Politics & Policy

Where Regulation Makes Sense

Our investment watchdogs need to look out for the little guy.

Investors are well aware of the risks involved with acting on insider information. Even Martha Stewart, who took her broker’s recommendation to sell a stock simply because the owner was selling his stock, and then lied about it, received enormous negative publicity and went to jail for five months. The public castigation of Stewart supposedly served to warn other investors about the risks of acting on inside information.

 

While the regulators threw the proverbial book at this public figure, seemingly to warn other potential inside traders, my experience as a portfolio manager has led me to believe that there are many other practices that need greater attention than those given to Stewart’s transgressions.

 

Here are four stories to validate my point.

 

Investment advisors are held to strict standards when managing client portfolios. Regulators such as the SEC, state securities agencies, the NASD, and the CFA Institute all go to great lengths to insure that investors get a fair shake. Yet investors get a raw deal once regulators take a hands-off policy. My first story may sound familiar to most active investors who listen to the media hype about stock investments. One popular TV stock jock touts a variety of stocks to novices who act on his recommendations. While I periodically listen to these rants about good and bad stocks, I am appalled that he can make recommendations with no real regulatory control or oversight. His influence on markets is obvious when small capitalization stocks get in his crosshairs.

 

In the latest gold-price boom, this loose cannon recommended a virtually unknown stock, Crystallex Intl. Corp. (KRY). At the time of recommendation, the stock was selling in the $4 range. Notwithstanding the fact that Mr. Tout eschews high P/E stocks, KRY has no earnings and actually has been losing money for five straight years. After the recommendation, the stock volume surged and the price spurted to $6.25, a 50 percent increase in only a few weeks. I doubt that the rally would have occurred without this stock jock’s strong buy recommendation. After novice lemmings pushed the stock price skyward, reality returned to the market and the stock fell back to a current $2.67 per share, a decline of 58 percent in a couple of months.

 

Maybe these one-off gurus need a little regulation, or need to at least fully disclose their investment records or the performance of their charitable trust portfolios.

 

Story number two involves the Glass Steagall Act, a regulation that once kept banks and brokers as separate entities, a result of accusations that banks were getting too involved in stock market activities back in the 1930s. This law was repealed in 1999. My recent experience suggests that the resurrection of these relationships is quickly moving some banks back into the business of increasing the risk levels of loans and engaging in illegal tie-ins with their brokerage subsidiaries.

 

As an investment advisor working with individual clients, I recently had the opportunity to compete for an account where the prospect desired a growth strategy, but also wanted to take advantage of the margin loan facility of a discount broker. The Federal Reserve sets the limit on such loans to 50 percent of the value of the portfolio. I was informed by the prospect that he decided to go with a regional bank since it would lend him 80 percent of the value of the portfolio. The catch was that the brokerage subsidiary of the bank had to be the portfolio manager. Despite the fact that such arrangements are illegal, the bank complied with the promise and signed up the client with the equivalent of an 80 percent margin loan.

 

The third story involves one of my relatives who had invested her retirement assets with a well-known brokerage firm. Television ads tout this firm as being “client-oriented,” offering all types of value-added investment products. Yet, in my relative’s case, cash reserves were plunked into a 1 percent yielding brokerage “bank” account while the firm offered a number of money market equivalents yielding more than 4 percent. These so-called “client-oriented” firms should be required to notify their clients that equivalent alternatives exist that offer higher returns, especially when the firm determines the investment alternatives for these accounts.

 

Mutual fund companies are also guilty of misleading investors. My final story involves one very large company that I have used to manage a portfolio of mutual funds. The company offers various share classes for each mutual fund, and as client assets grow above certain levels, clients have the right to transfer to other share classes that offer substantially lower expense ratios. However, this same mutual fund company does not inform shareholders when such levels are reached. Clients, in other words, have to initiate the transfers. This story illustrates a gaping hole in the philosophy of a mutual fund company that sells products based on being an advocate for the average investor.

 

In the case of Martha Stewart, the prosecution made an example of one little guy, a little overkill in my opinion versus the seemingly lax oversight of the big guy. As demonstrated in my four stories, such insouciant behavior is unacceptable. Stewart ultimately made a bad investment decision based on a tip from a supposedly astute stockbroker. The subsequent actions that resulted in her five-month prison term were caused by this stockbroker’s actions. As this case confirms, real damage occurs when large financial institutions take advantage of the little guy.

 

Where are the regulators when we need them?

 

– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc., and principal of Victoria Capital Management, Inc.

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