A Complaint on SEC Complaints...on Behalf of Investors

In this week’s edition of “You Know What Really Grinds My Gears”...


You know what really grinds my gears? SEC (and FINRA) complaints against a financial firm that fails to name bad actors involved who are not directly tied to the firm, leaving the investing public wondering who these bad actors might be.

SEC vs. Charles Schwab & Co., Inc.

The most recent example of this comes from an SEC complaint against Charles Schwab dated July 2, 20181, for Schwab’s failure to file Suspicious Activity Reports (“SARs”)2 on independent third-party advisers who charged their customers excessive advisory fees, allowed their state registrations to lapse, or were involved in schemes called “cherry-picking” (which the SEC defined as “a fraudulent trade allocation scheme where the Adviser allocates profitable trades to the Adviser’s personal account and unprofitable trades to client accounts”).


In Schwab’s defense (at first glance), they terminated its business relationship with the 83 investment advisers involved in this misconduct. Because an investment adviser can be either a person or a firm3, the SEC did not delineate whether it was 83 investment adviser persons, 83 investment adviser firms, or a mix of the two. Either way, that’s a ton of advisers pulling a lot of shenanigans. But I digress, let’s dissect what Schwab “terminated its business relationship” with these advisers means.


Investment advisers are not able to directly hold cash or buy and sell securities, so investment advisers have to use large broker-dealers like Schwab or TD Ameritrade or Fidelity to act as a “custodian” that holds customer securities and cash, executes trades, and provides account statements to the customer. Investment advisers choose which custodian to establish a business relationship with and then the customers of the investment advisers’ have their accounts transact and hold funds through that custodian.


When Schwab terminated its business relationship with these 83 investment advisers, there is no way to determine from this complaint if any sort of public disclosure (as SARs are very private documents which can get you jail time for releasing to the public) was made to the customers of these investment advisers to say, “Hey, by the way, your investment adviser is taking your money.”


Why wouldn’t Schwab have disclosed this to these customers? The customers of the investment adviser are not going to be treated by the SEC as customers of the custodian (I know, it’s confusing!), so the custodian didn’t need to provide any disclosures to someone who isn’t their customer. What’s worse, since the custodian only had a “business relationship” with these 83 investment advisers, the investment advisers didn’t get fired (which prompts a required disclosure document - called a Form U5 - detailing why they’ve been fired), they just had to change custodians. There were likely no public disclosures made on all of this misconduct by the 83 advisers.


I would have liked to research this to ensure that these investment advisers had no public disclosures when this all happened in 2012 - 2013, but this brings me to my biggest bone to pick with the SEC’s complaint: they don’t mention the names of the people or firms that comprised these 83 advisers.


These 83 advisers had 18,000 accounts and $1.62 billion in assets, so this clearly effects a ton of customers. In fact, the whole complaint reads as if the SEC is only concerned about Schwab’s failure to file SARs and not the 18,000 accounts at risk. I understand the complaint is about Schwab’s failure to file SARs, but isn’t the bigger issue here the fact that a ton of advisers were defrauding their customers? Shouldn’t some more information been provided on this topic for the investing public?


Again, maybe the SEC has some other cases against some of these 83 advisers, but they don’t reference any of them in this complaint, so a reader’s logical conclusion is that nothing has happened to these mysterious advisers taking advantage of their customers.


I’m flabbergasted by this complaint and the whole disclosure process in complaints because it only hurts investors not to name people and firms who have committed wrongdoing. The lack of identifying information in this complaint is not an anomaly, SEC and FINRA complaints will rarely call out other registered people or firms not directly tied to the complainant. I dealt with this constantly when working on complaints at FINRA.


Here are some additional questions I tried to answer by reading this complaint.


Do we know if the customers who were taken advantage of by these advisers were provided compensation by Schwab?

We have no idea as the SEC complaint does not state that Schwab took any means to compensate the aggrieved customers. Further, since Schwab was acting as a custodian for these investment advisers, Schwab may put the onus of restitution on the investment advisers, and we have no idea if the investment advisers provided restitution to these clients.  


So you’re saying the customers who were not taken advantage of (at least not yet) by their adviser might still be unaware of their adviser’s wrongdoing?

Certainly. Those same customers might have gotten a call from their adviser saying he’s switching “custodians” to be on a better technological platform (or some other reason unrelated to the actual misconduct). The customer, who doesn’t assume anything bad happened to facilitate this move, has no problem with a new custodian given the customer barely understands what a custodian is.


How could a customer or potential customer of these 83 advisers find out if a public disclosure exists on their adviser?

Because the SEC didn’t name them in a complaint, you won’t be able to find the misconduct via a Google search of the adviser’s name. Of course, this would be far and away the most effective for all people to get this needed information on these people, but oh well!


So instead, the average investor has to know where to look on the adviser’s IAPD Disclosures page through the SEC website, and that’s assuming the customer even knows what that is! This website is clunky with small font (I just searched “Wilson” and this lady came up): 

The customer must locate the “Disclosure Information” section and read the explanation to know this is where to look for misconduct. Hovering over the “?” next to Disclosure Information will prompt the customer that “Additional details of any disclosures listed below are available in the detailed report.”


So take a look under “Disclosure Information,” and if the bolded word says “Yes,” a customer then clicks “View Detailed Report” and then reviews that document. Scroll through to the last few pages, and you’ll finally identify what the “disclosure” is.


We are all ultimately responsible for our actions and inactions, and this will lead some to say it’s the investors responsibility to identify if their advisor has ever committed wrongdoing. But I would also say there should be a responsibility on the part of our regulators to provide full and active disclosure so all investors are immediately alerted if their adviser is a crook. We do not need 600,000 financial advisers in this country, and this kind of active disclosure (via mail and email) would help rid the industry of the bad advisors ripping their clients off.  


If a financial advisor is pointing a financial sniper rifle in your direction and the financial police are watching, it’d be safe to assume they’d protect you from a financial disaster. Yet many times the financial police sit idle because the power of money, lobbyists, and resources of the industry puts the handcuffs on them. Make no mistake about it, the regulators cannot provide full and active disclosure because they don’t hold the power in this relationship. As they say, money talks. And the SEC and FINRA can’t talk much. So when they do, it’s short and sweet.


Chew on this: In 2017, the SEC’s annual budget was $1.6 billion while in the same year JP Morgan Chase spent $6.8 billion (Page 148) solely to hire outsiders for “professional and outside services.” One Wall Street firm spent four times more than the SEC’s entire budget just to hire other people to do work it’s own employees couldn’t do!


The SEC has to get in front of our amazingly rich politicians (on both sides) to fight for more money and new laws every year while many of these same politicians view regulators as useless vessels that get in the way of business and profits. While I admit some regulations are burdensome and costly and should be removed, regulation is essential because greed, corruption, and crime will always win in the face of a free market with no regulations.


The SEC and FINRA are needed. Anyone who says otherwise is crazy. But are they effective enough? As the Schwab and JP Morgan examples show, of course not.

Is There a Silver Lining for the Investing Public?

Hmm. Being a former regulator and financial advisor has made me pretty skeptical of the financial industry and the hopes of the average investor. There are silver threads to hang on to, some of which (not regulators though - they’re never going to get significant resources) can grow thicker with time:

  • The regulators. I’m incredibly proud of the work I did with my teams at FINRA. We got a lot of really bad people and firms out of the industry, but nowhere near enough. While there’s a ton of incompetence, turnover, managerial problems, bureaucracy, and fear of losing, there are people who care and are doing the right thing. It’s just a really hard fight.
  • Financial advisors. There are a number of financial advisors, some of whom I’ve met in the sports industry and many on Twitter, what a conflict of interest is and work solely in the interest of the client. They understand how conflicted the financial world is in providing advice to people. They are solely investing in the interest of the client and getting paid a fee for their advice and nothing else. Rick Ferri, a great Twitter follow, proposed the following idea:
  • Democratization of finance. The winds are changing with the democratization of investing via online accounts with no minimums, free trades, cheap index funds, and an infinite amount of free online resources. Investors are taking note as records of funds are flowing into cheap index funds into great investing platforms like Vanguard. The answer we don’t know yet is what’s going to happen to the flows of index funds when the market tanks? Will investors flee at the worst time, psychology getting the best of them, forgetting that these investments are long term? Time will tell.

Yet the problem remains that the majority of investors don’t understand the issues presented earlier about the lack of disclosure and awareness of what capacity their advisor is acting. Most assume their financial advisor is one of the good ones, but they don’t understand that even advisors who are good people can still be salesmen working under the suitability standard selling more expensive products that they’re incentivized to sell. Given the wonders of compound interest, these higher fees drastically eat away at your returns over time while compensating your advisor. Interests just aren’t aligned in those cases.


When roughly 12% of all financial advisors operate solely (meaning not dually-registered investment advisers but solely registered investment advisers) under the fiduciary standard where they must put your interests first at all times, the odds that you’re in the right hands from the get-go is low. Then you realize the fiduciary standard doesn’t work all the time either because the 83 advisers mentioned in the complaint against Schwab were all registered investment advisers. Upon further inspection, the silver lining looks a little rusty.


1 - The skeptic in me says that the SEC was asked by Schwab to file this complaint on July 2, two days before July 4th, because no one will be working or reading this stuff and it’ll slide through the news without much fanfare or scandal.


2 - ’ll tackle SARs in another blog post because there’s a lot to say about these, and I dealt with these constantly in my time at FINRA’s Anti-Money Laundering Investigative Unit. Suffice to say, these are reports that are required to be filed (and many times are not - such as this case with Schwab) by financial institutions if a few rules (detailed in the SEC complaint) are triggered. SARs provide law enforcement, FBI, and other government authorities information to identify really bad conduct by bad people, like drug cartels, terrorist financiers, fraudsters, ponzi schemers, and others moving money/doing business through these financial institutions.


3 - Don’t blame the messenger but you read that correctly. It’s finance, it’s complicated for a reason.