United States: Regulators Discuss the "Hot Topics" for 2007 at Fall New York Compliance Seminar

Originally published November 2006

On November 13, 2006, the Securities Industry and Financial Markets Association Compliance & Legal Division hosted its Fall Compliance Seminar in New York City. During the course of the day, and across a variety of panel sessions, regulators from the SEC, SROs and the states repeatedly touched upon several issues that may form the central areas of inquiry in 2007. These "hot topics" include 1) hedge funds; 2) retirement accounts and elderly investors; and 3) the relationship between fee-based and investment advisory accounts.

According to Linda Thomsen, SEC Director of Enforcement, the Commission tends to "follow the money" in its investigations, and in the current market environment, that money is going into hedge funds. Joseph Borg, Director of the Alabama Securities Commission and current president of the North American Securities Administrators Association ("NASAA"), noted that there has been a proliferation of hedge funds over the past few years, which has led to increased "retailization" of hedge funds. The amounts required for investment have been pushed lower and lower to a $50,000 minimum in order to reach what Borg describes as "Main Street investors." The regulators expect to see issues arising as less wealthy and sophisticated investors are targeted. Thomsen also noted that it is becoming difficult to define a "hedge fund," because some funds are literally run out of basements, and lack of transparency by some funds adds to the problem. Susan Merrill of the NYSE noted that the broker-dealers who have hedge funds as clients are the NYSE’s "window" into hedge fund activities.

Particular areas of concern noted by the regulators included the following:

• Customer abuses such as misappropriation of funds.

• Market abuses, such as trading violations and hyping of stocks.

• Conflicts of interest: Are broker-dealers subject to undue influence because of the amount of business generated by hedge funds, which may be their largest clients? Do registered representatives turn a blind eye to alleged trading abuses at hedge funds?

• "Capital Introduction" and prime brokerage programs introducing hedge funds to public customers.

• Supervision of broker-dealer employees who are physically located at hedge fund clients. According to James Shorris, NASD Executive Vice President of Enforcement, this is an area of increasing concern.

• Crossing large customer orders with hedge fund clients.

• Insider trading by hedge funds, especially in the "PIPE" market (private investment in public equity).

• Proliferation of low net-worth investors. According to Borg, there is a need to increase the minimum financial standards for "accredited investors" to a net worth of at least $2 million, exclusive of value of personal residence, and indexed to increase with inflation.

The regulators have noticed a great deal of advertising and marketing directed to the retiring baby boomers. Concerns were expressed by regulators that medical advances leading to greater life expectancy create the need for greater returns. Due to these factors, there may be a desire by the clients (and indeed, sometimes a need) to increase the equity and growth allocations in retirement portfolios. Consequently, the regulators believe retiree and senior accounts should be supervised to ensure that portfolio allocations are suitable.

Particular areas of concern to the regulators relating to retirement accounts and senior investors included the following:

• The marketing of complicated products to seniors. According to SEC Commissioner Annette Nazareth, this is an area that requires heightened supervision.

• Variable annuity sales.

• Exchanges to equity indexed annuities.

• Supervision of rollover IRAs, especially with regard to coding of accounts that contain substantial assets.

• Unsuitable fee-based account arrangements.

• Hedge funds targeting retirement accounts and retirement money. According to Thomsen, scrutiny will increase if retirement monies flow into hedge funds.

Regulators say they believe there is a blurring of the lines between fee-based accounts and managed accounts, with the potential for the argument that fee-based brokerage accounts implicate fiduciary duties. Whereas fee-based accounts remain a smart choice for many investors, and remove the potential conflicts arising from a commission-based system, the regulators believe that some broker-dealers market the fee structure with an invitation to "take care of" the customer’s account. Particularly when the scenario involves retirement planning for an elderly investor, regulators and claimants’ counsel may argue that the registered representative crossed into the realm of an investment advisory relationship and that the distinction between managed and non-managed accounts was not explained to the customers or that the customers did not understand.

Particular areas of concern expressed by the regulators included the following:

• Firms should regularly assess the suitability of fee-based accounts, especially for low-dollar, inactive, or retirement accounts.

• SEC Rule 202 implementation: When does advice cross into the realm of "financial planning" in fee- based accounts, especially with the use of retirement projections?

• Registered representatives are commonly referred to as financial advisors or financial consultants, which may lead to confusion by clients with respect to fee-based accounts.

• If the registered representative is deemed to be an investment advisor, he or she may have clients who have both managed and non-managed accounts, with the result that the registered representative effectively wears "two hats" with respect to that customer. Are all aspects of the relationship being properly disclosed to the customer?

Thomsen, Merrill, and Shorris each stated that while regulatory sweeps of firms will continue, they will be used more judiciously. To determine areas for inquiry, the agencies will be mining information previously gathered, as well as information gathered by academic researchers, which helped trigger the investigations into backdated options.

© 2006 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.