SEC Settlement Proves That It’s Easy Enough For An IA To Get In Trouble Just For Doing Nothing

Ulmer & Berne LLP
Contact

My job frequently requires that I explain to someone – whether my client, an ALJ, an arbitration panel, even a regulator – the fundamental difference between a broker-dealer and an investment advisor.  An IA operates pursuant to a fiduciary duty; a BD, on the other hand, even with the advent of Regulation BI, largely has transactional duties.  That is, a BD’s duty to its customers largely manifests itself if and when it deigns to make a recommendation.  It could be a recommendation to buy or sell (or hold) a security, but it could also be a recommendation regarding the nature of the relationship the customer undertakes with the BD, i.e., a commission account vs. a fee-based account.  In the absence of a recommendation, however, it is difficult to pin responsibilities on a BD.

Not true for IAs.  As fiduciaries, IAs are legally compelled to do things that BDs aren’t.  For instance, ongoing monitoring of accounts.  Once a BD makes a recommendation to a customer, in a commission-based account, the BD is pretty much off the hook for any subsequent developments that may impact the success or failure of that trade.  (There are certain notorious exceptions, like after a BD makes a recommendation to a customer to invest in a private offering of securities; there, BDs are required to conduct ongoing diligence to ensure that the issuer actually uses the proceeds in a manner that’s consistent with representations made in the offering materials.)  Not so for IAs.  IAs, in theory, have to constantly monitor the position, the account overall, the markets, to ensure that no further changes need to be made (or at least recommended to the customer).

Recently, Michigan-based IA Regal Investment Advisors LLC learned the hard way that an IA does not fulfill its fiduciary obligation by putting advisory accounts on cruise control, paying them no attention while the financial world continues to turn.  And what’s worse than ignoring advisory accounts?  Charging such accounts an advisory fee for the privilege of being ignored!

Well, that’s exactly what happened to Regal, according to this settlement with the SEC.  The case involved so-called “orphan accounts,” i.e., advisory accounts left behind when the IARR who had been responsible for the accounts leaves the firm.

For reasons that remain unexplained, until November 2019, Regal had no written policy or procedure that addressed what happened when an IARR left Regal, but his/her client accounts remained at Regal.  Instead, Regal relied on “an informal procedure” that designated those orphan accounts as “house accounts” and assigned them to the firm’s three owners, two of whom “would share responsibility for managing these accounts” and split the IARRs’ share of the advisory fees paid by the customers.

But, between July 2015 and April 2021, while Regal classified approximately 250 such accounts as house accounts, which paid both advisory fees – i.e., a fee for “account management services” – and portfolio management fees – i.e., for “selection of securities in the account,” about 81 of those accounts received no advisory services.  That is, they “continued to receive portfolio management services, but failed to receive regular account monitoring by [the two owners] to determine whether the selected portfolio remained consistent with clients’ investment objectives and goals.”  Consistent with that, Regal didn’t even bother, in many instances, to inform the customers that their IARR had left, or that someone else had been assigned to their account.  As an example, the SEC cites one customer in particular whose IARR left Regal in 2014 to work with a different firm, resulting in his account being classified as a house account.  Despite the customer paying over $7,600 in advisory fees to Regal from then until 2017 when he closed his account, “[n]o one at Regal provided [him] with advisory services during this period[,] . . . no one from Regal ever contacted [him] after the departure of [his] IAR, and there is no indication anyone at Regal monitored or conducted periodic reviews of [his] account.”

Everyone knows that BDs, too, can get in trouble for seemingly doing nothing.  There are any number of “reverse churning” cases, where a BD puts a customer in a fee-based account – an account that can be cheaper for clients who trade a lot – yet the customer doesn’t make many (or any) trades (meaning that the customer would have paid less if the account had been set up as a commission account).  Indeed, I have blogged about such cases before here and here.  But, it is a bit misleading to suggest that it was the absence of trades that triggered these cases.  In fact, these cases did not arise as a result of the fact that a BD failed to make enough trades in a fee-based account to justify charging a fee; rather, they stemmed from the BD’s threshold recommendation – the unsuitable recommendation – to the customer to open a fee-based account.  In other words, the BD did not, in fact, get in regulatory hot water for doing nothing, but, rather, for doing something – making a recommendation – wrong.

Putting aside this reverse-churning issue, I stick with what I said earlier: generally speaking, a BD doesn’t really have to do anything with an existing customer account if it doesn’t want to.  (Granted, it might not make any money – buy and hold strategies don’t generate new commissions, after all – so it’s not necessarily a great business model.)  But IAs don’t have that luxury.  Frankly, it is the constant monitoring, and the potential adjustments that monitoring mandates, that justifies the advisory fee in the first place.  Absent that monitoring, I’m not really sure what advisory clients are buying.

This case also serves as a good reminder that orphan accounts are still accounts.  A house account doesn’t mean they get moved to the attic, or the basement, or the garage.  These customers are entitled to the same attention, the same energies, as any other account.  It is not their fault their IARR left them behind.

Look, most cases don’t present the layup that Regal handed to the SEC here.  Most cases in this area don’t provide the SEC with such an easy means to establish liability, given that Regal literally had nothing to show the SEC.  But, just because an IA does something more than “nothing,” it still doesn’t necessarily mean that it is meeting its fiduciary responsibility to its customers, or that it will be enough to avoid an awkward moment with a regulator.  That’s why here, my advice to my clients sounds the same as it does in many other circumstances:  when you do something, document it!  If you do an account review, put it writing, for heaven’s sake.  If you call an advisory client to discuss his/her account, create a memo of the call.  Create a document trail.  Always act as if two years from now, you may be called upon to prove to some stranger exactly what you did and said and when you did it, and, in many instances, to do so without any assistance from your customer, who despite having sat next to you during that account review, manages not to recall that it happened.  This is true for BDs, for IAs, for RRs, and IARRs.  I hate to sound so cynical, but, after all, history teaches.

Written by:

Ulmer & Berne LLP
Contact
more
less

Ulmer & Berne LLP on:

Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
- hide
- hide

This website uses cookies to improve user experience, track anonymous site usage, store authorization tokens and permit sharing on social media networks. By continuing to browse this website you accept the use of cookies. Click here to read more about how we use cookies.