​The Unscrupulous Advisor

Internal auditors at investment firms should look out for schemes to overbill clients — even when they originate at the top of the organization.

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​A federal grand jury has indicted the CEO of an investment management firm on 23 counts of fraud, the Idaho State Journal reports. Federal prosecutors say David Hansen, majority owner of Yellowstone Partners LLC, headquartered in Idaho Falls, Idaho, overbilled client accounts by submitting false billing requests to a brokerage firm. Last year, former Yellowstone Partners employees told the Post Register newspaper they had found "significant irregularities" in some customer accounts in 2016. Prosecutors estimate Hansen's alleged scheme defrauded clients of more than $9 million. The indictment also charges Hansen with aiding in preparing false corporate and personal income tax returns that underreported the company's revenue and his own income in 2012 and 2013.

Lessons Learned

The CEO of the investment management firm in this story allegedly has run afoul of the U.S. Securities and Exchange Commission (SEC) and more particularly Section 206 of the Investment Advisers Act of 1940 (the "Advisers Act"). In part, Section 206:

"prohibits misstatements or misleading omissions of material facts and other fraudulent acts and practices in connection with the conduct of an investment advisory business. As a fiduciary, an investment adviser owes its clients undivided loyalty, and may not engage in activity that conflicts with a client's interest without the client's consent."

In addition to the general anti-fraud prohibition of Section 206, other sections of the act regulate several practices relevant to the alleged fraud in this story. These include disclosure of fees, investment advisor advertising, custody or possession of client funds or securities, and disclosure of investment advisors' financial and disciplinary backgrounds. All of these rules were allegedly broken in one way or another in this case.

Internal auditors should consider measures to help their organization prevent and detect the kind of fraud represented in this story. Two main areas of concern surround disclosure obligations:

  • "The Brochure Rule" (Advisers Act Rule 204-3), requires every SEC-registered investment advisor to deliver to each client or prospective client a Form ADV Part 2A (brochure) and Part 2B (brochure supplement) describing the advisor's business practices, conflicts of interest, background, and its advisory personnel. Advisors must deliver these documents to a client before or at the time the advisor enters into an investment advisory contract with a client. In addition, advisors must provide them whenever there is a material change to the advisor's profile.

    Both investors and auditors need to be aware of how business practices and conflicts of interests can be hidden or manipulated. Hansen is a partner at Elite Advisor Institute, a company that trains and coaches investment advisors. Was this partnership disclosed, and were some of the people involved in the overbilling scheme at Yellowstone Partners trained there?

    A further step that needs to be taken is to cross-check an investment advisor's background with those who regulate and accredit them such as the SEC (registration information is available on the SEC's website). The Financial Industry Regulatory Authority also offers information about the professional designations used by advisors as well as measures that investors can take to avoid investment fraud.

  • The SEC mandates that an investment advisor disclose to clients all material information regarding its compensation such as whether the advisor's fee is higher than the fee typically charged by other advisors for similar services. In most cases, this disclosure is necessary if the annual fee is three percent of assets or higher.

    Investors and auditors should be proactive in regularly reviewing investment transactions to determine what fees are being incurred, as an early way to detect overbilling. The investment industry should continue to be obligated to regularly and transparently disclose fees to clients. A good practice would be to disclose such fees monthly, although often this is only done annually.

    A further part of this transparency is to carefully monitor the use of other mechanisms that incur fees such as performance fees and referral to third-party fees. Another mechanism susceptible to overbilling is a "wrap fee program" where advisory and brokerage services are provided for a single fee that is not based on the client's account transactions.
Art Stewart
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About the Author

 

 

Art StewartArt Stewart<p>​Art Stewart is an independent management consultant with more than 35 years of experience in internal audit, financial management, performance measurement, governance, and strategic policy planning.​​​</p>https://iaonline.theiia.org/authors/Pages/Art-Stewart.aspx

 

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