The constant headlines of regulators' actions against broker/dealers recall the image of falling dominoes.
One by one, the blocks begin to fall over: Edward Jones & Co., Morgan Stanley, Quick & Reilly, Piper Jaffray, and American Funds were either fined or became targets for investigation by regulators. Recently, American Express Financial Advisors joined that unflattering lineup.
Advisors have responded to the increased scrutiny by voluntarily disclosing additional information to clients. Some also report that these disclosures have had an impact on clients and potential clients.
The areas of regulators' concerns focused on broker/dealers' and registered representatives' compensation, directed brokerage transactions in exchange for pushing certain funds, revenue sharing in exchange for increased shelf space, and higher payouts on proprietary products.
"Some proprietary products have received a negative image because they are more expensive than the average product in their peer group," said Tony Batman, chief executive and founder of broker/dealer 1st Global, in Dallas. "But I disagree with the apparent sentiment of regulators that the cost of products should be a major determinant of investor suitability."
In an administrative complaint, the New Hampshire Bureau of Securities Regulation filed a petition for relief against AEFA after a routine audit revealed a disproportionate amount of American Express funds in clients' financial plans. A further investigation turned up management's support of advisors that promoted the firms' poorer-performing funds, as opposed to those of competitors, and backed it up by offering better incentives for AmEx products.
New Hampshire is asking for restitution of planning fees in the amount of $17.5 million.
An AEFA spokesman said that the company was cooperating with New Hampshire in the matter.
The probe comes as parent American Express said that it would spin off Minneapolis-based AEFA, which has been valued at roughly $10 billion.
"Proprietary products are not inherently inferior or wrong. Many of the best solutions for clients are proprietary products," said Batman, who is also chairman of the Financial Services Institute, a trade group. "But it seems to me that recent actions and rule proposals mandate complete disclosure and transparency of any and all conflicts of interest, including the problematic ones of 'differential compensation on preferred products,' and certain types of product sales contests."
The allegations of AEFA's wrongdoing focus on the inherent conflicts of interest in companies with both in-house funds and an employed distribution network.
According to Ryan Batchelor, who covers American Express as an equity analyst for Chicago-based Morningstar, AEFA's problems seem localized. "This situation probably won't have big implications for the company based on the statement that was released," says Batchelor. "I have a hard time believed that a company as large as American Express has a company-wide policy of doing something as obviously illegal as touting its own mutual funds to the exclusion of others."
While regulators question the appropriateness of proprietary funds, industry experts point out that the impact on investors is perhaps different. "The client walked into the firm, got a financial plan from the firm, and then invested in mutual funds with the same name on the prospectus," says Roger Ochs, JD, MBA and president of broker/dealer H.D. Vest Inc., of Irving, Texas. "They must know they got the house product and there's nothing unfair in that. But there should be full and fair disclosure."
Many firms voluntarily disclose the fees and commissions paid by the client. H.D. Vest provides the information in the point-of-sale document, a six-page analysis of the transaction that covers breakpoints and asks for client confirmation of understanding.
"Implementing breakpoints to find the clients' cost is difficult to calculate, because different fund families have different breakpoints on the different fund classes, as well as different household aggregation policies," said Ochs. "This changes the industry, because the reason mutual funds are so popular is that they are easy."
Firms face a good chance of being questioned about disclosures. To prevent being the subject of future investigations, companies are ramping up the amount of information provided to clients. "I see the industry moving to much greater disclosure, at least in the near term, to eliminate appearance of conflicts," says Morningstar equity analyst Justin Fuller, who covers insurance brokers and reinsurance. "Near term, the attorneys general and insurance regulators are looking into past transactions, and we are likely to see more action to uncover improper disclosures."
Phyllis Bernstein consults with CPA firms on how to fulfill their disclosure commitments. All programs start with the law. Some states mandate highly formal disclosures. California, for instance, specifies content and format, down to the demand for 12-point font type, not small print on the bottom of the page. Others are less formal, and handwritten notes of client conversations stand as documented record. "We first work on items required by law, and then decide what other criteria to follow," said Bernstein.
In addition, clients drive the disclosure process. With the expectation of lower returns and magnified press coverage of the issue of advisor compensation, investors increasingly make decisions based on price. "I've heard of clients going elsewhere when they find an advisor will receive a commission as payment for his or her advice," said Bernstein. "This is especially true with middle-market customers and those close to retirement who feel they may not have enough when they want to quit working."
While the AEFA case may impact the advisor industry, the incidents of overcompensating for proprietary products are less of a concern to many CPA advisors. Since the majority of CPAs work as independent contractors, their affiliated broker/dealers do not provide in-house products.
What concerns the independent financial services firms are abuses of revenue-sharing arrangements with mutual fund companies. "These funds are used to educate brokers on the products," said Ochs. "We list our agreements with educational partners on our Web site for full transparency."
