Investor Fraud - Improper Transactions

This is the last segment on investor fraud that covers improper transactions. In particular, it covers the situation where an investor looks at a statement and wonders when and why did my advisor make these trades.

First, let me tell you a true story about a farmer in North Dakota about 1990. This person invested money with a well knows investment firm with an advisor that he trusted. The money was designated to be invested at a conservative risk level. The advisor made some trades that lost money in a declining market. As the market declined and the account went down this advisor made more trades and got more aggressive. The farmer looked at his monthly statement and saw transactions and that he was losing money. This account went into a downward spiral because of the advisor taking higher and higher levels of risk in a declining market.

I will tell you the end of the story in a little bit. You can control investor fraud due to improper transactions by taking control in level of authority and level of risk. Some trading is done by advisors to generate revenue associated with making the trade. You can reduce the chance of fraud by hiring a fee based investment advisor that does not get paid by doing a trade.

Level of authority is the amount of control that you give an advisor. This authority has 3 levels: full custody, discretionary control, and no control. Full custody means that you give an advisor full control including the movement of money into and out of an account. Discretionary control means that you give an advisor full control of trades without getting your prior approval but can not handle money. No control means that the advisor must get your approval before making a transaction.

Fidelity Investments ask for permission for either full trading authority or limited trading authority. Full trading authority is most similar to full custody. Limited trading authority is most similar to discretionary control.

If you want to eliminate improper transactions in your account you do not want to give an advisor either full custody or discretionary control. You want the advisor to have your approval before any transaction.

My business practice is to have limited trading authority as designated by Fidelity Investments with a clause in the client contract that states any transcation must have prior approved by the client. This is done to improve communication, eliminate any concerns up-front, and because this is how I would want to be treated as an investor.

Level of risk is the amount of risk that you authorize in the profile section of an application. If you state that you are a conservative investor then money must be invested in a conservative manner as appropriate using the Prudent Man Rule. It is improper for the risk level to change without written approval by the client.

So what did the farmer's advisor do wrong? First, the level of risk was not approved by the client and the advisor acted on his own without approval. Second, the amount of trades was not prudent for a conservative investor.

How did the story end? The farmer contacted the investment firm with the issue and talked with the Compliance Officer. An investigation was conducted and it was found that the advisor did not act properly. The advisor drowned in a boating incident the weekend before action was going to be taken against the advisor. The farmer's account was reimbursed and put back to a conservative portfolio where it should have been by the investment firm. The investment firm did this because they did not want a very nasty fine by the SEC and having this incident made public.