Archive for August, 2012

NYTimes: Hedge Fund Proposal Would Allow Secretive Enclave to Open Up

The tight-lipped world of hedge funds might soon be able to speak more freely.

The Securities and Exchange Commission on Wednesday proposed rules that would remove a longtime prohibition against general solicitation by hedge funds, a huge change for an industry that has ballooned in size and influence in recent decades.

Unlike their mutual fund brethren, hedge funds have long been barred from advertising in public forums like newspapers or television. Releasing information as basic as performance and assets has been prohibited, the idea being that such complicated and risky investment opportunities should be promoted only to those deemed financially fit. That means at least $1 million in liquid assets, or a $200,000 annual income for an individual or $300,000 for a couple.

But under the new rules, hedge funds may be able to rent billboards, buy full-page advertisements in newspapers or have Web sites that offer the public a real look inside their operations and performance, as opposed to the password-protected sites most operate today. The proposal — which was mandated by a new law, the Jump-Start Our Business Start-Ups Act, also called the JOBS Act — could go a long way toward demystifying and increasing understanding of hedge funds, which are often accused of being highly secretive.

But critics fear that loosening restrictions could also leave some investors open to fraud if unscrupulous money managers are allowed to appeal to the least sophisticated among them.

“Today, the S.E.C. began undermining significant investor protections and putting ordinary Americans’ investments at risk,” said Senator Carl Levin, a Michigan Democrat.

It is not clear yet whether the agency will ultimately restrict certain types of advertising. Some worry that the lack of such curbs would be a shortcoming that could allow misleading ads aimed at vulnerable investors.

“There are no substantial proposals to address this increased vulnerability,” Luis A. Aguilar, an S.E.C. commissioner, said during a hearing where the rules were discussed Wednesday.

Hedge funds are likely to be divided when it comes to the new freedom. The largest, best-known funds already have sizable asset bases and gold-plated client rosters of pensions and endowments. These funds have little incentive to market more widely. Small and midsize funds, however, could find the ability to advertise and solicit clients directly useful tools in the highly competitive industry.

“For a start-up, it’s difficult to differentiate yourself because your track record is short,” said Adam Guren, whose Hunting Hill Global Capital opened in February with money from friends and relatives. “Advertising would allow us to differentiate ourselves, speak to the potential investors directly about why we’re better than our competitors.”

Even seasoned managers say that easing the restrictions would lessen the regulatory headache. Under the current regulations, it is difficult for a hedge fund to market directly to investors if they do not already have a relationship with them. They typically need an introduction.

“We would give money to local charities, and people would say, ‘We’ll put your name up as a sponsor,’ but technically I can’t do that,” said Howard Fischer, founder of Basso Capital Management, which manages about $500 million. Under the proposal, he said, that would be permitted.

Mr. Fischer said advertising could be tricky. A sophisticated shop would not want to send mass mailings, he said. “Would I take an advertisement out in the Hamptons magazine? Maybe,” he mused. “But the freedom to do so and lose those restrictions, it’s a terrific opportunity.”

More than 10,000 hedge funds are registered worldwide, and a large majority are small and anonymous. One worry is that by opening the floodgates of advertising, the less scrupulous among them could prey on individuals who barely meet the accredited investor threshold.

“There is some concern that there are fraudsters out there who want to play fast and loose with the truth,” said David Lopez, a partner at the law firm Cleary Gottlieb Steen & Hamilton. “You worry that the least sophisticated within this universe of accredited investors may be approached with investments that don’t suit them.”

The proposal will take months to wind through the regulatory process before it is complete.

– By Azam Ahmed

Source:  NYTimes

Posted by Steven Maimes, The Trust Advisor


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Fidelity Investments Chooses Chairman’s Daughter as Leader

Fidelity Investments said on Tuesday that it had promoted Abigail P. Johnson to run all of the company’s core businesses.

She will continue to report to her father, Edward C. Johnson III, the chairman and chief executive of the mutual fund company.

John Bonnanzio, who edits a newsletter for Fidelity investors, said the move made it obvious that Ms. Johnson, 50, would eventually replace her 82-year-old father as chairman of Fidelity, which managed $1.58 trillion in assets at the end of June. Mr. Bonnanzio said he was surprised only that she had not been given more responsibilities already.

Fidelity named Ms. Johnson president of Fidelity Financial Services, which includes asset management, retail and institutional brokers and retirement and benefit services.

Ronald O’Hanley, who continues to oversee all of asset management and corporate services, will report to Ms. Johnson.

Ms. Johnson most recently was president of Fidelity’s personal, workplace and institutional services organization, which includes the retail and institutional brokerage divisions, as well as retirement and benefits services.

Source:  NYTimes

Posted by Steven Maimes, The Trust Advisor


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How Holistic Advisors Are Stealing Clients

High-net-worth investors crave truly comprehensive wealth preservation advice. Wealth managers that can deliver on their 360-degree promises have the keys to become billion-dollar firms in the near future.

Offer prospective clients the choice between an advisor who’s content to stick to the discretionary assets and a rival who offers input on every aspect of their finances, and the “holistic” advisor wins by an overwhelming margin.

The logic isn’t hard to understand. What wealthy family wouldn’t put their trust in the advisor who can confidently weigh in on all the accounts, especially if everything else — expertise, character, credentials — is relatively equal?

Unfortunately, there aren’t many concrete examples of how full-spectrum advisors can put their “holistic” approach to work preserving clients’ wealth, retaining the accounts themselves and maybe even winning new ones through referrals.

To provide some guidance, I spent some time talking about best practices with Don Hertling at Heller Wealth Advisors.

Don’s a true believer in technology in general, but loves account aggregation in particular as a way to demonstrate that the firm is dedicated to the best client outcomes possible.

As it is, Heller only switched to an RIA model in April and has about $300
million in client assets.

The firm explicitly markets as holistic wealth managers who not only handle the usual advisory services — financial planning, investment management and wealth preservation and transfer — but also keep an eye on assets held in employer-sponsored accounts, IRAs and even those nominally managed by competitors.

“We can include 401(k)s within our allocations that may include stocks, bonds, alternatives, commodities, and real estate,” Don Hertling explains.

“A lot of our clients have a relationship with a UBS person, for example. We can turn around and keep track of what the UBS person is doing on top of what we’re doing to make sure there’s no overlap.”

The goal here is to establish Heller as the “gate keeper” for all of the client’s holdings, so if there’s a question or concern, their number is the first one investors call and the first website they check.

That’s an obvious competitive high ground that Hertling and his two partners work to exploit throughout their meetings with clients.

“We achieve it by not just focusing on investments but also focusing on every other area of the client’s financial life,” he says.

“When we’re meeting with clients now we’ll tell them ‘If you want us to keep your 401(k) within your managed portfolio, we can do that.’ For new clients we have no problem linking accounts to their portfolio reports so they can have everything together. Everything is included and in one spot. 90% of our clients love it and think it’s great.”

Don’s day starts at 7 a.m. downloading and reconciling overnight performance data from custodian Schwab as well as client 529 accounts and aggregated third-party data.

A better competitor and more efficient as well

In the interest of full disclosure, Heller receives aggregated financial account data from ByAllAccounts, but the overall rationale here would apply even if the firm were not using outsourcing its aggregation needs.

Don also wears the chief compliance officer hat, so he’s keenly aware of what the SEC demands when it comes to client communications, monitoring employee trading and keeping an eye on rivals’ fees in the interest of transparency.

The aggregation of financial account data makes it possible for him to handle all those tasks and be ready to meet with clients by the time his partners get into the office.

In the process, aggregation lets him peek on what Heller clients are paying out in fees to other advisors, and not just what’s in their portfolios.

“We see significant opportunities in the 401(k) business due to the new department of labor rules regarding fees,” he points out. “Everyone is forced to tell the participant what they’re paying. If you didn’t care about this previously you are going to care now.”

Keeping an eye on the competition also gives Heller the ability to lay out its fees against what prospects are currently paying — an especially compelling argument when they compound the drag of that fee spread over the long term.

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And the comparison includes what it costs to have Heller manage the held-away assets. Clients are aware of the cost here — part of their overall asset management fee — and Don says none are balking at paying it.

With all these competitive levers under their control, the Heller team is optimistic about their “holistic” power to double or even triple their AUM in the foreseeable future.

“We want to get to at least $750 million or $1 billion because at that point you’re of a size and scale where people aren’t worried about succession or that you’re a small firm,” Don tells me.

As it is, the firm is pursuing multiple merger opportunities in order to bolt on the assets. And it has the luxury to be choosy where new accounts are concerned.

“At this point we’re saying no to people with under $2 million,” Don says.

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Retirement Portfolios for High-Net-Worth Clients

Even if the nest egg is so huge it takes multiple lifetimes to spend it down, advisors need to take the IRA and 401(k) accounts seriously.

Most American families could probably live well on the income from $3 million and never have to work again, but that barely keeps the lights on for the truly wealthy.

Figure a dot-com executive who’s gotten used to spending $400,000 to $500,000 a year just to keep up appearances would burn through $3 million in under a decade.

That’s a problem if he’s expecting to live to a ripe old age, much less quit the rat race  on his 50th birthday to focus on philanthropy.

And if he was planning on leaving a stuffed IRA behind as as part of his legacy, his advisor needs to be thinking well outside the middle-class box.

Even big numbers obey the rules

Unless you happen to have a client with truly infinite assets, the money has to be managed well or it will eventually run out.

Not even Larry Ellison, with about $36 billion to his name, can buy more than one or two $500 million tropical islands a year before the accountants go on strike.

“Retirement saving shortfalls run up and down the income scale and wealth scale,” says Wharton School risk management professor Olivia Mitchell.

“In some cases, shortfalls were worst for people with high earnings. Of course, these people are in a position to save a lot, but people with high earnings also spend a lot. They don’t necessarily set money aside.”

Larry has been known to burn $200 million a year on miscellaneous living expenses not counting yachts or adding to his mansion collection.

If anything happened to his Oracle Computer empire, he’d have to make sure those living expenses are covered for the rest of his life — and he’s 68 now, so that bucket’s got to be big enough to hold at least $3 billion.

After that, he can go on doing what he likes until the money runs out.

Your clients who lead more modest lifestyles will be able to get by with much, much less, but the same logic applies. Until the amount of money available lines up with what the family needs to spend across a reasonable lifetime, nothing else matters.

And unless the family can live on the income the investments will actually generate, the breadwinners can’t retire yet no matter how rich they are.

There’s no wishful thinking here about consumption fatigue or slower spending when the kids are grown. Just take what your clients spend and compare it to what the money in the “retirement” bucket can support.

“If you look at what people want to do when they retire, most say they’d like to spend about the same amount of money as they did before retirement,” Olivia Mitchell notes. “My suggestion is to assume that you’ll need a 100% replacement rate.”

Taking the load off future generations too

It takes a bit of creativity to push more than a few million dollars into retirement accounts designed to maybe accept $20,000 a year, so the truly high-net-worth will still need to draw on taxable savings as well as the 401(k) or IRA.

That doesn’t mean advisors should ignore these vehicles as too small to meet top clients’ needs.

After all, Mitt Romney proved that an IRA loaded with private equity — whether from a white-glove firm like Bain Capital or a homegrown family business — can swell to huge size if the company thrives.

True, not all custodians will work with these “alternative” assets and there may be liquidity issues if the IRA never sells the shares.

But as long as the account is funded with truly earned income and doesn’t flirt with taboo investments like what the IRS considers collectibles — which are arguably better held in trust anyway — there’s a lot of room for flexibility.

The appreciation can be absolutely breathtaking in the meantime, especially because these accounts won’t suffer any tax drag on current income or capital gains as their owners buy and sell.

Besides, by the time the final bill comes due, the heirs should be the ones paying it.

As long as all required minimum distributions are met, your mega-millionaire clients can probably pass on a big lump of cash to the kids and grandkids — and stretch out the tax break for decades to come.

A surviving spouse should always be the first designated beneficiary, but after he or she dies and the IRS takes any estate tax due, anything left in the account can split as many ways as the client desires.

It might not give the heirs complete freedom to never work again, but the longer these assets can compound without triggering a taxable event, the more money they can throw off.

Stacking the allocations

With that in mind, what assets should the ideal long-term retirement portfolio hold?

Target-date funds may be the vehicle of choice for middle-class 401(k) accounts, but don’t really rate a mention here.

For one thing, the “glide path” these funds follow assumes that the owner will need to start aggressively drawing down the account on the retirement date.

Families that are deliberately putting off distributions beyond the absolute minimum would logically want a much longer accumulation period, arguably long enough to take heirs who haven’t even been born yet far into adult life.

Instead, advisors might consider a perpetual portfolio model similar to what they’d build for a small charitable trust, dynastic trust or foundation.

In such a model, any remaining private equity investments can eventually give way to traditional blue-chip securities — maybe 60% stock, 40% fixed income — as opportunities to sell emerge.

An account built along those lines could theoretically last forever at any reasonable beneficiary required drawdown rate, while bigger withdrawals will of course deplete the assets faster.

Look at billion-dollar charities like the Mott or the Robert Wood Johnson Foundation, and you’ll find a similar broad allocation at work.

If you keep your wealthiest clients on a similar course and the heirs are disciplined about spending it, these accounts can turn retirement into a multi-generational proposition.

Scott Martin, senior editor, The Trust Advisor


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Payday Lenders Use Courts to Create Modern Debtors’ Prison

Wakita Shaw’s troubles started with a $425 payday loan, the kind of high-interest, short-term debt that seldom ends well for the borrower.

But most of them don’t end up in jail. So Shaw was surprised in May of last year to hear that the St. Louis County police were looking for her. She and her mother went to the police station.

They arrested her on the spot.

They told her the bail was $1,250. “And I couldn’t use a bail bondsman to get out,” Shaw recalled.

The Bill of Rights in the Missouri constitution declares that “no person shall be imprisoned for debt, except for nonpayment of fines and penalties imposed by law.” Still, people do go to jail over private debt. It’s a regular occurrence in metro St. Louis, on both sides of the Mississippi River.

Here’s how it happens: A creditor gets a civil judgment against the debtor. Then the creditor’s lawyer calls the debtor to an “examination” in civil court, where they are asked about bank accounts and other assets the creditor might seize.

If the debtor doesn’t show, the creditor asks the court for a “body attachment.” That’s an order to arrest the debtor and hold him or her until a court hearing, or until the debtor posts bond.

The practice draws fire from legal aid attorneys and some politicians. They call it modern-day debtors prison, a way to squeeze money out of people with little legal knowledge.

Debtors are sometimes summoned to court repeatedly, increasing chances that they’ll miss a date and be arrested. Critics note that judges often set the debtor’s release bond at the amount of the debt and turn the bond money over to the creditor — essentially turning publicly financed police and court employees into private debt collectors for predatory lenders.

“You wouldn’t want to be spending taxpayer money to collect $400 and $500 debts. Don’t the county police have something better to do?” asks Rob Swearingen, attorney for Legal Services.

Creditors’ lawyers say body attachments are necessary to get debtors to obey the courts. To avoid jail, they simply have to show up when told.

In Illinois, Gov. Pat Quinn’s administration and Attorney General Lisa Madigan have joined the chorus of critics. The result was a new law, signed by Quinn last month, restricting body attachments for civil debt.

In Missouri, the practice goes on with little public opposition.

Shaw, 27, lives in Hazelwood and works as a clerk. Her memory of the legal process is vague.

“My mom gave me the court documents. I just didn’t remember to go,” she said. “After a few months, I forgot about the debt all together.”

Court records show that Shaw was sued in 2010 by Sunshine Title and Check Loan Company. Sunshine got a judgment against her, and she was summoned to an examination in April of last year, but didn’t appear. Circuit Judge Dale Hood of St. Louis County issued a body attachment. By the time she was jailed two weeks later, interest and legal fees on grown the $425 debt to $855.

She recalls spending three days in the city jail.

“It was horrible,” she said. “They tell you when to wake up and they tell you to go to sleep. The beds are hard,” she said. “I had to get out or I’d lose my job.”

Her mother had to borrow the $1,250 her bond. “I think it’s horrible for them to arrest me over something so small,” Shaw said.

No one knows how many people go to jail over debt in St. Louis. Courts keep no count of body attachments for debt.

Legal Services of Eastern Missouri, which represents poor people for free in civil cases, checked records for civil debt cases filed by a single St. Louis creditors’ attorney, Mitchell Jacobs in 2011 and this year. His law firm summoned 55 debtors for examinations and requested 23 body attachment orders, ending in seven arrests.

Illinois attorney general Lisa Madigan called the practice unfair. “It is outrageous to think, in this day and age, that creditors are manipulating the courts, even threatening jail time, to extract whatever they could from people who could least afford to pay, ” Madigan said.

Creditors’ lawyers see things differently. Jacobs, who represents payday shops and other lenders, says he has sympathy for debtors. “Most are good people who just don’t have the money to pay,” he says.

But sympathy has limits. “If they’ve had notice and they fail to appear, then they get what they deserve,” he said.

Although creditors attorneys request body attachments, it’s the judges who issue them, he noted. “It’s the judge saying, ‘You didn’t show up when we told you to, and I don’t like it.”

It’s not a free service for creditors, he notes. In Missouri, they pay the courts $90 in advance for each body attachment, whether it results in an arrest or not.

But an arrest often gets the debt paid. A review of several debt cases found lawyers suggesting bonds in the amount of the debt as they request body attachments, and judges setting those bond amounts.

Once the debtor bails himself out, the bond money often ends up in the hands of creditors. In Missouri, debtors sometimes sign documents prepared by the creditor’s lawyer, releasing their bond money to creditors.

Wakita Shaw hired a lawyer after her arrest, fearing that she might face criminal charges over the debt. A court document shows the lawyer agreeing to release the bond to the Sunshine Title.

Although borrowers provide post-dated checks to payday loan shops, they actually can’t be charged with criminal check kiting, says Swearingen, as long as they don’t stop payment on the check or close the bank account.

Sometimes, the bond goes to the creditor without the defendant’s permission. One bond release document reviewed by the Post-Dispatch had the word “absent” written above the defendant’s name. Paul Fox, administrator of the St. Louis County courts, said the debtor apparently failed to show up for another hearing and her bond was forfeited. The creditor, Sunshine Title got $800 of the bond money.

Judge Hood, who presided over both the Lewis and Shaw cases, declined an interview request. “He will have no further statement since the court talks by its orders and judgments,” said Fox, who functions as the court’s spokesman.

Swearingen, the legal aid lawyer, complains that one trip to the courthouse often isn’t enough for a debtor facing an examination. Creditors attorney’s get continuances, demanding repeated appearances.

“They were dragging them back to court again and again, waiting for them to fail, so they could get a body attachment against them,” said Swearingen.

Shaw said that happened to her once at court. “They said the lawyer was busy with another case, so they were giving me a new court date.”

Lawyers and court observers say that judges differ in their approaches to body attachments in private debt cases. Some issue them liberally, and others don’t. They also differ on how they treat arrested debtors.

Angela Townsend, 29, of north St. Louis County found that out when she was jailed for not appearing in court on a $588 debt to Ardmore Finance Company.

“I felt like I was a criminal. I had to ride in the back of a paddy wagon, handcuffed,” she said. “That was pain and suffering for me, because I don’t have a record.”

After a night in jail, she was brought before Judge Thomas Clark in St. Louis City Circuit Court. He let her go without posting any bond, but told her to come back the next day with $50 to pay toward her debt and answer questions from Ardmore’s lawyer.

The new law in Illinois forbids body attachments in private debt cases if the defendant doesn’t appear for an examination hearing. Instead, the judge may issue a second summons, threatening a contempt of court action. Only if the defendant skips again can an arrest be ordered.

Debtors can’t be repeatedly summoned for examinations unless the creditor has evidence that the debtor’s circumstances have changed. And bond money can no longer be routinely turned over to creditors.

The law also changed the practice of summoning debtors by mail. Now the summons must be given to them personally, or to someone at their home. Missouri requires service to the person or someone in the household over age 14.

As for Wakita Shaw, she’s learned a lesson. “I will never, never, never get a payday loan again. This was so traumatic. You better pay, because they will come and get you.”

Source:  St. Louis Post-Dispatch

Posted by Steven Maimes, The Trust Advisor



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Pershing Continues to Bolster Trust Network with Additions of BOK Financial and Independent Trust Company of America

Pershing LLC, a BNY Mellon company, announced today that it has further enhanced its Trust Network with the additions of BOK Financial and Independent Trust Company of America. 

Trust Network is Pershing’s open-architecture platform that enables its introducing broker-dealer and independent registered investment advisor (RIA) customers to offer their clients a wide range of personal trust services and solutions from industry leading trust companies.

“Investment professionals today serve a variety of clients, all of whom have diverse needs. Because trusts are among the most important wealth management tools, it remains crucial that advisors continue to have the flexibility to offer the trust administration that is specific to client requirements, said Tom Sholes, head of product management and development for Pershing. The additions of BOK Financial and Independent Trust Company of America not only further enhance our platform of solutions, but also demonstrate our continued commitment to providing our customers with the widest array of choices to serve their clients and grow their businesses.

BOK Financial Corporation is a $26 billion regional financial services company based in Tulsa, Oklahoma. Advisor trust services are offered through its national bank affiliate, BOKF, NA, which works nationwide with more than 125 trust officers and provides personalized trust services. Independent Trust Company of America was founded by Santa Fe Trust, one of the first trust companies to work exclusively with financial advisors. Independent Trust Company of America continues in the tradition of helping advisors successfully service trust clients throughout the country with all of the additional benefits of a South Dakota charter.

Launched in 2008, Pershing’s Trust Network capabilities include full trustee services and administrative trustee services. The platform enables Pershing’s customers to perform investment management activities for their clients’ trust accounts with all related assets held in custody at Pershing. Trust Network is available to Pershing’s introducing broker-dealer customers through Pershing LLC and RIAs via Pershing’s affiliate, Pershing Advisor Solutions LLC.

Pershing LLC (member FINRA/NYSE/SIPC) is a leading global provider of financial business solutions to more than 1,500 institutional and retail financial organizations and independent registered investment RIAs who collectively represent approximately 5.5 million active investors. Located in 23 offices worldwide, Pershing and its affiliates are committed to delivering dependable operational support, robust trading services, flexible technology, an expansive array of investment solutions, practice management support and service excellence. Pershing is a member of every major U.S. securities exchange and its international affiliates are members of the Deutsche Brse, Australian Stock Exchange, Irish Stock Exchange, London Stock Exchange and Toronto Stock Exchange. Pershing LLC is a BNY Mellon company. Additional information is available at

Source:  Pershing

Posted by Steven Maimes, The Trust Advisor



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Gay Man Told to Marry Woman or Son Would Lose Inheritance

The gay son of a deceased New York City businessman is fighting a stipulation in his late father’s will that required him to marry the mother of his child or risk losing the child’s inheritance.

Robert Mandelbaum, who is a Manhattan Criminal Court judge, said in court documents that his father, Frank Mandelbaum, knew he was gay and included his male partner in family activities. The elder Mandelbaum died in 2007 at the age of 73.

Mandelbaum, who amassed a fortune after founding the ID-verification firm Intellicheck, died before his grandson, Cooper, now 16 months, was born.

Cooper’s fathers, Robert Mandelbaum and Jonathan O’Donnell, married shortly after his birth via surrogate in 2011. It’s unclear which of the men is Cooper’s biological father.

The late businessman’s will left behind a $180,000 trust for his grandchildren, including those who would be born after his death. The heirs will receive installments from ages 25 to 30, although the amounts will be contingent on the performance of the investment.

But Cooper will not be eligible for his inheritance because he has two dads, according to the terms of the will.

The words “child,” “grandchild” and “descendant” include natural and adopted children and children born out of wedlock, according to the will, which was filed in Manhattan Surrogate’s Court.

“However, such words shall specifically not include an adopted child of Robert, if adopted while Robert is a single person, or a biological child of Robert, if Robert shall not be married to the child’s mother within six months of the child’s birth,” the will states.

Robert Mandelbaum is challenging the will on the basis that it would require him to enter into a “sham marriage” which would violate New York marriage-equality law.

Attorney Anne Bederka wrote that the stipulation Robert Mandelbaum marry a woman was “tantamount to expecting him either to live in celibacy, or to engage in extramarital activity with another man, and is therefore contrary to public policy.”

“There is no doubt that what [Frank Mandelbaum] has sought to do is induce Robert to marry a woman,” Bederka wrote.

A settlement has not yet been approved by the Manhattan Surrogate’s Court.

– By Alyssa Newcomb

Source:  ABC News

Posted by Steven Maimes, The Trust Advisor


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Regulator Says Broker Audits Fail to Include Required Work

The many auditors who inspect the financial statements of brokerage firms appear to be cutting corners and not doing all the work they should do, a worrisome sign after the collapse of the Peregrine Financial Group, a leading commodities brokerage firm, where a fraud had gone undetected for many years.

Having completed the first review of such brokerage firm audits, the Public Company Accounting Oversight Board said on Monday that it had found deficiencies in every audit its inspectors reviewed.

“The auditors,” said Jeanette M. Franzel, a member of the board, “were not properly fulfilling their responsibilities to provide an independent check on brokers’ and dealers’ financial reporting and compliance with S.E.C. rules.”

That does not mean that any of the statements misrepresented the financial conditions of the 23 brokerage firms whose audits were reviewed by inspectors from the board. In most cases, the accounting board concluded that the audit firm had failed to do the necessary work to ensure that the financial statements were accurate or that the firms had sufficient capital.

“In 13 of the 23 audits,” the board reported, auditors “did not perform sufficient procedures to identify, assess and respond to the risks of material misstatement of the financial statements due to fraud.”

Lynn Turner, a former chief accountant of the Securities and Exchange Commission, called the report “mind-boggling” and said it indicated that audit firms had failed to respond to the disclosure of Bernard Madoff’s Ponzi scheme. It was that fraud that led Congress to authorize the oversight board to review audits of brokerage firms.

The Peregrine fraud was uncovered after the National Futures Association, a self-regulator, stopped relying on paper copies of bank records in its own inspections. Peregrine had forged such records for years. Its independent auditor, a one-person firm, did not discover the fraud even though bank accounts are supposed to be confirmed.

A significant question for auditors of brokerage firms to evaluate is whether the brokers are subject to consumer protection rules specifying what can be done with customer money, and, if so, whether they are in compliance with the rules. Generally, brokers who do not handle customer cash are not covered by the rule, and auditors of those smaller firms have been pushing to be exempted from inspections by the accounting oversight board when final rules are established.

Of the 23 firms, 14 claimed to be exempt from the rule, but the board said none of the auditors of those 14 smaller firms had gone to the trouble of establishing whether that was actually the case. It added that auditors for two of the nine bigger brokerage firms had failed to verify that the firms maintained special reserve bank accounts that “were designated for the exclusive benefit of customers and that the account agreements contained the required restrictive provisions.”

The accounting oversight board, which was established by the Sarbanes-Oxley Act a decade ago, initially was authorized only to review audits of companies that issue securities in the public market. Audit firms that audited only broker dealers were not subject to inspection by the board.

That was changed in 2010 by the Dodd-Frank law, as lawmakers reacted to the Madoff scandal, which was carried out through his brokerage firm. The Madoff enterprise was audited by a tiny firm that was not subject to board inspection. The audit firm’s principal, David G. Friehling, has since pleaded guilty to nine criminal charges, admitting he did not perform adequate audits.

The new report covers work conducted by 10 audit firms, seven of which were previously exempt from board review because they did not review the financial statements of any public companies.

The board said that about 800 accounting firms perform audits of brokerage firms, and that about 500 of those were previously exempt from board inspection. Most of them could continue to escape board oversight if the board decides against reviewing audits of smaller brokerage firms, as many auditors have urged.

One issue with such audits that emerged in the board report was compliance with independence rules. Auditors of nonpublic companies often essentially prepare the books that they then audit, and that is allowed under the rules of the American Institute of Certified Public Accountants. S.E.C. rules prohibit such practices at public companies or at brokerage firms.

But the board said that auditors of two of the brokerage firms had violated those independence rules by helping in the preparation of the reports that they then audited. “This is of particular concern to the board,” said Jay D. Hanson, a board member, “because we think it is due to a lack of understanding” of the rules. He said that many auditors of small broker dealers had told the board they believed that they were exempt from the S.E.C. independence rules.

Those rules have been around for many years, but there was never before any way to police whether or not they were being obeyed, and it now appears that in many cases they were not.

Other findings of the report included:

  • Auditors failed to adequately test whether seven of the 23 firms had sufficient capital.
  • At 10 firms, auditors did not do enough work to identify and assess transactions with related parties.
  • At 15 firms, auditors “did not perform sufficient procedures to test the occurrence, accuracy and completeness of revenue.
  • In six of nine audits where auditors needed to review the values of securities, the auditors failed to do enough work to assure that the valuations were reasonable.
  • Auditors of seven firms “did not perform sufficient audit procedures to test the accuracy and completeness of certain financial statement disclosures.”

Ms. Franzel said that by the end of next year the board expected to have inspected about 100 audit firms and looked at the audits of 170 brokerage firms. She said information gained from such inspections would be used in considering how a permanent inspection program should be conducted.

– By Floyd Norris


Posted by Steven Maimes, The Trust Advisor



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