A spate of recent high-profile incidents of “selling away” client assets – moving money off the broker-dealer custody and records platform — should have financial advisors and others who manage money on the alert. Even if you don’t fully know the rules, you could find yourself violating federal securities law.
Independent powerhouse LPL Financial terminated its relationship with top broker James Bashaw and now Wunderlich Securities has let him go too.
It looks like the rules he broke revolved around selling away. Before the allegations started, Barron’s magazine had ranked him as the number one financial adviser in Texas, with assets under management totaling nearly $4 billion.
A few weeks earlier, Merrill Lynch fired two brokers for recommending that clients invest in a third-party hedge fund without supervisors’ knowledge or permission. The two worked in Merrill’s Pittsford, NY, office and together managed $2.5 billion in assets.
Defining the Problem
What exactly is “selling away” and why is it such a serious matter?
Selling away occurs when a broker or advisor sells securities without processing the order through his or her firm. While brokers may sell these securities, they must give prior written notice and any compensation must be handled as though the transaction took place on the firm’s platform.
Even if the broker doesn’t receive any compensation, the firm must acknowledge that it received the notice before anyone recommends the securities to a client.
Private placements or other non-public investments tend to raise red flags. However, according to many securities lawyers, selling away can conceal more deliberate fraudulent activities, including Ponzi schemes.
“While some of these selling away violations do not seem to be intentional, all too often they are deliberate and frequently involve some theft or scheme,” says David Neuman, a partner with Israels & Neuman PLC in Denver.
That’s why FINRA and other securities regulatory bodies are taking a closer look at these schemes, and why investment firms are keeping closer tabs on their employees.
“With the rise in number of private placements, selling away is on the priority list of things FINRA reviews,” says Braden Perry, an attorney at Kennyhertz Perry LLC in Kansas City.
Selling away violations are probably more common than they appear, he says, because the investor often does not know the transactions are “off the grid” and without the approval of the affiliated firm.
“The rules have not really changed, but I absolutely have been hearing from clients that FINRA has been much more active in initiating inquiries and investigations overall, not simply with respect to selling away cases,” says Christine R. Fitzgerald, a partner at Belcher Fitzgerald LLP in Boston.
“Because of the potential exposure to broker-dealers from investors claiming losses as a result of ‘selling away’ transactions, firms must be diligent in ensuring compliance and pursuing potential violations.”
If anything, the incidence of “selling away” outside of the firm may actually be on the upswing.
“Selling away schemes are still all too common,” says David Neuman. “Even with the positive markets of the last several years, selling away violations are still occurring on a nearly daily basis. There is no slowing down.”
Unfortunately, not only are such incidents not unusual, they’re quite serious.
“Selling away is one of the most pernicious and dangerous investment scams in the brokerage industry,” notes Stuart R. Berkowitz, a securities lawyer in St. Louis.
It is outlawed by the Financial Industry Regulatory Authority’s Rule 3040 as well as all state security regulators, he says.
Punishments can be tough, depending on the severity of the violation.
“Generally, where the conduct was isolated or minor in scope, and there was no apparent intent to defraud investors or the firm, FINRA will assess a monetary fine and/or order the advisor to disgorge any gain from the transaction,” Christine Fitzgerald says.
“However, in cases involving aggravated or egregious conduct, punishment is also likely to include a suspension or even a complete bar from the securities industry.”
In addition, the advisor’s firm will usually impose some form of discipline, which can range from a written warning or being placed on heightened supervision to termination.
Know the Rules
Selling away often occurs because the firm’s failure to put in place a reasonable supervisory system places it in violation of FINRA rules, explains Adam J. Weinstein, a partner at Gana LLP in New York.
In some cases, the advisor can legitimately claim ignorance about the rules, but that doesn’t get them off the hook.
“Sometimes, the violations are inadvertent, because the broker didn’t know or fully understand the rule,” says Joel Beck of the Beck Law Firm LLC in Lawrenceville, GA.
“Sometimes the violation comes because the broker trusted the wrong person and believed that the product was not a security, and then in some cases, failed to consider the implication of the outside business activity rule. Because of the significant consequences to a violation of these rules, it is important for brokers to understand these rules.”
Other cases revolve around the firm looking the other way for as long as it can, especially if it involves a top-producing broker.
“In case after case, we see firms that had the clues of selling away staring them in the face, but the supervisory chain failed to act,” says Ralph M. Stone of Stone Bonner & Rocco LLP in New York.
“Immediate supervisors don’t want to interfere with the income-generating activities of their brokers, and higher-up supervisors are either clueless or willfully negligent. Broker-dealers pay lip service to their duties to prevent inappropriate conduct associated with selling away, but most are doing little or nothing to genuinely police their registered reps.”
Even RIA Reps Need Guidance
Compliance starts with a compliance culture and that requires the proper tone at the top, says Greg Nowak, a partner at Pepper Hamilton LLP in Berwyn, PA.
“If you think you have tiptoed through the regulatory landscape and are not subject to regulation, think again: regulators and courts will find novel ways to apply the rules to protect investors.”
If there’s a bright side to this subject, it’s that selling away is usually not an issue with investment advisors compared to broker-dealer reps, Stuart Berkowitz sums up.
For one thing, they’re compensated differently. Most financial advisors work on a fee basis based on the amount of money they’re managing, so there’s less of a financial incentive to turn over the assets just to churn the account for commissions.
Investment advisors can sell things that are off the grid, Berkowitz says, but an undisclosed ownership interest in what they’re selling might be a conflict of interest and a breach of their fiduciary duty.
CONTACT David Neuman and Aaron Israels at www.israelsneuman.com or call us at 720-599-3505.