Taking Sides: Frauds big and small depend on gullible investors, industry

Brokers and their bag of tricks – there seems to be no end to the manipulations that some will orchestrate to take advantage of their clients.

Arthur Levitt, the departing chairman of the Securities and Exchange Commission, made a brief reference to one such nefarious practice in his last town hall meeting as the nation’s chief securities regulator.

Below radar

He sounded the alarm about “switching,” a scam similar to churning a stock portfolio. It’s usually associated with annuities, but in this case Mr. Levitt was talking about industry pros who repeatedly switch investors in and out of mutual funds solely to generate commissions for themselves.

InvestmentNews reporter David Hoffman picked up on the reference in Mr. Levitt’s comments and began to look into the matter. As his story noted last week, switching has largely fallen below the radar of federal regulators.

That’s because as scams go, it’s pretty small-time. Lawyer Vincent DiCarlo told InvestmentNews it amounted to “nibbling.” Unless switching involves wildly excessive commissions, it is unlikely to result in the kind of harm that’s going to make someone angry enough to file a complaint, he noted.

But that doesn’t make it any less important – quite the contrary.

The fact is mutual funds today are still the investment of choice for the vast majority of people. Although no figures were available to quantify the problem, rest assured that the potential for abuse is huge. What’s more, switching is considered a nuisance crime and unscrupulous brokers count on that to avoid getting caught. Yet the industry pays a price in bad publicity, ill will and loss of confidence among investors.

When it comes to switching, the SEC largely counts on the industry to police itself, and most firms do have some sort of control procedure in place – usually form letters – to notify clients about changes in their portfolio. But for this system to work, companies must diligently oversee their brokers. Frankly, we doubt that that happens on a regular basis.

The industry is often quick to complain when regulators impose detailed rules in matters such as switching, but ineffective self-policing is an open invitation for more red tape. It may be premature to say that more regulation is needed, but without more effort to address the problem, the industry is begging for it.

The other line of defense, of course, rests with the investors themselves.

For another thought-provoking article this week, Mr. Hoffman looks at recent fraud cases for any patterns that could serve as warning signs for investors.

The results are surprising. He finds that a very close relationship exists between the broker and the investor. It seems as though offending brokers go out of their way to establish a friendship beyond the normal professional relationship that should exist between a broker and client.

Does that mean such friendships are wrong? Not necessarily. In many cases, brokers and advisers have clients who were friends before they entered into a financial relationship. Others can maintain friendly relations, with no harm done. Even so, investors need to be wary of brokers or advisers who try to overly ingratiate themselves.

A crucial element of any fraud is the need to first establish a bond of trust. Without that, no fraud can take place. Obviously, we’re talking about a fine line here, with lots of gray area on either side. But when it comes to money, investments or retirement, it’s better to keep the relationship at arm’s length.

In the meantime, if you need a friend, get a dog.