Friday, December 12, 2014

Supervision on vacation , compliance out of sight

                                                                                                                                     December , 2014
Supervision on vacation , compliance out of sight

Following a disciplinary hearing held on September 22 – 24, 2014, in Calgary, Alberta, a Hearing Panel of the Investment Industry Regulatory Organization of Canada (IIROC) found that Grant Patrick Matthews made unsuitable recommendations in the accounts of four Deele Financial Markets Inc. ( a Calgary based dealer ) clients, engaged in discretionary trading in the accounts of two clients, and engaged in excessive trading (churning) in the accounts of three clients. The Hearing Panel also found that allegations of failure to know his clients, with respect to the four clients, and discretionary trading, in the accounts of one client, had not been proven.
The Hearing Panel’s decision dated November 21, 2014, is available at: .

Specifically, the Hearing Panel found that Mr. Matthews committed the following violations:
a) Between approximately January 2009 and May 2012, Mr. Matthews failed to use due diligence to ensure that recommendations were suitable for four clients, based on factors including the client’s financial situation, investment knowledge, investment objectives and risk tolerance, contrary to IIROC Dealer Member Rule 1300.1(q);
b) Between approximately June 2010 and May 2012, Mr. Matthews engaged in discretionary trading with respect to the accounts of one client, without being authorized and approved as having discretionary authority, contrary to Dealer Member Rule 1300.4;IIROC Notice 14-0289 Enforcement Notice/News Release – In the Matter of Grant Patrick Matthews – Discipline decision - Liability
c) In December 2008, Mr. Matthews engaged in discretionary trading with respect to the accounts of one client, without being authorized and approved as having discretionary authority, contrary to Dealer Member Rule 1300.4; and
d) Between January 2009 and March 2011, Mr. Matthews engaged in improper practices by excessively trading in (churning) the accounts of three clients, for the sole purpose of generating additional commissions, contrary to Dealer Member Rules

These are fine regulator-speak words but let's take a closer look at what really happened to one of the clients in more detail , client EF. Source :

Know your Client (KYC): Client - EF is a 69 year old retired widow. She has a high school education, and was a homemaker for much of her working life. She also worked at one time as a franchisee operator of a lottery booth. Her late husband, RF, worked as a custodian at a local high school before he retired. Prior to that, he managed a gas stationer generally left the household financial affairs and investment decisions to her husband.11. A March 2004 New Client Account Form (“NCAF”) for EF’s RRSP account stated that EF earned $40,000 per year from the lottery booth, and RF earned $32,000 per year as a custodian. Their stated liquid assets were $100,000, and their fixed assets were listed as $300,000. The stated [ emphasis ours] investment objectives [ emphasis ours] were 50% long term growth, 50% short term speculative, [ are these are clear and proper objectives for a retiree?] and her stated risk tolerance parameters were 50% medium and 50% high. At the time, EF was 60 years old and her investment knowledge was listed as “fair” [ whatever that means but we can be confident she didn't understand the leveraged ETF's mechanics] . Her husband died in May 2010. Following her husband’s death, in June 2010, EF, met with Matthews to sign estate documentation and discuss his future handling of her accounts. She was then 67 years old. Do you think this is a well defined set of “objectives” for a person in this financial situation? Do you think this is robust KYC or a setup for a fee grab?

She completed an NCAF to open her TFSA account, which stated that she was retired,
with a modest income of $32,000 per year. The investment objectives were 25% income/50%
long term growth/25% short term speculative, and the risk tolerance parameters were
changed to 33% low/33% medium/33% high [ whatever that means]. The stated assets remained the same, as did the description of her investment knowledge as “fair”. Given the available information, her risk capacity , the ability to absorb losses, was low . Losses in a TFSA cannot be offset against capital gains. The word “ fair” is meaningless and it appears to be a slick way to justify the risky trading strategy in her TFSA account by portraying her as more knowledgeable than she really is..

Following her husband’s death, EF completed an NCAF for the TFSA, but not for her other accounts. There are no account updates between June, 2010, and EF’s transfer of her accounts to another firm in May, 2012 [ for us, this suggests a compliance systems problem] IIROC notes that for the period of June 2010 onward, the stated investment objectives and risk tolerance parameters were too aggressive for EF, who was then a retired and recently widowed senior, with limited assets and income. IIROC says Matthews failed to learn and remain informed of the essential facts relative to EF as the stated investment objectives and risk tolerance parameters in her accounts were inconsistent with her true financial situation, investment knowledge, investment objectives and risk tolerance. In our view that is being disingenuous. We say Mathews deliberately set it up so he would have a paper trail to show his actions were consistent with a knowingly defective KYC document. He didn't fail, he succeeded at deception.We also ask, where the heck was the supervisor or Branch manager to prevent this obvious information travesty? And why does the IIROC investigation report play word games?

Suitability :EF's investing knowledge was very limited so naturally IIROC has concluded EF relied upon and followed Matthews’ recommendations for the investments in her accounts. “This was particularly evident during the time period of June 2010 onward, following her husband’s death” IIROC notes. Did the Branch manager not notice the change in pattern? In general, the nature of the trading in the RRSP account [ her retirement fund] was focused on frequent trades in medium to high risk securities. The medium risk securities were primarily resource issuers trading on the TSX, and the high risk securities were primarily commodity-based leveraged exchanged traded funds (“LETF”) , a complex speculative product that works on the basis of daily returns. There were no low risk holdings according to IIROC yet the dealer's systems did not detect this wholly unsuitable portfolio construction.. From May 2010 to April 2012, the average hold period for all securities was approximately 5 months. The average hold period was just 38 days for positions in which gains or losses were actually realized. In addition, although there were some purchases made in the accounts of dividend-paying securities, in many cases the securities were not held long enough to be eligible to actually receive the dividends. By now, you'd think someone at the dealer would have woken up to the fact this poor retiree was being gamed. No such luck.

Between Jan. 2009 and Oct. 2010, there were an incredible 66 LETF transactions, which resulted in losses of $14,999 (including $7,805 in commissions). The majority of the LETF positions were held for short time periods, on average 2.74 days. However, there were 5 LETF trades which were held for a much longer period, an average of 178 days, and resulted in losses of $17,485. Between June 2010 and May 2012, the total value of EF’s accounts declined from $115,478 to $106,159, reflecting a loss of 8%. This included the payment of commissions of $13,378. During the same time period, the S&P TSX Composite Index increased by 5.29% for a differential of 13.5 %. During this time period, the performance of her holdings was very volatile in comparison to the overall market performance. The total value of her accounts ranged between approximately $160,000 to $100,000. Such volatility is a sure sign that account risk was high The dealer Reps recommendations were not suitable for this client in light of her age, employment status, investment knowledge , experience and true circumstances but inexplicably they continued for a considerable time without dealer intervention except to cash brokerage commission cheques.

Discretionary Trading : The nasty “advisor” behaviour doesn't stop with unsuitable investments. . During the period from June 2010 (after her husband’s death) to May 2012, Matthews made 113 trades ( about 1 trade per week!) in EF’s retirement and savings accouterments tells us that EF says that she instructed Matthews to “take care of her”, and that she “left everything up to him”. She wanted him to continue the type of trading activity that he had carried out with RF, as she had limited investment knowledge. Gimme a break . During the material time, Mr. Matthews executed many trades in EF’s accounts without confirming the details of the trades with EF prior to their execution. The hapless widow's retirement account savings were not designated as discretionary by Leede but they happened anyways. Leede’s supervision and systems failed to pick up on this in your face financial assault.

What do we learn form this case ?

Clearly , Risk tolerance does not match the trading patterns. It should have been 100% speculative risk. Anything else is a compliance breach. Investment knowledge is “fair”. An attentive supervisor should not ever set up a speculative account for an investor with “fair” investment knowledge. And of course Objectives did not match risk . Despite the obvious, this exploitation carried on in plain view for a prolonged period of time.

The first lesson learned is therefore quite clear. The most basic systems and processes were not in place at Leede . Nearly everything that could be wrong , was wrong. The real culprit here is Leede Financial . We do know the abusive practices by this individual impacted 4 other investors possibly many more at that Branch. IIROC tell us it is standard practice for IIROC Investigation teams to consider the issue of supervision whenever they are conducting an investigation of a dealer Rep, and to investigate where there are indications of a failure to supervise. However, given the confidential nature of their investigations, they cannot confirm whether or not they have or had an active investigation ongoing, unless and until any such matter proceeds to disciplinary action, in which case it then becomes public record when a Notice of hearing is issued. They assert that it is general practice to prosecute cases involving a failure to supervise by way of a separate Notice of Hearing before a separate Hearing panel.

Here's some 2013 IIROC Enforcement statistics for 2013 that we think speak for themselves.:
There were 1690 complaints of which 280 originated from the public
There were 203 complaints involving unsuitable investments and 88 involving unauthorized trading
There were just 63 prosecutions of individuals by IIROC of which 19 involved suitability ,1 involved discretionary trading and just 4 involved supervision
There were only 12 prosecutions of dealers of which a mere 5 involved supervision ( this is for the entire year for all of Canada)
Fines imposed on individuals amounted to $4,382,500; only 10.5% of the penalties assessed against individual registrants were collected.
Fines imposed on dealers amounted to $2,220,000 ,about half that imposed on individuals; 98.1% of the penalties assessed against dealers were collected
What do these numbers suggest to you?

In the Mathews case we say that management was asleep or willfully blind at such horrific and highly visible and prolonged financial assault. This cannot and should not ever happen in the wealth management industry especially to multiple victims over such a extended period of time. The advocacy community, including a number of former and current Reps, is of the firm conviction that SRO's are spending too much time on disciplining Reps ( and not collecting fines) and not going after the root cause : Deficient supervision / compliance systems and a broken KYC system. The great Quality Control expert Edward Deming coined the rule: 85-97% of problems are the responsibility of management. We are convinced this is correct .This is why for every Rep prosecution we expect at least one corresponding supervisory prosecution and with much higher penalties and sanctions. A few strong high profile examples would change dealer behaviour real fast.

We argue that suspected supervisory breakdowns should have at least as high investigation priority than Rep prosecutions and should carry larger fines. This is further supported by the fact that Reps are usually fired but Branch managers often remain on to be negligent again in the future.

Hopefully, 2015 will see a lot more timely prosecutions of dealers for breakdowns in supervision , compliance and KYC deficiencies/adulteration.

The other BIG lesson . CAVEAT EMPTOR ! You are not dealing with “advisors” that are required to act in your Best interests.

Kenmar SRO surveillance Team

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