A recent study on U.S. investment advisory firms is out and it is a shocker. Collectively, such firms manage nearly $50 trillion in assets. The majority of them (54%) have significant regulatory violations or conflicts of interest that should give pause to prudent investors. (“An Ethics Test Your Adviser Might Not Pass ? New research suggests most assets are managed by firms with regulatory violations or conflicts of interest,” by Charles Passy, Smartmoney.com).
According to the study, approximately 11% of U.S. advisory firms disclosed significant negative regulatory events that should raise red warning flags to investors; 43% disclosed information that that would cause a prudent investor to investigate further before investing (yellow caution flags); and 46% have no significant negative information on their Form ADV (green flags), according to a study by New York-based Diligence Review Corp. that was released on August 1, 2012.
Diligence’s Jennifer Cooper reportedly said that the color codes should not be seen as yes, no or maybe ratings, but rather as a tool for investors when researching an investment advisory firm. “We think a prudent investor should know the flags and let that enter into their decision-making process,” she was quoted as saying.
The ratings system has drawn fire from some in the industry. They complain that the ratings are too strict, that events leading to red flag disclosures (such as a felony conviction) may have happened a long time ago or may not be investment-related. Critics also say that what Diligence calls potential conflicts of interest are commonly accepted practices throughout the industry — for example, purchasing or providing investment advice regarding products the firms has a financial interest in using or recommending.
What does Diligence consider a red flag (“significant adverse regulatory event”)? A “yes” answer to one or more of the following questions on the firm’s Form ADV:
- In the past 10 years, have you or any advisory affiliate been convicted of or pled guilty or nolo contender (“no contest”) in a domestic, foreign, or military court to any felony?
- In the past 10 years, have you or any advisory affiliate been convicted of or pled guilty or nolo contender (“no contest”) in a domestic, foreign, or military court to a misdemeanor involving: investments or an investment-related business, or any fraud, false statements, or omissions, wrongful taking of property, bribery, perjury, forgery, counterfeiting, extortion, or conspiracy to commit any of these offenses?
- Has the Securities and Exchange Commission (“SEC”) or the Commodity Futures Trading Commission (“CFTC”) ever found you or any advisory affiliate to have been involved in a violation of SEC or CFTC regulations or statutes?
- Has the SEC or the CFTC ever entered an order against you or an advisory affiliate in connection with investment-related activity?
- Has any other federal regulatory agency, any state regulatory agency, or any foreign financial regulatory authority ever found you or any advisory affiliate to have been involved in a violation of investment-related regulations or statutes?
- Has any other federal regulatory agency, any state regulatory agency, or any foreign financial regulatory authority, in the past 10 years, entered an order against you or any advisory affiliate in connection with an investment-related activity?
- Has any self-regulatory organization or commodities exchange ever found you or any advisory affiliate to have been involved in a violation of its rules (other than a rule designated as a “minor rule violation” under a plan approved by the SEC)?
- Has any domestic or foreign court ever found that you or an advisory affiliate were involved in a violation of investment-related statues or regulations?
Investor attorney J. Boyd Page of Atlanta-based Page Perry said: “The industry protests are concerning. It’s a little like a restaurant owner being cited for unsanitary conditions in the kitchen, and instead of responding that we take this very seriously and will clean it up immediately, says the inspection was too strict, we feel picked-on, and we’re no worse that other restaurants. Now let me ask you, would you eat at that restaurant?”
Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.