generic graphThe Wall Street Journal reported that the SEC is not moving forward on a measure to require broker dealers and investment advisers to vet individual investors before permitting them to trade leveraged and inverse exchange-traded funds. These funds use debt to try to increase returns. But this leveraged approach to investing also increases the size of potential losses.

Many leveraged and inverse exchange-traded funds are complicated investments and difficult to understand. The Wall Street Journal reported that two companies that offer these investment products, Direxion Investments and ProShares considered the SEC’s proposed vetting requirement a threat to their business model. The Wall Street Journal also reported that between March and July, representatives and lobbyists for Direxion and ProShares met or had phone conferences with the SEC nine times.

SEC Commissioner Allison Herren Lee released a statement criticizing the SEC’s decision not to implement the protection for investors. The Commissioner wrote that she was “deeply disappointed in the failure to advance the proposed sales practice rules, which were designed to address the very real investor harms arising from unsuitable purchases and sales of leveraged and inverse ETFs.” The Commissioner further commented that many enforcement cases at the SEC and FINRA “have shown that even investment professionals often lack a basic understanding of these complex products.”

Investors have access to free electronic search tools through self-regulatory organizations, federal, and state regulators to research investment firms and professionals. This post describes several free tools that give access to information beyond what you can learn using Google and other search engines.

FINRA’s BrokerCheck is a good starting place to learn about registration and reported discipline. BrokerCheck allows you to search for an investment firm or professional by name or CRD number. BrokerCheck will tell you whether a firm is a broker or an individual is a registered representative regulated by FINRA. If regulated by FINRA, a BrokerCheck search will include information about reported disclosures, such as arbitrations or customer disputes, and provide information about registration. Click on the “Detailed Report” link—as the name of the link implies—for more detailed information, including summaries of any complaints. Also, keep in mind that through expungement, a broker can ask FINRA to remove customer complaints and arbitrations from records available through BrokerCheck. This means that an expunged complaint will not show up in your BrokerCheck search. Further, customer complaints are not always timely reported and may be missing from BrokerCheck.

FINRA also provides a free search tool for certain disciplinary actions since 2005. This search tool is available at https://www.finra.org/rules-guidance/oversight-enforcement/finra-disciplinary-actions-online.

If a firm is registered as an investment adviser or an individual is registered as an investment adviser representative, searching for the firm or individual using BrokerCheck will provide you with a link to the SEC’s Investment Adviser Public Disclosure website. For investment adviser representatives, the SEC’s Investment Adviser Public Disclosure search provides information similar to what FINRA makes available about brokers and registered representatives using BrokerCheck. For investment adviser firms, the SEC’s search tool gives access to the firm’s Form ADV, brochure, and Form CRS. These documents include information about an investment adviser’s business, including information about fees.

You should also check with the division in your state that regulates investment advisers. Some state regulators make available free information about investment advisers licensed to conduct business in the state. For example, the State of Oregon provides a free search tool that gives access to limited license information here: https://www4.cbs.state.or.us/ex/dfcs/dfcslic/adviser/.

Some investors may not realize that the person who the investor thinks of as his or her investment adviser is actually a solicitor for another business who is paid a cash fee to bring in clients. Investors who are working with an adviser who uses a solicitor may be paying higher fees because of the solicitor arrangement. Often times, the investor receives no additional services in exchange for paying higher fees. In other cases, the relationship between the investment adviser and solicitor is hidden or unclear, or the investment adviser and solicitor wear multiple hats, providing investment advice and receiving payments for bringing in new clients. 

Investment advisers who must register under the Investment Advisers Act of 1940 (“Advisers Act”) are generally prohibited from paying a cash fee, either directly or indirectly, to a person who acts as a finder or runner, soliciting clients for the adviser.  However, a complex rule, 17 CFR Section 275.206(4)-3, provides an exception to the general prohibition against an adviser paying a solicitor to bring in clients.  This rule says that it is unlawful for an investment adviser required to be registered under section 203 of the Advisers Act to pay a cash fee to a solicitor with respect to solicitation activities unless a long list of requirements are met.  Among others, the requirements include:  i) that the adviser be registered under the Advisers Act; ii) the cash fee is paid pursuant to a written agreement to which the adviser is a party; iii) the adviser must keep a copy of the written agreement; iv) the written agreement must describe the solicitation activities and the compensation to be received for them; v) the solicitor, at the time of any solicitation activities for which compensation is paid or to be paid by the investment adviser, provide the investor with specific disclosures; and vi) the investment adviser must receive from the client, before or at the time of entering into an advisory contract with the client, a signed acknowledgment of the investment adviser’s written disclosure statement and the solicitor’s written disclosure statement.

The SEC’s Office of Compliance Inspection and Examinations (“OCIE”) published a risk alert in October 2018 about compliance issues related to cash solicitations.  The OCIE identified some of the most frequent deficiencies that its staff found regarding the cash solicitation rule, 17 CFR Section 275.206(4)-3.  The frequent deficiencies include that advisers paid cash fees to a solicitor without a solicitation agreement, missing disclosure documents, incomplete disclosures, and missing client acknowledgments.  The OCIE staff also observed advisers who did not make a bona fide effort to determine whether solicitors complied with solicitation agreements. Any one of these deficiencies means that the adviser and solicitor may have violated the prohibition against paying or receiving a cash fee for soliciting clients.

Click to read the complete text of 17 CFR Section 275.206(4)-3. Investors can read here the October 2018 OCIE risk alert.

On June, 3, 2020, the U.S. Securities and Exchange Commission (“SEC”) obtained a preliminary injunction against investment adviser Paul Horton Smith, Sr. and related entities. The SEC alleges Smith and his entities engaged in a Ponzi scheme targeting senior citizens.

The SEC’s complaint refers to three entities associated with Smith: Northstar Communications, LLC, eGate, LLC, and Planning Services, Inc. Through these entities, the complaint alleges that Smith targeted seniors, guaranteeing investors annual interest payments in so called “private annuity contracts.” Smith did not in fact invest the money as promised, the SEC explained, and instead used the money to pay investors in a Ponzi-like fashion. The SEC also alleges that Smith held himself out to be a trusted fiduciary.

The case is Securities and Exchange Commission v. Paul Horton Smith, Sr., et al., Central District of California, No. ED CV 20-1056 PA (SHKx).