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When 'Just Trust Me' Isn't Enough

Transparency is essential if you want to keep your clients' trust.

Helen Modly, 04/30/2009

You can't blame clients for being worried about the security of their investment accounts. Highlight these four points to reassure clients that their funds are safe from fraud.

Bernie Madoff and Allen Stanford made off with more than half a billion dollars of other people's money. No one knows yet where it all went or how much of it can be recovered for the investors who trusted in these two crooks, or in the numerous intermediaries who referred to them. The new administration and its regulators are busy beating their chests about how concerned they are and what a top priority it is to design a new regulatory environment. Our clients will be getting an earful of arcane regulatory concepts as the media continues to cover this developing process.

I suspect that the vast majority of our clients and prospective clients don't really understand the difference between a registered representative and a registered investment advisor. You may function in both of these roles, furthering their confusion. Maybe you also promote yourself for marketing purposes as a group of advisors under a broker-dealer's umbrella. You client knows you as an advisor with ABC advisors, but your business card says something about securities being offered by a completely different firm. Even worse, many of you have had your broker-dealers bought or merged into a completely different firm, some more than once.

Is it any wonder that your clients are asking themselves, "How do I know what is really happening with my money"?

Encourage Clients to Read Their Statements
So many clients have become numb to the market that many are not even opening their statements. One recent survey stated that the majority of clients who do look at their statements spend less than three minutes reading them.

Encourage your clients to really look at their statements to be sure that the beginning values and any deposits or withdrawals of funds or securities match what they believe should have occurred during the month.

Most registered representatives manage accounts without discretion, meaning that they must obtain the client's consent before making any trades. Most registered investment advisors manage accounts with limited discretion, meaning that they can place trades without specific consent. Depending upon your style of practice, highlight for your clients the protections that exist with either model. Transactions are either specifically approved or are blanket approved by the account application, giving the advisor limited trading authority or limited power of attorney.

Clients need to understand that even with trading discretion, advisors cannot transfer funds or securities to the accounts of others without written instructions or standing electronic orders.
Remind your clients that any deposit or transfer of client funds or securities should be reflected on their custodial statement for the account involved.

Security Investors Protection Corporation
Review the fine print on the back of their brokerage statements to help them understand the relationships between the various entities involved. For example, as an RIA, we custody client accounts with Fidelity, and on the back of client statements it explains that the actual custodian is Fidelity Brokerage Services, while all transactions clear through an affiliated broker-dealer named National Financial Services, LLC. Both entities are members of SIPC. SIPC membership is an important safeguard for clients, but they need to understand what it does, and does not protect against.

One of Madoff's entities, Bernard L. Madoff Investment Securities, LLC, was in fact a member of SIPC, and thus many of his investors may receive at least some of their funds back. It is important to note that the SIPC does not insure against market losses, rather they insure against missing securities. For member firms, the coverage is up to $500,000 per customer with a maximum of $100,000 for cash claims. Your clients can visit the SIPC website, www.SIPC.org to check whether their custodial firm is a member.

Changes in Supplemental Insurance Protection
On top of the protection provided to investors by membership in the SIPC, many custodians used to offer supplemental investor protection up to the full value of the customer's account. This coverage was often provided through a consortium of broker-dealers called CAPCO. Again, this was protection against missing securities, not the loss of market value of any security.

One of the repercussions of the financial market meltdown was CAPCO's withdrawal from issuing excess SIPC coverage as of February 2009. Lloyds of London is providing many custodians a different form of excess coverage that has an overall limit per custodian of up to $1 billion, as well as other limitations. It is still protection against missing securities, not loss of market value.

Be sure your firm does offer this excess SIPC protection and let your clients know about it. Most firms have a little brochure that you can send out describing SIPC and supplemental coverage. This would make a good envelope-stuffer right about now. PAGEBREAK

Custody and Custodians
Explain to your clients that the cornerstone of investor protection is the segregation of assets. The assets in their brokerage accounts are required to be held in custody, that is separate from the brokerage firm's own assets, and are not available for the firm's use. This requirement is described in SEC Rule 15c3-3, the Customer Protection Rule. Your broker-dealer may custody accounts themselves or through an affiliated broker-dealer. Many insurance or bank related broker-dealers, as well as some independent broker-dealers and Registered Investment Advisors utilize one or more non-affiliated broker-dealers for custodial services to their clients.

One of the biggest features of Madoff's swindle was that he was not only the advisor on his clients' accounts, but he also functioned as the custodian. If he had been using one of the major custody firms, his clients would have received a periodic statement directly from the custodian that would have revealed exactly what was (or was not) in their accounts. This is the single best way for clients to know what their account holds and what it is really worth. You may provide a periodic performance report, but the actual statement they receive should be sent directly from the custodian.

The only exception to this is when the advisor is also serving as the custodian. In this case, the advisor would be subject to intense audit scrutiny, as was Madoff. In his case, he apparently had either an inept or a complicit accounting firm, but I'm sure we will be hearing more about that later. If you do take custody of your client's assets, then you will need to stand behind the integrity of the accounting firm that audits your books and records, otherwise your clients will be able to rely on the division of responsibilities and accountability between you and their custodian.

Where Art Thou, Regulators?
Normally, both registered representatives and registered investment advisors could point to the enormous regulatory structures under which they operate as a form of client safety. However, both of the primary regulators of investments, the SEC and the Financial Industry Regulatory Authority, were asleep at the wheel on Madoff. This concerns clients, and it should. While we all wait to see what response these same regulators come up with, encourage your clients to develop the habit of vigilance.

Trust! But Verify!
We all want clients who trust us, but trust requires verification. Impress upon your clients the importance of reviewing and understanding their monthly or quarterly statements from their custodian. They should also compare the transactions from their confirmation statements to their monthly statement. Encourage them to view their accounts online from time to time and contact you with any questions or discrepancies sooner rather than later. In the event they ever do have to file a claim for missing securities, they will need accurate records to prove what should have been in their accounts.

If you haven't already, prepare a response to these recent investment frauds by highlighting the significant differences between the operations of you and your firm and the tightly entwined business activities of Madoff and Stanford. When clients see so many prominent, intelligent, and savvy people being taken by these swindlers, they worry about their own situation. Help your clients understand why they are not at risk for this type of fraud by highlighting the oversight provided by an independent custodian, as well the security of SIPC and supplemental insurance for member firms.

If, after all this, they are still unsure that they have not been fleeced or aren't going to be fleeced by fraud, you probably can point to their recent account performance as proof of your honesty. Only a really stupid crook would manufacture false market losses to attract new victims.

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