Big fraud cases put focus on disclosure

The Stanford and Madoff fraud cases have put the brokerage industry's disclosure system under the spotlight.

The Stanford and Madoff fraud cases have put the brokerage industry’s disclosure system under the spotlight.

News reports have uncovered the fact that regulators had looked into activities at the Houston-based Stanford Financial Group and Bernard Madoff Investment Securities LLC of New York long before the investing public learned of the suspected frauds.

According to the Wall Street Journal, the Securities and Exchange Commission opened a formal investigation into Stanford’s sales of certificates of deposit in 2006.

The paper also said that the Drug Enforcement Administration probed alleged money-laundering at Stanford’s Antigua-based bank in 1997, and in April 1999, the Department of the Treasury issued a warning that Antiguan banks controlled their regulator.

Stanford was also the subject of several private lawsuits alleging fraud, one in 2005 filed by two Venezuelans, a second filed in 2006 by a former Stanford employee and a third filed the following year by two former Stanford executives.

None of these probes and suits was publicly reported by the company on the BrokerCheck system run by the Financial Industry Regulatory Authority Inc. of New York and Washington.

By contrast, an individual registered representative has to disclose publicly virtually any investment-related lawsuit and any resulting settlement.

The one relevant item on Stanford’s BrokerCheck record is a July 2008 settlement with Finra over charges that it failed to disclose conflicts and gave unbalanced information in marketing its CDs.

“I and my family certainly wouldn’t have invested in 2008 [with Stanford] if we’d seen one report from Finra” raising questions about possible fraud, said Angela Shaw, a Dallas investor who runs the Stanford Victims Association.

She and other family members invested about $5 million in Stanford CDs after checking out both the firm and their broker. The money was from the sale of a family business.

But the record now shows “regulators knew something was going on” at the firm, but didn’t disclose it, Ms. Shaw said.

In January 2006, the SEC began an inquiry into a whistleblower’s allegations of a Ponzi scheme at the Madoff firm. According to the SEC’s case-opening report, Bernard Madoff misled it about the nature of his advisory activities, and failed to disclose to investors that he was managing their money.

The agency closed the case in November 2007, saying it found no evidence of fraud.

The inquiry didn’t have to be disclosed on BrokerCheck.

Finra spokesman Herb Perone declined to comment on reasons for the difference in the ways firms and brokers are treated. SEC spokesman John Nester didn’t respond to requests for comment.

Critics of the disclosure system aren’t surprised that Madoff and Stanford had relatively clean records.

“The disclosure rules don’t work very well,” said Edward Siedle, founder of Benchmark Financial Services Inc. in Ocean Ridge, Fla., who conducts investigations of money managers for pension-fund clients.

Mr. Siedle, a former SEC attorney, said he has seen disputed cases against investment management firms drag on, unreported, for nearly a decade.

Pat Huddleston, chief executive of Investor’s Watchdog LLC in Marietta, Ga., said that too much information has been expunged from BrokerCheck. His firm, which conducts investigations for both investors and advisers, has put together its own database that includes expunged information.

What’s more, the gap between the amount of information that individual brokers have to report, versus what their firms must disclose, should be closed, critics say.

“That’s one of the issues that should be examined [by Congress and regulators]: Does the process resort in the underreporting of firms’ [violations] and unfairly impact [registered reps]?” asked Mr. Siedle, who has written a book on loopholes in the reporting system.

It is an important issue, he said, because firms can cause much more damage to investors than an individual broker or adviser.

“If you’re a customer, you want to know about [pending investigations and complaints]” regarding a firm, Mr. Huddleston said. “I think it would be appropriate to require that disclosure.”

If and when brokers are placed under a fiduciary standard, the disclosure issue could become even more important. Some observers say that fiduciaries may have a duty to disclose anything that could be material to a relationship.

Much of that information is available. Separately from the disclosure forms that are used to populate the BrokerCheck database, brokerage firms also make quarterly disclosures to Finra of written customer complaints alleging fraud, as well as any settlements by the firm for $25,000 or more, and settlements by their brokers of at least $15,000.

These quarterly filings aren’t shared with the public.

For his pension-plan clients, Mr. Siedle said that he asks money managers to provide any deficiency letters or correspondence from the SEC.

But deeper disclosures of this type would be needed only if the failure to disclose would conflict with a duty to advise a client, said securities attorney Bill Singer, a shareholder in Stark & Stark, a Lawrenceville, N.J., law firm.

“Lack of disclosure could be a problem under a fiduciary standard if a customer sues a broker,” he said. Plaintiff’s attorneys will likely home in on why disclosures weren’t made, Mr. Singer said.

The industry, on the other hand, points out that the level of disclosure required of brokers and firms is unmatched by any other profession. Some have even argued that making brokers disclose unproven allegations is unconstitutional.

But the trend in recent years has been to narrow loopholes and in-crease the amount of information disclosed. Given the number of frauds being uncovered, that isn’t expected to change.

Mr. Singer, though, dismisses the idea that more disclosure will help uncover more fraud.

“I’m sure we could look at [improving disclosure], but the problem is the skill set [and] politicization of the regulators,” he said. “The problem is not with the forms that are filed, it’s with the folks who are reviewing them.”

E-mail Dan Jamieson at [email protected].