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What Would FINRA Do?

Investment advisors who have reflexively blasted SEC Chairman Mary Schapiro for saying the government should further regulate RIAs ought to look upon the civil fraud complaint filed against former NAPFA President James Putman as a cautionary tale.

I’m no big fan of FINRA. The Self-Regulatory Organization’s rules often get in the way of communicating with clients and running an honest advisory business. But the SEC’s allegations against Putman are so terribly damning.

Inarguably, additional rules are needed to better protect investors from unscrupulous RIAs. Far less clear, however, is whether being regulated by FINRA would have prevented the fraud Putman is accused of carrying out.

While the case against Putman is but one of a string of SEC enforcement actions targeting RIAs in recent weeks, it’s notable because Putman was a prominent member of the fee-only advisor community and at the moment this once-priestly segment of the advisor world benefits by confronting some ugly realities about the erosion of fidelity within its ranks. With RIAs vociferously protesting SEC Commissioner Schapiro’s stated intention to “harmonize” rules faced by RIAs with those faced by securities salespeople, reps of RIA may be more mindful that something must be done to protect the public’s trust in investment professionals if they understand the facts of the case against Putman.

In reading my summary of the facts stated in the 30-page, nine count SEC civil complaint filed against Putman, his RIA, and his former president and chief investment officer, please think about whether FINRA regulation would have better protected his clients. Leave a comment with your thoughts.

Putman, 57, started Wealth Management LLC, an Appleton, Wis. RIA, in 1985. He served as president of NAPFA in 1996 and 1997. Putman reportedly has not been active in NAPFA in recent years. However, as recently as September 2006, he participated as a panelist at a “NAPFA Cutting Edge Conference,” speaking at a session entitled, “The Search for the (NEW) Investment Paradigm.”

Putman is charged by the SEC with a litany of securities law violations, along with Simone Fevola, 49, who was president and CIO of Wealth Management (WM) from September 2002 to October 2008. The wrongdoing allegedly surrounds six unregistered private limited partnerships created in 2003 by Putman, which significantly changed his firm’s business model. In one of several similarities withthe Madoff fraud, WM took custody of client assets in the pools.

The pooled investments were structured like hedge funds and, as private vehicles, were unburdened by the need to register publicly. Each of the six funds had a specific objective, according to Part II of Wealth Management’s (WM’s) Form ADV ranging on the risk spectrum from capital appreciation to income producing. None was described as speculative. They were to invest in other private funds, funds of funds, debt, real estate partnerships and trusts, and asset-based loans.

As is often the case, the funds wese given an assortment of cryptic names, such as Gryphon, Quetzal, Pantera, and Watch Stone. Putman, who had discretion to invest on behalf of his clients, invested about 47% of his firm’s clients in Watch Stone and 40% of them in Gryphon.

According to the SEC complaint, offering documents for Watch Stone and Gryphon, the two largest of Putman’s pools, say their investment objective would be “to achieve a high level of income consistent with the preservation of capital” and the pools would primarily invest in “investment grade debt securities.” However, Putman and Fevola invested in “risky illiquid alternative investments,” the SEC says. It gets much worse.

An April 14, 2009 Form ADV filing by the federally regulated RIA claimed investments in the six pools were worth $102 million and that WM had another $29 million in separately managed accounts. The SEC says nearly 90% of the $102 million in client funds was invested in two of the partnerships, Watch Stone and Gryphon, which respectively had $50 million and $38 million. The SEC says now that the six WM funds “appear to have limited remaining assets.”

The SEC says Putman loaded up Watch Stone and Gryphons with investments in a life-insurance premium financing partnership that was managed by Joseph Aaron. Aaron in 1996 had been the subject of an SEC enforcement action alleging that Aron had committed fraud in selling promissory notes to investors. Moreover, the SEC says, Putman and Fevola knew about Aaron’s disciplinary history by 2004 but they still failed to verify that valuations Aaron placed on his funds were accurate.

Not only did Putman and Fevola fail to disclose Aaron’s shady past to WM’s clients, but the SEC says they also each accepted “undisclosed kickbacks” from him of $1.24 million in 2006.

Thus, even if you believe that Putman and Fevola were victims duped by Aaron, the SEC allegations paint a picture of Putman and Fevola falling in deeper with Aaron instead of blowing the whistle on him and admitting their mistakes to WM’s clients.

Meanwhile, in addition to the disastrous investments in Aaron’s life insurance investment scheme, other investments made by Stone Watch and Gryphon also went bad. Three of Stone Watch and Gryphon’s largest investments beyond Aaron’s partnerships are now in bankruptcy. Two are real estate funds, managed by California-based MKA Advisors, that went bankrupt in April 2009 and another investment is in fund called Sagecrest, a Connecticut partnership investing in asset backed loans that went bankrupt in the summer of 2008. While Putman in December 2008 wrote off 50% of the value of Sagecrest, the SEC says Putman has continued to value MKA’s investments at pre-bankruptcy levels in reports to clients.

The SEC alleges Putman had never fully disclosed the risks of the underlying funds invested in by Stone Watch and Gryphon, saying the funds were investing in investment grade securities when the offering documents for the underlying funds said investments were be risky and speculative, such as oil drilling deals. The SEC complaint cites a 70-year-old retiree with Alzheimer’s disease who had signed an investment policy statement targeting a fund with a 95% allocation to fixed income securities.

The Case Now
In the last 10 months, a majority of WM’s staff resigned or was terminated, the SEC says. To a reporter who has read many such SEC complaints over the last 25 years, it seems likely that WM staff, possibly Fevola, is actively cooperating with the SEC investigation and that the SEC is now targeting Putman.

As of December 30, 2008, the SEC says Putman valued Watch Stone at $47 million and Gryphon at $22 million. But according to notes taken by a staffer of the RIA during a recent client meeting, the SEC says, Putman admitted to the client that its investment in one of Aaron’s deals could be worthless.

One investor, whose statement cites an investment worth $1 million, was recently told by Putman that his investment could be worthless. Another investor, with a reported value of $670,000 on his 2008 year-end statement, told SEC investigators that he was recently informed by Putman that his investment could also be worth nothing. The SEC says Putman has continued to collect his 1.25% management fee on the funds based on the allegedly overstated valuations of the assets.

The government says that in February 2008 Putman wrote to clients saying that he was was limiting redemptions to 2% per quarter of the value of each client’s holdings for liquidity reasons. However, the SEC says he has arbitrarily honored full redemption of some investors.

“Absent immediate relief, it is likely WM and Putman will distribute the remaining assets of the WM Funds to a few investors who submitted redemption requests prior to September 3, 2008 and leave remaining investors with little or no recovery.”

What's It Mean?
The SEC complaint against Putman should serve as a cautionary tale to advisors. Those who knew Jim Putman say he was a straight shooter and cannot imagine what could have led him down such a tragic path. It's unlikely that Putman intended to defraud his clients when he started the partnerships in 2003.

Anyone who understands human nature should know that we are all tempted by greed, hubris, and corruption. Years of good bullish stock and bond markets and over-the-top returns on alternative investments could easily have caused some advisors to believe they could do no harm and to underestimate risks posed by some deals. From there, it’s a slippery slope and easier to fall in with scoundrels and become corrupt in desperation.

That's why I think advisors should start talking about the shape of coming regulation. Instead of knee-jerk reactions that dismiss calls for new regulation, groups respresenting advisors should be constructively helping to propose solutions.

For example, officals from the Financial Planning Asssociation, Investment Advisers Association, and NAPFA are quoted in an Investment News story pusblshed this afteroon saying that they strongly oppose an SEC proposal to conduct surprise audits by outside firms and have the cost of the exams come out of advisory fees.

How can FPA say that such a program would not affect investor protection? Why is NAPFA saying it's "overkill?" What are these people thinking?

I cannot remember a time when NAPFA and the Consumer Federation of America have been at odds. What's happened with NAPFA's penchant for being on the right side of consumer issues?

The Putman case shows that advisors need to be better policed, and the industry's leadership should embrace that idea by coming up with realistic good-faith proposals–not rhetoric aimed at protecting the interests of advisors but solutions that protect both investors and advisors and, thus, in the long run make for a better business environment for advisory firms.

My question is:
What regulatory framework is best able to restore investor trust when it has been so badly abused under the current compliance regime? Would FINRA oversight of Putman have made a difference? What do you think?

5 Responses to “What Would FINRA Do?”

  1. May 25th, 2009 at 11:34 am

    Tom Grzymala says:

    I defer commenting on FINRA oversight of Jim Putman per se because, as an RIA, he was registered with the SEC and subject to their regulations and oversight. Although I prefer to believe, for now, that Putman and Bernie Madoff are birds of different feathers, Madoff too was subject to SEC oversight.

    FINRA is a self-regulatory organization created in July 2007 through the consolidation of NASD and the member regulation, enforcement and arbitration functions of the New York Stock Exchange. You may recall that the "SD" in NASD = "securities dealers". It appears that NASD and now FINRA is an organization created by broker/dealers to watch over themselves. The fox guards the chickens and prior, to her appointment as SEC-Chairman by the Obama administration, Mary Shapiro was the head fox. Now she’s leading an organization whose mission "is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation." For additional boilerplate I invite you to the "Invesor’s Advocate" website at

    I submit that perhaps since the tenure of Arthur Leavitt as Chairman the SEC has failed miserably in fulfilling its mission. Having testified in numerous NASD/FINRA arbitration hearings, all well’s in the chicken coop despite some recent tap dancing by several B/Ds.

    The fiduciary standard to which RIAs must adhere must not be sacrificed in the investment advisor/broker-dealer "harmonization" process suggested by Ms. Shapiro. It must be THE undiluted standard for ALL persons dealing with the investing public, people who have little idea of the difference between fiduciary responsibility and suitability. These folks just don’t want to be lied to or cheated; they want to trust us. To make this happen both the SEC and FINRA must cause their people to become better educated about the whirling dervishes which have made Wall Street a ghost town and have the necessary financial and manpower resources to better enforce the rules and regulations of the marketplace.

  2. May 25th, 2009 at 11:57 am

    Marcus Saskin says:

    Hi Andrew, good write up. While I believe in regulation, I believe that it needs to be carefully thought through and not done in haste. When regulation is pursued due to emotional reactions to specific events, such as: Putnam, Madoff, Nadel, etc. it will probably lead to bad decisions or overly burdensome regulation (similar to the bad decisions that are made due to emotional investing). Nor should new regulation be pursued just because of the opportunities presented to the regulation community due to the current economic and political volatility. While we all have agendas, the regulators need to keep their eagerness in check even though they are being presented with opportunities not seen in many decades by the sweeping changes occuring in our country in both the economic and politcal realm. I do not want the responsible and ethical financial professionals to be plagued by overly burdensome regulation and compliance when it is a limited few giving the profession a bad reputation. To that point, can you give us any statistics on how many financial advisors, registered reps, stock brokers, planners, RIAs, insurance agents, etc. there are out there and the number of complaints or actions there are against them on an annual basis? I think if people understand how limited these transgressions are as a percentage of those working as financial professionals it may give some credibility back to the industry. Therefore, the public can know that, for the most part, the people they are working with or are going to work with in the future are legitimate people working hard to do a good job for them.

  3. May 27th, 2009 at 4:36 pm

    Rosa Cole says:

    I agree with Mr Saskin. It is a possiblity that we will throw the "baby" out with the bathwater. Over the last decade I watched one of my adult children build a independent RIA business. He poured his blood, sweat, tears and retirement nest egg into it. The needs of the clients were always put first and as the expense of complying with the myriad of additional SEC rules I watched my adult child barely break even. To my horror, my child made the decision to close last month because as a small independent advisor, my child’s pockets aren’t deep enough to pay for the additional expenses of new regulations as a consequence of the recent scandals involving RIA’s. My child had a perfect compliance record and many satisfied clients. I was at a loss to understand the decision to close. But after reading the story I realize that a small, independent RIA has considerable liability in this current environment. One misunderstanding or disgruntled client could make false allegations that the SEC would have to investigate therefore putting a burden on the RIA firm and their reputation. Too bad there is so little focus on the RIA’s that stayed out of trouble. I have yet to read an article about that.

  4. May 28th, 2009 at 3:09 pm

    Shelley Ferro says:

    The financial system needs to be overhauled, but more regulation is not the answer. Attorneys get disbarred, doctors lose their license, and financial advisors will act irresponsibly. But, these are the minorities in the profession, and these actions of a few should not degrade the entire profession.

    There is apparently a disconnect between what unscrupulous advisors are telling their clients, and the reality. If each financial product that was brought to market received a "risk rating" and this risk rating was indicated on the client’s statement, the client would have a better understanding of what that investment represents in their portfolio. If "risk ratings" went from 1-10 with 10 being the highest, and an investor saw their overall rating was a 8 when when it should be a 2, the investor would know the advisor was investing inappropriately. Financial professionals would be responsible for assemblying a portoflio of financial products meet the client’s risk tolerance.

    The question I have is who approved these "pooled investments" to get to market? That’s where the problem began.

  5. May 28th, 2009 at 3:24 pm

    Andrew Gluck says:

    Such risk ratings already exist. In this case, Putman is alleged to have told his clients that an investment was income oriented and aiimed at "capital preservation" when, in fact, he was invetsing the pool in a water park and oil wells.

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