alleging, among other things, a violation of section 206(2). (For more examples of alleged violations of section 206, go to , click on Litigation Release s and enter investment adviser fraud in the search field.)

Although the Supreme Court’s “conflict-disclosure” approach creates some ambiguity, it also clarifies the importance of a keystone concept of good investment adviser management: disclosure. In order to reduce the risk of an SEC investigation, advisers should take to heart their fiduciary duty, as interpreted by the Supreme Court, by not only meeting their disclosure obligations but scrupulously abiding by their disclosed practices.

The very nature of this approach places the uninformed in a precarious position, regardless of motive. Advice by qualified counsel to comply with this nuanced area of the law can be very helpful and is recommended. The ultimate responsibility for full disclosure, however, falls on the adviser.

AICPA Resources

AICPA Code of Professional Conduct, .

AICPA Personal Financial Planning Center, .

AICPA Professional Ethics Division, .

Other Resources

The New Fiduciary Standard—The 27 Prudent Investment Practices for Financial Advisers, Trustees, and Plan Sponsors by Tim Hatton, Bloomberg Press, , 2005.

Prudent Investment Practices—A Handbook for Investment Fiduciaries, Center for Fiduciary Studies, , 2003.


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