Madoff Scandal May Lead to New Rules on Adviser Accountability

/Home/Madoff Fraud to Impact Fund Management Biz/Pressure on Investment Advisors after fraud

Madoff Scandal May Lead to New Rules on Adviser Accountability

By Jeff Plungis

Jan. 21 (Bloomberg) -- The Bernard Madoff scandal has intensified efforts to hold investment advisers more accountable for their clients’ interests, as the Obama administration considers an overhaul of financial regulation.

Madoff was an investment adviser with a fiduciary duty to act on behalf of his clients and a broker-dealer, subject to oversight by the Financial Industry Regulatory Authority and the Securities and Exchange Commission.

None of it mattered. Madoff allegedly betrayed his clients’ trust, and regulators didn’t catch what prosecutors describe as the largest Ponzi scheme in history. In a speech last month, then President-elect Barack Obama said the scandal shows “how badly reform is needed.”

Investment advisers and brokers are squaring off as Washington turns its attention to rewriting regulations. Financial planners are pushing for greater accountability by making more advisers fiduciaries. Wall Street brokerages are seeking to preserve a growing business of offering advice without subjecting their employees to a new layer of regulation.

“It’s not just an industry spat,” said Barbara Roper, director of investor protection at the Consumer Federation of America. “If we’re going to reform financial regulation, it makes sense to develop a common-sense, pro-investor approach.”

Some brokerages have marketed their professionals as advisers without following the requirements of the 1940 Investment Advisers Act, Roper said. The problem is that average investors aren’t able to distinguish between a broker earning income from commissions on products from someone who doesn’t have a monetary interest in the financial decision, she said.

Making Money

Underscoring the debate are two very different ways of making money. Financial planners typically are paid a fee, usually a fixed percentage of managed assets, to watch over a client’s money. Brokerages make most of their money from charges for buying and selling customers’ securities. They also profit when customers buy the firm’s own offerings.

Adviser groups like the Financial Planning Association and the National Association of Personal Financial Advisors have teamed up to make sure any new post-Madoff rules have a “consumer-first” focus.

The Securities and Exchange Commission has allowed brokerages to offer limited advice on fee-based accounts, as long as the information was a part of its business of buying and selling securities. There were approximately 1 million fee-based brokerage accounts worth $300 billion as of May, 2007, the agency estimates.

‘Merrill Rule’

Merrill Lynch & Co., the largest U.S. brokerage, was one of the first firms to offer the accounts. The SEC regulation that governs them is known informally as “The Merrill Lynch Rule.” The firm employs both brokers who buy and sell securities and financial planners. “The firm’s advisers are in compliance with the relevant regulatory requirements,” said Mark Herr, spokesman for New York-based Merrill Lynch.

The average registered investment-adviser firm, typically made up of between one and 10 employees, manages $200 million to $250 million in assets, according to an October report from Citigroup Global Markets. Industry wide, there is about $2.4 trillion under management by 10,000 to 15,000 advisers, the report said.

Michael Muhm, a small-business owner in Colleyville, Texas, said he found himself questioning his TD Ameritrade broker after having lost access to more than $150,000 in Reserve Management Corp.’s Yield Plus Fund. Yield Plus accounts were put on hold when financial markets seized in September until a distribution worth 69 percent of account balances went out Dec. 30.

‘Snake Oil’

Muhm said that when he complained about the broker’s recommendation of Yield Plus as a liquid, safe place for cash -- reading a transcript of the call to a company representative -- he was told it was his word against the broker’s.

“They should have a fiduciary responsibility to give you information that is accurate, unbiased and true, because if they’re not, they’re snake-oil salesmen,” Muhm said.

Kim Hillyer, a spokeswoman for TD Ameritrade, declined to comment, citing company policy of not responding to individual customers in the media.

The Financial Planning Association won a 2007 legal challenge to the SEC’s decision to exempt fee-based brokerage accounts from rules followed by other investment advisers, such as a requirement that they must act in the investors’ best interest. The SEC enacted a temporary rule enabling the accounts to continue through 2009.

The accounts offer investors a choice, price certainty and “access to a wide range of services that are typically not available through an investment advisory account,” Merrill Lynch Vice Chairman Robert McCann wrote to the SEC in July 2007.

Well Regulated

The securities industry argues that brokerage accounts are well regulated. Brokers must meet a legal “suitability standard” for investment advice, and their conduct is subject to enforcement by both the SEC and Finra. Problems with investment advisers must be settled after-the-fact, in court, they say.

The Securities Industry and Financial Markets Association would like “more consistency” in the regulation of broker- dealers and investment advisers, said Travis Larson, Washington- based spokesman for the group.

“The Madoff scandal has put the spotlight on these different business models, and the debate in Congress is likely just beginning,” Larson said.

The financial planner organizations think a new watchdog may emerge in Washington. It may be a private-industry body such as Finra, or it may be Finra itself. A professional standards board or stepped-up oversight by state agencies are also possibilities.

“The fear is any standard of regulation would be lower,” said Marilyn Capelli Dimitroff, chairwoman of the Certified Financial Planner Board of Standards, Inc. “If you provide any kind of financial advice, you should put the client’s interest first.”

To contact the reporter on this story: Jeff Plungis in Washington at jplungis@bloomberg.net.

Last Updated: January 21, 2009 00:01 EST