COVID-19 Update: How We Are Serving and Protecting Our Clients.

Articles Posted in Complex Products

Over the past several years, there has be an increasing number of registered investment advisors and financial advisors using omnibus accounts.  In short, an omnibus account allows an advisor to trade the same securities on behalf of multiple clients, while typically identifying in advance which trades are intended for which client accounts.  However, in some cases, trades are allocated after they are made.  This creates an increased risk of fraud since some firms’ supervisory failures have allowed advisors to “cherry-pick” which accounts get the winning trades, and which accounts suffer losses.  The securities fraud lawyers at Rich, Intelisano & Katz, LLP (RIK) won multiple claims against broker-dealers for allowing third parties to engage in this misconduct.

An omnibus account is intended to facilitate large purchase blocks of securities for multiple client accounts.  The idea of aggregating or bunching purchases in a single transaction is to obtain more favorable prices, lower brokerage commissions, and create more efficient execution.  After the trades are made, the advisor is supposed to allocate the trades to client accounts in accordance with the previously approved allocations.  The allocations of trades then should be reviewed by compliance and/or risk management periodically to ensure that accounts are not systematically disadvantaged by this policy.

Unfortunately, some advisors use this policy to scam their clients.  Sometimes allocation instructions are submitted after trades are executed, when the adviser has had the opportunity to view the performance of the trade over the course of the day.  By reviewing trade performance first, the advisor knows which trades are profitable and which are unprofitable, then can “cherry-pick” – that is to allocate the profitable trades to favored accounts and allocate losing trades to other disfavored accounts.

Deutsche Bank has agreed to pay a fine of $55 million to settle charges by the SEC that it filed misstated financial reports during the height of the global financial crisis relating to a multibillion dollar portfolio of derivatives.

The SEC’s multi-year investigation culminated in an Order Instituting a Settled Administrative Proceeding, available on the SEC’s website. According to investigators, the bank overvalued a portfolio of derivatives consisting of Leveraged Super Senior (“LSS”) trades, through which it purchased protection against credit default losses. This leverage created a “gap risk”, which the bank initially took into account in its financial statements, by adjusting down the value of the LSS positions. However, according to the SEC’s Order, when the credit markets started to deteriorate in 2008, Deutsche Bank steadily altered its methodologies for measuring the gap risk. Each change in methodology reduced the value assigned to the gap risk until Deutsche Bank eventually stopped adjusting for gap risk altogether. In other words, the bank slowly tweaked its formula over the months so that the risk didn’t show in its financial reports.

Therefore, “at the height of the financial crisis, Deutsche Bank’s financial statements did not reflect the significant risk in these large, complex illiquid positions”, according to Andrew J. Ceresney, Director of the SEC’s Division of Enforcement.

What are non-traditional exchange-traded funds (ETFs) and non-traded real estate investment trusts (REITs)? Why are independent broker dealers selling these complex products without proper supervision? FINRA wants to know and just slammed LPL Financial for doing such a thing.

This week, FINRA censured and fined LPL $10 million for broad supervisory failures in the sale of complex products such as leveraged ETFs and non-traded REITS. It also ordered LPL to pay an additional $1.7 million in restitution to certain customers who bought non-traditional ETFs.

This is a watershed moment for these and other complex products. First, LPL has over 14,000 brokers nationwide and is by a wide margin the largest independent broker dealer in the U.S. (Lincoln Financial Network with over 8,000 brokers is second). The biggest independent broker-dealer getting hit like this by FINRA is the equivalent of FINRA fining the old Merrill Lynch in wire house terms.

Contact Information