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UNDERSTANDING HEDGE FUNDS
EMPLOYMENT
DISPUTE RESOURCES
AVOIDING
THE PITFALLS OF IRS SECTION 72(t)
SERIES
9 & 10 SUPERVISORY EXAMINATION STUDY OUTLINE
NASAA SUITABILITY GUIDELINES - REAL ESTATE PROGRAMS
(Adopted 11-20-86 - Effective 1-1-87)
HEDGE FUNDS
Hedge funds have become one of the hottest investment vehicles in recent
years, growing to more than $1.44 trillion in assets under management,
according to Hedge Fund Research. Not only have institutional
investors embraced these popular alternative investments, but individual
investors also have been jumping into hedge fund-of-fund products and
hedge-like mutual funds.
Hedge funds have significant stakes in 38% of
the world's public companies, up from 24% two years ago, according to
analysis prepared for Financial News in November 2000 by UK fund
manager Gartmore. Hedge funds hold stakes of at least 10% (enough to
call a general meeting in many countries) in a fifth of public companies,
twice as many as in 2004. Companies in which hedge funds have
significant holdings include the $12 billion NYSE, where eight funds
hold 12%; Mastercard, the $11 billion financial services group in
which 19 own 26%; NTL, the UK cable operator with a $9 billion US
listing, where 28 funds control 38%. and the $7 billion Polo Ralph Lauren
clothing group, in which 10 funds account for 16%. Last year,
Blockbuster, a $1 billion US video and DVD rental company in which hedge
funds own 40% of the equity, was forced to take on three hedge
fund-nominated directors including Carl Icahn, whose fund owned 10% of
it.
For some investors, hedge funds might seem like
unregulated, high risk ventures where you can lose all your money.
Others might see them as actively managed funds, which provide high returns
regardless of market conditions. But most would probably agree that
hedge funds are not well understood by the investing public.
Hedge funds are private investment pools, so the
lack of public awareness is largely because hedge funds are restricted by
law from advertising. Most investors hear about hedge funds through
word of mouth, investment advisors, or stock brokers. If an investor
is interested in learning about a particular hedge fund opportunity, they
must actively request information from the fund. With a lack of public
presence, many hedge fund myths and misconceptions have persisted,
especially in the media.
Hedge funds are an alternative investment
vehicle for high net worth individuals and institutions. Hedge funds
are much different than the traditional mutual fund. To 'hedge' means
to avoid or lessen investment risk by offsetting one investment by another
investment. The most basic type of hedging is to hold both long
(betting price will rise) and short (betting price will fall) positions at
the same time in order to reduce risk. This type of strategy was first
developed by sociologist Alfred W. Jones in 1949.
A good way to understand this concept is to
remember what happened after the market bubble burst in 2000. If an
investor had maintained 100% long positions during the market decline from
2000 - 2003, they would have suffered big losses. Suppose instead that
an investor had held a mixture of long and short positions during the
decline and let's assume further that all asset prices in this portfolio
fell, during this period. The losses from the long positions would be
offset against the profits from the short positions, thereby reducing market
risk and limiting losses. While this is a simplistic, theoretical
model, it does illustrate the basis on which many hedge funds control losses
with long/short hedging strategies.
Today, 'hedge fund' applies less to the hedging
process and more to how hedge funds are structured and managed for the
various types of strategies they use. Hedge funds are a private
investment pool formed under a limited partnership agreement. The
investors are 'limited' partners; they do not participate in the fund's
operations, and their liability is limited to the amount of capital
invested. The fund manager is the 'general' partner, who is
responsible for operating the fund and is liable for any potential
misconduct under Federal Securities Laws.
Unlike mutual funds, not everyone is eligible to
invest in a hedge fund. For an individual to be an 'accredited
investor', they must have a minimum of one million dollars of tangible net
worth. Institutions (pension funds, endowments, investment banks) can
also invest in hedge funds as 'qualified purchasers' if they have at least
five million dollars in assets. Hedge funds have a minimum investment
amount which is usually $250,000.
Hedge funds are loosely regulated by the
Securities and Exchange Commission. In contrast, mutual funds are
highly regulated; but regulation comes at a price. Mutual funds are
largely prohibited from using leverage and shorting. During the 2000 -
2003 market decline, they either held long positions or partially went to
cash. In contrast, hedge funds were able to short during the market
decline. Hedge funds are allowed a wide range of investment options,
such as shorting, leverage, arbitrage and derivatives, which allow them to
take advantage of all market conditions and produce higher returns.
Hedge funds also have an incentive to outperform
traditional investments. As part of their compensation, hedge funds
charge a performance fee, commonly 20% of profits. The median fee
structure, according to the TASS database (which collects data on hedge fund
returns), is a 1.5% management fee plus a 20% incentive fee (where managers
are paid 20% of all returns that are above their target benchmark). Over the
last 10 years, this came out to an average fee of about 3.8%, which is about
2.3% greater than the charge on a typical, actively managed mutual
fund. In addition, fund
managers usually invest their own money in their hedge fund. Hedge
funds seek absolute returns and pursue profits under all market conditions,
including bear markets. In contrast, mutual fund performance is
compared to the general stock market and is highly dependent on a bull
market to create positive returns. The mutual fund manager's
compensation is based on assets under management rather than their
performance.
One of the biggest misconceptions about hedge
funds is that they must take excessive risks in order to gain higher
returns. The best hedge funds are specialists at minimizing risk and
make it an integral part of their investment plan. Conscientious risk
management serves to limit losses and promotes more consistent, generally
higher risk-adjusted returns. Hedge funds are also more actively
managed than mutual funds and use more advanced strategies such as shorting
and leverage which require greater skill. Active management also
places greater emphasis on making the right investment at the right
time. It's no wonder hedge funds attract some of the brightest minds
on Wall Street.
Most hedge funds are highly specialized in the
type of investment strategy they use. There are over a dozen different
types of hedge fund strategies, and each fund is based on a particular
strategy and the financial instruments traded (stocks, options or futures,
etc.). For instance, one type of stock fund seeks to provide high
returns by investing in growth stocks (Aggressive Growth Fund) while another
looks to generate consistent income with dividend-paying stocks (Income
Fund). There are also 'funds of hedge funds' which are funds that
invest a portion of their capital in each of several different hedge
funds. It is important for an investor to understand the type of hedge
fund which best fits their portfolio because funds vary in risk and
return.
Investors should also research the fund
manager's background and experience as well as the hedge fund's track
record, although past performance does not imply equivalent performance in
the future. Many hedge funds now list their returns at websites.
Hedge funds will provide accredited investors with documents that cover key
information about the fund including the structure, rules and investment
objectives. One can also use a research consultant, who specializes in
hedge fund analysis. For general information about hedge funds, a good
place to start is the not-for-profit Hedge Fund Association (www.thehfa.com).
From a tax standpoint, many hedge funds claim
"trader" tax status, which can also be used by some individual
traders, when their strategy involves frequent turnover of stocks,
commodities or other investments. Hedge funds that use a buy-and-hold
strategy are deemed "investor" funds and aren't eligible.
Each investor in a "trader" hedge fund may deduct a proportionate
share of fund expenses, including management fees but excluding interest
expense, as a business expense under Section 162 of the tax code.
Management fees are typically 1% to 2% of assets. A performance fee,
which usually amounts to 20% of profit, is fully deductible in some
cases. But individuals in "investor" hedge funds must treat
such expenses as investment expenses. They are deductible only to the
extent that the investor's share, combined with other miscellaneous itemized
deductions. exceed 2% of the taxpayer's adjusted gross income. For the
average hedge-fund investor, the difference between "trader" and
"investor" status can be thousands of dollars in tax
savings.
Hedge funds are not for everyone, and they are
not intended to replace traditional investments. Hedge funds can serve
an important and valuable role in a well-diversified portfolio, especially
since hedge funds reduce market risk by achieving positive returns during
market declines. The more an investor understands hedge funds and
their operation, the more they can set aside myths and misconceptions and
capitalize on the advantages that hedge funds can offer.
Despite the growing mainstream use of hedge
funds, the industry is largely unregulated. That's because hedge funds
are usually either limited partnerships or offshore corporations. This
gives managers in this arena tremendous flexibility, but it makes it
difficult to accurately measure performance. Since hedge funds aren't
required to report their returns, most of the results reported to data
collectors are voluntary. However, we can analyze the after-fee
performance of a universe of about 3,000 hedge funds in the TASS database
form January 1995 through March 2004. Bloomberg reported in September
that 106 hedge funds had withdrawn their registrations with federal
regulators since an appeals court ruled in June that the SEC did not have
the authority to requires such registrations. On an equally weighted basis, it
provided an average annual return of 16.64% after all fees, with a
standard deviation of 6.90%. However, we must adjust for two biases
that inflate these figures:
1. When a hedge fund fails, the fund
(along with its poor performance history) is frequently removed from the
index and data re-set. This leaves an artificially inflated index
composed solely of surviving funds that have all had some level of
success. The Wall Street Journal reported that 850 hedge funds
failed last year.
2. Then, because hedge funds must report
returns in order to join an index, they frequently tend to join only after a
period of solid performance
If we take these two bias factors into
consideration with the TASS numbers, the annual average returns declined to
nearly 9.1%, with a standard deviation of 7.89%! In looking closer at
the data, the larger hedge funds tended to produce greater returns than
smaller ones. For example, the largest 1% of hedge funds in the TASS
universe had average annual returns of 12.94% (adjusted for the bias
factors) and the largest 5% of hedge funds produced returns of 10.53%.
The smallest 50% of the universe, however, posted returns of
8.67%.
Hedge funds returned an average of 13% this year, according to
the Credit Suisse/Tremont Hedge Fund Index. That compares with returns ranging
from 31.2% in 1999 to minus 1.45% in 2002. In 2004 and 2005, Hedge
Fund Research's composite index returned slightly over 9% each year.
The best hedge fund performers were emerging markets, up 17.2%, and
event-driven funds, those that bet on mergers and restructurings, up 13.9%.
Meanwhile, in a year of double-digit stock market advances, hedge funds
betting on falling stock prices, or "short" funds, fell
7.2%.
Still, hedge funds aren't for everyone.
They carry significant risk, high minimum investments, and liquidity
restrictions and they're usually not very tax-efficient. They do
however provide good diversification exposure for qualified investors to a
portfolio of traditional investments. By way of contrast, the
S&P 500 gained 15.8% for the year and the MSCI World Index was
up 23.5%.
The SEC is intent on regulating hedge
funds. This is because since 2001 the SEC has brought 90 enforcement
actions against them. These have involved misdeeds such as
misappropriating fund assets, engaging in insider trading, misrepresenting
portfolio performance, falsifying experience and track record credentials,
market manipulation and illegal short selling. The growth of hedge
funds is also a factor. There are estimated to be 8,800 hedge funds
controlling approximately $1.44 trillion in assets - almost 3,000% growth in
the last 16 years. Last year, 2000 new funds opened. Further,
the total value of equities in hedge funds worldwide is estimated, as of
November 2000, to be $28 trillion, according to data provider MSCI Barra.
The number
of hedge funds has doubled over the past five years. Although
hedge funds represent just 5% of all U.S. assets under management, it has
been estimated that they account for 30% of all U.S. equity trading
volume!
In a move that it says is designed to protect
investors, the SEC voted December 13, 2006 to raise the asset accreditation
minimum for investors in investments such as hedge funds, private equity,
and venture capital from $1 million to $2.5 million. Under the proposed
rule, investors are not allowed to count real estate, such as their
homes toward the $2.5 million minimum. SEC Chairman Christopher Cox
told reporters the day before the December 13 meeting that concerns about
the "retailization" of hedge funds prompted the SEC to raise the
accredited investor standard, which has been stuck at $1 million since
1982. The SEC also voted for an anti-fraud provision under the
Investment Advisers Act of 1940 that would make it "fraudulent,
deceptive, or manipulative.. for an advisor in a pooled investment vehicle
to make false or misleading statements or to otherwise defraud investors or
prospective investors in that pool." Both proposals are out for a
60-day comment period.
A recent study by the consulting firm Greenwich
Associates indicated how strongly hedge funds have invested in the fixed
income markets. The have quickly become a one of the most dominant
players in the world of debt. Hedge funds are responsible for nearly
30% of all U.S. fixed-income trading, according to the survey. That
level which reflected activity over a 12-month period through April 2007,
was double the amount of trading hedge funds accounted for the previous
year. Greenwich found that hedge-fund trading comprises 55% of U.S.
activity in derivatives with investment-grade ratings, and also 55% of the
trading volume for emerging-market bonds. The rapid rise in hedge-fund
trading underscores the changing nature of the debt markets. Unlike
many mutual funds that look for stable returns or pensions and insurers that
want steady, long-term holdings, hedge funds frequently seek short-term
gains through numerous trades they can amplify with borrowed money. In
some corners of the U.S. debt market, hedge funds practically are the
market. For instance, hedge funds generated more than 80% of the
trading for derivatives with high-yield ratings, and more than 85% of volume
in distressed debt, Greenwich found. Hedge funds also accounted for a
good portion of the trading in mortgage-backed securities. asset-backed
securities, collateralized debt obligations and other parts of the debt
market that have suffered recently as worried over sub-prime loans have
spread. Analysts say these debt instruments were developed primarily
for sophisticated investors like hedge funds, which sometimes use these
products to protect themselves. But the debt securities have also been
sold to pension funds and other institutions that may not completely
understand them.
Hedge funds have come under renewed scrutiny in
recent months punctuated by the high-profile collapse of Bear Stearns' two
leveraged hedge funds which filed for bankruptcy protection last month as
clients sue to reclaim their investments The SEC sought fraud
charges against Sentinel Management, which recently filed for chapter 11
bankruptcy. The regulator alleges the money manager defrauded its
customers when it co-mingled, misappropriated and leveraged their securities
in violation of the Investment Advisers Act of 1940. The complaint
also alleger that Sentinel used securities from client accounts as
collateral to obtain a $321 million line of credit as well as additional
leveraged financing.
Hedge fund managers will face a new restriction
with the SEC's anti-fraud rule, against a backdrop of spectacular failures in the $1.5 trillion
industry. The rule reinforces the authority of the Investment
Advisers Act of 1940 governing cases where investors in a pool are defrauded
by an adviser. The SEC proposed the new rule to clarify its authority
over account statements for investors, as well as private placement memos,
offering circulars or responses to proposal requests for prospective
investors. It is widely felt that the new rule will most likely lead
hedge funds to seek more advice surrounding the valuation of underlying
assets in their disclosures.
One greatly needed disclosure, utilized by
hedge funds, involves the true meaning of SIV's (Structured Investment
Vehicles) which have been in the news headlines of late. These
instruments make money by a simple arbitrage-like strategy: they raise
money by selling short-term, low-yield, asset-backed commercial paper and
then invest the proceeds in longer term, higher yielding debt, such as bonds
and mortgage-backed securities. They use the cash flow from the higher
yielding investments to roll over (pay-off) the commercial paper, and
whatever is left is profit. To remember the SIV investment strategy in
an acronym, remember B-STILL. B-STILL = Borrow ShorT, Lend Long.
Its a great strategy unless investors refuse to buy the commercial paper
that finances the long-term debt, which is precisely what happened this past
summer. An inverted yield curve is poison to this type of investment
strategy - long term yields undermine an entity's ability to pay the
suddenly higher short-term yields. So to is a situation in which
investors don't trust the valuation or credit soundness of the holdings in
the long-term debt. This type of disclosure is essential when
instruments which appear totally safe, like money-market funds, contain
SIV's to boost the yield.
HEDGE FUNDS RISKS YOU WILL NORMALLY ENCOUNTER:
WHEN CONSIDERING
ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS
RISKS INCLUDING THE FACT THAT SOME ALTERNATIVE INVESTMENT PRODUCTS: OFTEN
ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY
INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO
PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE
COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION,
ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN
CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT
TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.
WITH RESPECT TO AN INVESTMENT IN A HEDGE FUND ("FUND"), YOU SHOULD
BE AWARE THAT:
- FUNDS ARE SPECULATIVE AND MAY USE LEVERAGE AND AS A RESULT THEIR
RETURNS MAY BE VOLATILE.
- YOU MAY LOSE ALL OR PORTION OF YOUR INVESTMENT IN THE FUND.
- WITH RESPECT TO SINGLE MANAGER FUNDS THE FUND'S MANAGER HAS TOTAL
TRADING AUTHORITY. THE USE OF A SINGLE MANAGER COULD MEAN A LACK OF
DIVERSIFICATION AND HIGHER RISK. WITH RESPECT TO FUNDS OF FUNDS, THE
FUND'S MANAGER HAS COMPLETE DISCRETION TO INVEST IN VARIOUS SUB-FUNDS
WITHOUT DISCLOSURE THEREOF TO YOU OR TO US. BECAUSE OF THIS LACK OF
TRANSPARENCY, THERE IS NO WAY FOR YOU TO MONITOR THE SPECIFIC
INVESTMENTS MADE BY THE FUND OR TO KNOW WHETHER THE SUB-FUND INVESTMENTS
ARE CONSISTENT WITH THE FUND'S HISTORIC INVESTMENT PHILOSOPHY OR RISK
LEVELS.
- THERE IS NO SECONDARY MARKET FOR THE INTERESTS. TRANSFERS OF INTERESTS
ARE SUBJECT TO LIMITATIONS. THE FUND'S MANAGER MAY DENY A REQUEST TO
TRANSFER IF IT DETERMINES THAT THE TRANSFER MAY RESULT IN ADVERSE LEGAL
OR TAX CONSEQUENCES FOR THE FUND.
- THE FUND IS SUBJECT TO SUBSTANTIAL EXPENSES THAT MUST BE OFFSET BY
TRADING PROFITS AND OTHER INCOME. A PORTION OF THOSE FEES ARE PAID TO
THE FUND. THE FUND MAY SPLIT THOSE FEES WITH PRINCIPALS OR
REGISTERED REPRESENTATIVES WHO SELL THE FUND.. SUCH FEE SHARING
ARRANGEMENTS COULD PRESENT A CONFLICT OF INTEREST. WITH RESPECT TO FUNDS
OF FUNDS, BECAUSE THE FUND INVESTS IN OTHER FUNDS AND FEES ARE CHARGED
AT BOTH THE FUND AND SUB-FUND LEVEL, THE OVERALL FEES YOU WILL PAY WILL
BE HIGHER THAT YOU WOULD PAY BY INVESTING DIRECTLY IN THE SUB-FUNDS. IN
ADDITION, EACH SUB-FUND CHARGES AN INCENTIVE FEE ON NEW PROFITS
REGARDLESS OF WHETHER THE OVERALL OPERATIONS OF THE FUND ARE PROFITABLE.
- A SUBSTANTIAL PORTION OF THE FUND'S TRADES MAY TAKE PLACE ON FOREIGN
EXCHANGES THAT MAY NOT OFFER THE SAME REGULATORY PROTECTION AS US
EXCHANGES.
A FUND'S OFFERING MEMORANDUM DESCRIBES THE VARIOUS RISKS AND CONFLICTS OF
INTEREST RELATING TO AN INVESTMENT IN THE SPECIFIC FUND AND TO ITS
OPERATIONS. YOU SHOULD READ THE OFFERING MEMORANDUM CAREFULLY TO DETERMINE
WHETHER AN INVESTMENT IS SUITABLE FOR YOU IN LIGHT OF, AMONG OTHER THINGS,
YOUR FINANCIAL SITUATION, NEED FOR LIQUIDITY, TAX SITUATION, RISK TOLERANCE
AND OTHER INVESTMENTS. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE
RESULTS. THERE IS RISK OF LOSS WHEN INVESTING IN MANAGED FUTURES OR
HEDGE FUNDS.
.
EMPLOYMENT DISPUTE RESOURCES
1. On June 5, 2002, a branch
manager for UBS PaineWebber wrote a memo to all branch personnel, regarding
a departing employee. It read, "Non-Solicitation of
Accounts" - "_______________ is leaving UBS PaineWebber to join
another firm. He has been a valued employee ans is leaving us as a
broker in good standing. Do not solicit any of his accounts, as
we have agreed to let him take his book with him. He has been a valued
employee and we wish him the best as he faces new challenges. Please
contact me if you have any questions".
2. April 1, 2003 - Registered
Representative Magazine by David A Gaffen - Whose Clients Are They -
"How much of a fight depends on many factors, including how the client
came to the firm. Reps can usually lay claim to clients that they
recruited, especially those they brought with them".
3. 8-3-06 - Hearing transcript from NASD
Arbitration 05-01659 page 741 by Jay Price, BAISI attorney, Employment
Relations, with Bank of America for 25 years. "We were permitting
them (the brokers) to take with them, those clients before they came to
BAISI....that they had brought to BAISI after they joined".
4. July, 2007 - Registered Representative
Magazine - PROBLEM - CLIENT OWNERSHIP - " Brad, a wire-house advisor
producing in excess of $5 million annually, serving only 22 client
households, was wooed by a competing wire-house. Brad and the new firm
had come to terms on the size of the transition package (a total of 200% by
the end of 24 months), start date and payouts. Everything seemed to be
moving along at a comfortable pace until the contracts were presented and
reviewed by his attorney. Counsel pointed out that the proposed
agreement stipulated that all of his clients, both existing and those that
would be acquired, would belong to the new firm. Upon learning of
this, Brad was advised that he should not sign on the dotted
line".
SOLUTION - "After attorneys for the parties had the opportunity to
further discuss the matter, the agreement was modified to provide a
"carve out" for Brad's existing clients. It was set forth
that any clients brought to the new firm by Brad, plus any new clients added
within 12 months of the transition date, would belong to him and any clients
procured after that would be "owned" by the firm. Brad
joined the new firm several months ago.
5. October 15, 2007 - Investment News,
"A number of Wall Street firms have signed a "recruitment
protocol" including Merrill Lynch, Citigroup, Inc., UBS Financial
Services, Inc., Raymond James Financial, Inc. and A.G. Edwards & Sons,
Inc. The protocol allows brokers to take clients' names, addresses,
e-mails, phone numbers and account numbers and titles prior to leaving their
respective firms. (The protocol provides that reps cannot make clients
aware of their departure until after they have joined the new firm.
According to the pact, those clients who choose to follow the rep will have
their accounts transferred within one day by the broker's prior employing
firm - Registered Rep Magazine, September 2007). Representatives
aren't supposed to be sued if they make good-faith efforts to follow the
protocol. In a current lawsuit against A.G. Edwards reps, the
Investment News article by Dan Jamison stated, "The litigation is
unusual for A.G. Edwards, which has always told brokers that they own their
books". (Currently, 54 brokerage and advisory firms are
signatories to the protocol, according to Ted Levine, of counsel at Wachtell
Lipton Rosen & Katz in New York. He wrote to the SEC in a comment
letter on behalf of a number of wirehouses, "the sharing of client
information under the protocol is permissible under the current Reg.
S-P". "The protocol was reviewed by he [SEC], the New York
Stock Exchange and [Washington-based NASD] prior to its implementation,
"Mr. Levine wrote. .
6. March 2004 - On Wall Street Magazine,
by Mr. Schwartzkopf, Headhunter - ON TEAM BUILDING - "Let me get back
to team building. I've talked to many people about the issue and have
been in the industry and created those programs. They were built for
one reason only.........not to help the firms or the clients or the
brokers. They were built to keep assets at the firm. There's no
other reason, no matter how they spin it".
7. February 15, 2008 - Merrill Lynch
suffered another defeat, this time against brokers who had transferred their
book of business to Bear Stearns. While Bear Stearns is not a
signatory to the agreement that allows brokers at participating firms to
move client accounts between those firms without fear of TRO litigation, the
federal court in Ohio was persuaded that Bear Stearns should benefit by that
agreement. The court stated that Merrill Lynch could not prove a
critical element for its injunction action, irreparable harm, because by the
agreement "Merrill tacitly accepts that such an occurrence [brokers
ACAT of accounts] does not cause irreparable harm." The court
also rejected Merrill Lynch's argument that it would lose customer trust and
goodwill, reasoning that by the protocol, Merrill and industry peers
"are well aware of, and content with, the idea that brokers will leave
and take client lists with them." The agreement
"significantly undercuts the notion that such behavior destroys
customer goodwill", wrote the court. Source: Merrill
Lynch v. Brennan et al. (2007)
AVOIDING THE PITFALLS OF IRS SECTION 72(t)
FINRA is concerned about abuses related to early
distributions from qualified plans. It has but advisers on notice
about "early-retirement investment pitches that promise too
much". Specifically, the Financial Industry Regulatory Authority
is concerned about abuses related to early distributions from qualified
plans based upon section 72(t) of the Internal Revenue Code.
That provision allows employees to take early
distributions from their 401(k) or individual retirement account without
suffering the 10% early-withdrawal penalty, so long as withdrawals are part
of a series of substantially equal periodic payments that last for five
years or until the retiree reaches 59 1/2, whichever is longer.
Notably, the IRS permits modification of the withdrawal methodology, but may
impose a penalty. It actually provided a one time-penalty free
modification in October, 2002.
Read another way, Section 72(t) can be a way for
advisers to recommend that employees retire early, and therein lies the
problem.
Last year, New York and Washington based FINRA's
predecessor, the NASD, fined Securities America, Inc. of Omaha, NE, $2.5
million and ordered it to pay $13.8 million in restitution in connection
with an investment scheme aimed at retirees from Irving, Texas-based Exxon
Mobil Corp. In June, Citigroup, Inc. of New York was ordered to pay
$15.2 million by the NASD to settle charges that its brokers misled
employees of BellSouth Corp. of Atlanta.
Both companies were targeted for promising high
returns and permissible withdrawal rates couples with unreasonable and
misleading assumptions, the NASD said. Victims of 72(t) abuses
typically are in their 50's, poorly educated and lacking in investment
experience. In many cases, they have worked for years in low-level
supervisory or management positions, earning $45,000 to $60,000 per
year. They view receiving a lump-sum payment from their retirement
plan of, say, $350,000, as a fortune.
Their only question, posed to the financial
adviser (and the adviser alone) with full faith, confidence and trust in the
latter's opinion, is: "Can I live on it for the rest of my
life?"
Responsible advisers who want to avoid getting
snared in 72(t) problems should take the following five steps:
First, discuss the risks. As FINRA's alert
stated, not everyone can or should retire early. Promises of earning
investment income during retirement that is equivalent to income one would
have earned by continuing to work "usually hinge on unrealistically
high returns on investments and unsustainably large yearly
withdrawals".
Second, explain the effect of fees and expenses,
both initially and on a continuing basis. One section 72(t) expert
estimates that a 1% fee on portfolio assets shortens payouts to 29 years,
from 36 years, in most illustrations, while 2% fees shorten payouts to
between 24 and 26 years.
Third, assume and project reasonable and
conservative rates of return. The law doesn't require advisers to
equate the return rate with the withdrawal rate, and advisers shouldn't do
so. Moreover, FINRA faults returns projected to be 12% or more, for
several reasons. No one can predict investment returns; any return
over 10.4% exceeds the historical long-term returns for the stock market and
greatly exceeds long-term returns for less risky securities such as bonds,
which are less than 6%. Also, the stock market is inherently volatile,
and returns during many years have been well below the historical
average. Similarly, advisers should explain various asset allocations
among the major asset classes and demonstrate, how each asset class and
asset allocation has performed historically.
Fourth, assume and recommend reasonable and
conservative withdrawal rates. According to FINRA, many experts
recommend withdrawal rates of between 3% and 5% per year. One expert
who has analyzed the numbers stated that using a 4% withdrawal rate instead
of an 8% withdrawal rate nearly doubles the number of years that an
investor's original principal can be expected to last under normal market
conditions.
Advisers also should provide amortization
schedules that aren't limited to five t eight years. Instead, they
should provide the full amortization schedule. This schedule will
disclose declining principal balances, such as at the end of the retiree's
life expectancy, when the withdrawals will have depleted the value of the
account.
Finally, if the withdrawal rate becomes
unsustainable, advisers should consider recommending that the client modify
the withdrawal methodology, especially early on, regardless of whether the
IRS imposes a penalty. Incurring such a penalty may be the best
strategy to ensure that the client doesn't outlive their retirement nest
egg.
SERIES 9 & 10 SUPERVISORY EXAMINATION STUDY OUTLINE
(NYSE and NASD/ FINRA)
Securities regulators (including the New York
Stock Exchange and the NASD) have prepared a study outline for the General
Securities Sales Supervisor Qualification Examination (Test Series 9 &
10). The examination is required for those who will supervise sales
activities in corporate, municipal and option securities, investment company
products, variable contracts and direct participation programs. The
topics tested are considered to be the "major job functions" of a
branch manager/sales supervisor, with the bulk of the questions (47%)
devoted to supervision of accounts and sales activities.
The Series 9 & 10 study outline provides a
helpful roadmap of responsibilities imposed upon sales supervisors such as
branch managers in the retail brokerage setting. Lets overview the
more important responsibilities:
First, sales supervisors have duties regarding
the hiring of new financial advisers (known as registered
representatives). These duties include conducting a pre-hire
investigation, as well as reviewing the new employee's previous securities
firm registrations and work history.
Second, the sales supervisor must do a great
deal with respect to communications with the public. Critical
functions include reviewing, approving and evidencing review of
correspondence to customers (incl.e-mail ). The sales supervisor also
must review and approve sales literature, sales material prepared by
financial advisors at his or her branch office, and public seminars and
presentations. Sales supervisors must maintain a log of public
seminars and presentations by financial advisers. Finally, sales
supervisors have a duty to monitor the use of "internal use only"
sales material as well as telemarketing procedures, for example by
maintaining a "do-not-call" list.
Third, sales supervisors have responsibilities
regarding customer account documentation. Sales supervisors must
review customer information and documentation in order to approve new
accounts. This review and approval must determine suitability and must
comply with the requirements imposed by both the financial services firm and
the securities regulators.
Fourth, sales supervisors have significant
responsibilities regarding suitability of account activities. For example,
sales supervisors must ensure that their financial advisers understand
suitability requirements and must "assist RR's [financial advisers] in
helping customers formulate investment objectives and to set financial
goals". Also, sales supervisors just ensure that their financial
advisers have necessary product knowledge, and must review trading and
suitability of trading activity, including the use of margin, day trading,
concentrated securities positions and excessive transactions.
Significantly, sales supervisors have a duty to review "for initial and
ongoing suitability for various investment portfolios and objectives."
(Emphasis added). with respect to managed (third party) accounts,
sales supervisors must review managed accounts "to ensure that the
investment styles of the advisers and managers are consistent with the
objectives of the customer." Finally, sales supervisors must
monitor customer accounts to determine the suitability of mutual fund
switching and variable annuity 1035 exchanges.
Fifth, sales supervisors must do several things
in connection with sales and business practices. Sales supervisors
must monitor trading activities for the possible "selling away" of
investments outside of the firm. Likewise, sales
supervisors have a duty to review customer accounts to ensure that
investments are consistent with stated investment objectives and risk
tolerance. Finally, sales supervisors must ensure that proper
disclosures are made regarding the nature of the securities sold to a
customer. Balanced communication should always include the risk
factors and appropriate disclaimers.
Sixth, regarding general supervisory
responsibilities, the sales supervisor must review possible outside business
activities of their financial advisers, and if there is an outside business
activity, to obtain necessary approvals and note in writing, evidence of
follow up to investigate those activities to be certain that no securities
are being sold away from the firm. Additionally, the study outline
again reminds sales supervisors that they must review and follow up for
possible "selling away". Likewise, sales supervisors must
review the financial advisers' accounts and employee-related accounts held
at other financial services firms. This duty includes ensuring that
necessary approvals are obtained as well as reviewing confirmations and
statements of investment activity.
Seventh, sales supervisors have several
responsibilities regarding options transactions. These
responsibilities extend to ensuring that financial advisers receive adequate
training in options as well as understanding the tax implications of options
transactions. Furthermore, sales supervisors must assist financial
advisers in formulating an options strategy for customers, and must conduct
a suitability review to ensure that the use of options is consistent with
the customer's profile.
As one can see, the Series 9 & 10
examination tests critical knowledge required of those who will supervise
the activities of financial advisers in connection with their customer
accounts.
EXCERPTS FROM NASAA GUIDELINES
Investors must meet:
A. Minimum income & net worth
standards, established by program
B. Can reasonably benefit from program
based on prospective participants overall investment objectives and
portfolio structure.
C. Is able to bear the economic risk of
the investment, based on prospective participants overall financial
situation.
D. Has an apparent understanding of the:
1. Fundamental
risks of the investment
2. The risk that participant
may lose the entire investment
3. Lack of liquidity of
program
4. Background & qualifications of sponsor
5. Tax consequences of
the investment
Conclusion - The Sponsor and each person
selling the program interests will make a suitability determination based
on AT LEAST:
Age
Investment objectives
Investment experience
Net worth
Financial situation and other investments of the
prospective participant
Any other pertinent factors
Source - CCH - Topical Law Reports # 78 -
7-27-94
3601,3602 & 3605
FEND
- Securities Expert Witness
Telephone:
(310)641-0377
FAX: (310)649-3663
Email: fendmase@ca.rr.com
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