Frontline News

Private-Placement Claims Surge
(Dow Jones) A surge in arbitration claims over private placements is raising a good question: Shouldn't someone raise the income and asset thresholds that were designed to ensure that these largely unregulated securities are marketed only to institutions and well-heeled, sophisticated investors? The answer would seem obvious, considering that these thresholds were set more than 20 years ago.

Private placements--the sale of securities directly to a select group of investors who generally agree not to resell them--have long been a mainstay of institutional investors. The securities, often referred to as "Reg D offerings," are typically exempt from Securities and Exchange Commission registration because they're not intended for public sale.

Increasingly, however, some lawyers say they're reaching a crowd of individual investors for whom they were never intended. These investor attorneys say they're handling three to five times the number of private-placement cases they did even just a year ago. Many are against smaller broker-dealers who investors say sold them private placements that, according to regulators' charges, are fraudulent.

SEC guidelines set in 1982 allow the sale of private placements to "accredited investors." That includes individuals whose net worth exceeds $1 million, including the value of their home, or who earn $200,000 in individual income. In 1988, the rules were amended to include couples with $300,000 in joint income.

Back then, those requirements basically meant that only wealthy people were eligible. In the years since, average income and home values have easily more than doubled.

The SEC proposed in late 2006, and again in 2007, to increase the thresholds to $2.5 million in investments and $400,000 in individual income or $600,000 in joint income. It also proposed an automatic adjustment for inflation every five years.

The reaction was overwhelmingly negative. The agency received hundreds of comment letters, many from investors and advisors who said the increases would limit their options. Not only have the thresholds been easier for more investors to reach, but issuers also are allowed to sell a small percentage of their private placements to investors who don't meet the standards. That exemption has exposed some mom-and-pop investors to unsuitable investments, say attorneys.

Andrew Stoltmann, a Chicago-based lawyer, says he recently filed a claim on behalf of a couple in their 60s who were sold $586,000 in private placements and other illiquid alternative investments--representing about a third of their entire portfolio. One of those private placements included notes in Medical Capital Holdings Inc., which is now facing civil fraud charges by the SEC.
The SEC says Medical Capital had raised more than $2.2 billion through offerings of notes in associated corporations since 2003, and that five of the corporations were in default or late in making payments on $992.5 million of the notes. Several phone numbers for Medical Capital Holdings are not working, and the company is being liquidated, says Stoltmann.

The case has spawned numerous investor claims against small brokerages that attorneys say sold the securities, including Securities America in La Vista, Neb.; Capital Financial Services Inc. in Minot, N.D.; and QA3 Financial Corp. in Omaha, Neb. A spokesman for Securities America declined to comment on the Medical Capital case, but said the brokerage takes its clients' risk management seriously. A Capital Financial Services spokesman didn't immediately return a call for comment. A person who answered the phone at QA3 Financial said a spokesman wasn't available.

Holding Companies Holding On
Remember when the growth of holding companies was one of the splashiest trends in the RIA space? Holding companies--otherwise known as consolidators, aggregators or roll-ups (most of them hate that term)--were among the most aggressive acquirers of sizable advisory firms as mergers-and-acquisitions involving RIAs zoomed prior to the market crash. Post-crash has been a different story.

The acquisition spree has slowed, some advisors have bought back their businesses, and a recent lawsuit alleging breach-of-contract filed by one of the partner firms at Focus Financial Partners, a leading holding company, raises questions whether these structures make sense for advisors.

"There's no black-and-white answer," says Daniel Seivert, CEO and managing partner at Echelon Partners in Manhattan Beach, Calif., an investment banking and consulting company. "There is a long list of advantages and disadvantages."

Off-the-record scuttlebutt from advisors tells tales of one-sided financial and legal terms at some holding companies and their private-equity backers that've rankled some advisory firms. "There are a lot of elements embedded into stock agreements that give rights to management teams and investors," Seivert says. "You have to be real careful about that."

Are advisors conducting enough research before selling a stake in their firms or are they too eager to get a big check? "I think there's a disconnect when some of these advisory firms look into these types of deals without the same level of scrutiny as they would buying securities for a client," says Brian Hamburger, managing director at MarketCounsel, a consulting firm in Englewood, N.J.

Holding companies typically offer cash and an equity stake to the principals of advisory firms, and ideally provide infrastructure support, technology or other needed services to help their affiliated firms grow. In return, firms sell a percentage of ongoing future cash flows to the buyers (or, in some cases, the entire business) at a higher multiple than possible from a legacy transaction or a sale to a comparably sized outfit. And some holding companies hold out the promise of an initial public offering or potential buyout by a larger financial institution as a possible exit strategy that could provide a huge payout to all parties involved.

But the track record for publicly held financial holding companies hasn't been great. Two primary examples--National Financial Partners and Boston Private Financial Holdings--both have share prices that recently traded in the single digits and were roughly 80% below their all-time highs from the middle of this decade. (Of course, most financial companies took it on the chin in recent years.)

But while the pace of acquisitions has cooled, things could be warming up again. "Sellers have been focused more on taking care of their business than they are in talking to guys like me," says Rusty Benton, CEO of WealthTrust LLC, a Nashville, Tenn.-based holding company with ten partner firms. "For buyers, it's been hard to put a value on a business in this kind of market. And financing was hard to come by during the credit crunch."

WealthTrust hasn't made any acquisitions since October 2008, but Benton says he intends to make more acquisitions. In mid-November, New York-based Focus added its first major advisory firm in roughly a year when it took a stake in Joel Isaacson & Co., a leading RIA firm in New York City with $3.5 billion in assets. Meanwhile, United Capital Financial Advisers in Newport Beach, Calif., remained active this year with four acquisitions, and it expects to make two more by second quarter 2010.

"There's a role for these entities in that they're helping advisors create economies of scale either as business-building partners or by providing needed liquidity," says Dan Inveen, a principal at the consulting firm FA Insight in Tacoma, Wash. "Long term, we'll continue to see these businesses as viable business propositions. In the short term, some people are going through some angst."
But there's a twist to this strategy. "One trend we're seeing is that RIAs have gotten bigger and more sophisticated to the point where they're doing deals on their own," Inveen says. "The Focus Financials and United Capitals of the world have competitors from RIAs making acquisitions."

Thin Wallets
Here's a shocker: Many Americans are in poor financial shape. If we didn't know that already, along comes a national survey on the financial capability of the U.S. put out last month by the Financial Industry Regulatory Authority (FINRA) that details some of the financial shortcomings of rank-and-file consumer finances.

According to the survey of nearly 1,500 American adults, nearly half of respondents have difficulty covering monthly expenses and paying bills. Of these, 14% said it was very difficult to keep their noses above water and 35% said it was somewhat difficult.
To make ends meet, 9% said they've taken out a loan from their retirement accounts during the past 12 months, while nearly 5% have taken a permanent hardship withdrawal. These actions are most common among people who earn between $25,000 and $75,000 a year.

Household expenses during the past year exceeded income for 12% of those surveyed, and were roughly equal to income for 36%. One-third of respondents said they had a large and unexpected drop in income during the past year because of the economic downturn.

Making matters worse for many people is that rainy day funds are drier than they should be. According to the survey, nearly half (49%) of people said they haven't set aside enough money to cover expenses for three months in case of illness, job loss or other emergencies.

And when it comes to saving for college, only 41% of respondents said they've set aside money for that goal. And among those who have, just 33% are using tax-advantaged savings accounts such as 529 plans or Coverdell Education Savings Accounts.
When it comes to financial literacy, 37% said their financial knowledge was at the top of the scale. But when put to a financial literacy test, just 30% correctly answered both a question about interest rates and inflation, plus a question about risk and diversification.

Trick Or Tweet
Next time you tweet on Twitter, remember that FINRA might be watching. Or, at least, it might want to look at that and other types of electronic communication when it conducts examinations into potential wrongdoing at financial firms under its jurisdiction.

In an October speech, FINRA's CEO, Rick Ketchum, outlined the agency's efforts to beef up its examination and overall regulatory programs to better combat financial fraud. Ketchum added that social networking sites such as Facebook, LinkedIn and Twitter present new ways to communicate with clients that raise new regulatory challenges. "For example, as currently designed they may not allow you to archive and maintain the communications on your own books and records," he said.

And that could be a costly problem. In September, Carr Securities Corp. was fined $25,000 for failing to ensure that its electronic communications were archived to a non-rewriteable format in an adequate time frame. In November, Terra Nova Financial was fined $400,000 for "failing to properly supervise its soft dollar program, failing to implement adequate supervisory procedures and failing to retain its business-related electronic instant messages."

Also in November, MetLife Securities and three of its advisory affiliates were fined $1.2 million for "failing to establish an adequate supervisory system for the review of brokers' e-mail correspondence with the public."

"Firms need to ensure that their electronic communications policies cover all forms of electronic communications, not just e-mail," says Stephen Marsh, CEO of Smarsh, a compliance and records management company. "Many firms currently ban the use of these newer mediums, similar to the approach taken circa 2003 and 2004 regarding instant messaging in the workplace. In reality, employees are using these tools and firms can be held liable for them, just as they are for e-mails sent from outside the office."

Average Withdrawal Rates Decrease
Two trends emerged from a recent study conducted by the Financial Planning Association on retirement income. One, retirement planning is increasingly playing a bigger-and lucrative-role in the average financial planner's practice. Second, the average sustainable withdrawal rate used by advisors dropped fairly significantly versus prior years.

For advisors who use a systematic withdrawal program with clients, the average withdrawal rate was 4.4% in the latest survey. That continues a downtrend in recent years. The average rate in the 2007 survey was 5.3%, and in 2008 it was 5.0%. The recession, and its impact on portfolios, is presumed to be the reason for the lower rate.

Baby boomers are shifting from accumulating assets to living off them, so it's no surprise that retirement planning is becoming a larger piece of the puzzle for advisors. Survey respondents said 53% of their clients received some sort of retirement income assistance-products, services or guidance-during the past year. And 63% said that percentage increased over the prior year.
Retirement planning comes with its own set of complexities ranging from calculating a client's income needs over a retirement lifespan to calibrating the best asset allocation mix and developing a withdrawal strategy. But these are marketable skills, and 91% of survey respondents said they were able to leverage their retirement income background into acquiring new clients.
"Highlighting their expertise in retirement income planning appears to be a successful means of marketing their practice," the report concludes.

The asset distribution phase means less assets for advisors to oversee. Nonetheless, survey respondents on average expect retirement income-related revenue to grow almost by one-third during the next five years due to consolidating more of their client assets and higher fees associated with various planning and distribution services.

The 2009 Financial Advisers' Attitudes and Perceptions About the Retirement Income Distribution Market study was conducted in August with 460 participants. The study was produced by the consulting firm Diversified Services Group and was sponsored by Nationwide Financial.

UMAs Slow To Win Fans
(Dow Jones) For years, the brokerage industry has been touting unified managed accounts as the next big thing, but financial advisors and their clients evidently haven't gotten the message.

Unified managed accounts, or UMAs, were supposed to be an improvement on one of Wall Street's standby investment vehicles for the wealthy--separately managed accounts, or SMAs.

SMAs are investment strategies of, say, 20 to 40 stocks held in a brokerage account but overseen by an outside money manager. SMAs can have lower investment fees and lead to fewer tax bills than mutual funds, but they've always been a big source of back-office headaches because financial advisors have to open a separate account for every investment strategy a client uses.
UMAs are designed to streamline the process, allowing for SMA strategies, mutual funds, exchange-traded funds and other assets to all be held in the same account.

But a recent report from Boston-based consulting firm Cerulli Associates concludes UMAs have lately shown "underwhelming growth," in large part because they failed to accommodate one of advisors' biggest concerns over the past 18 months-the inability to quickly yank investors out of the stock market and put their money into bond and money market funds.