A 30-page ruling permanently barring a private wealth advisor from ever again associating with a Registered Investment Adviser delved into the minutiae of portfolio reporting practices and calculations, and could signal that the SEC’s promise to scrutinize more closely performance reporting in the post-Madoff era is starting to result in sanctions against RIAs and IA reps. The case also highlights the need for principals at advisory firms to be truthful in filing U5 termination notices when an employee is fired for misconduct, even if it means hurting an individual's professional career.
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The case involves Michael R. Pelosi, a CFA charterholder and MBA with 15 years of experience in the investment advice business, worked as an advisor at Halsey Associates Inc., an RIA in New Haven, Conn. The Halsey RIA was not charged with any wrongdoing and the ruling was mostly sympathetic to the firm’s two principals, James Zoldy and and Kenneth Julian.
According to the ruling filed with the SEC by Administrative Law Judge Cameron Elliot, Zoldy in August was informed by two of Halsey's portfolio assistants that Pelosi was sending client letters reporting investment returns with discrepancies when compared against performance figures in the firm’s portfolio reporting software, Advent Axys.
U5 Issue For Principals
After discussing the issue with Pelosi and conducting an internal inquiry, Pelosi’s employment at Halsey was terminated, according to the ALJ decision. “Because they (Zoldy and Julian) did not want to ruin Pelosi’s career, they decided not to report him to regulators,” says the ALJ’s ruling.
On October 1, 2008, Julian submitted a U5 Uniform Termination Notice to FINRA that “contained a false deceleration” by not disclosing that Pelosi had left the firm after being accused of violating investment related laws or standards of conduct.
About six months later, however, after a consultant hired by a client of Halsey questioned the firm’s decision not to report Pelosi to regulators, Zoldy and Julian re-filed and corrected the U5. The re-filed U5 reported Pelosi he left Halsey after being accused of changing the performance numbers reported to clients, according to the ALJ's ruling.
While owners of RIAs are understandably reluctant to wreck anyone’s career by reporting they were terminated for misconduct, the stakes for not being totally truthful are high. Zoldy and Julian’s initial decision to allow humanity to influence their legal obligation wound up triggering an SEC investigation after they corrected the U5. While reporting the real reason for Pelosi’s termination on its initial U5 may nonetheless have attracted an SEC investigation, the flip-flop raised a red flag and serves as a lesson to principals at advisory firms.
SEC Performance Reporting Scrutiny
In the post-Madoff era, it is widely expected that the SEC will more closely scrutinize performance reports. (Madoff, after all, just made up his numbers.) The investigation by the SEC into Halsey’s portfolio performance reporting procedures, which are detailed in the ALJ decision, is likely only the first of many cases that the SEC will bring in 2012 in which portfolio performance reports are scrutinized.
It is worth nothing that the SEC went to great lengths to investigate and quantify allegations against Pelosi. The SEC used a forensic accountant on its staff to study the discrepancies between the manually calculated returns Pelosi reported to clients and his firm’s Axys reports.
The ALJ’s decision says the SEC’s investigation found that Pelosi inflated annual results in 84% of 240 letters it studied that Pelosi sent to clients. Pelosi’s overstatements were greater than 100 basis points 16.8% of the letters and overstatements of between 50 and 99 basis points occurred in 22.6% of the client letters, the ALJ decision says.
Pelosi contended the misstatements were not material because they were too small and that he made them to correct for inadequacies of Axys, claims the ALJ said were unfounded.
This ALJ‘s decision on page eight highlights the need for RIAs to create compliance policies, procedures and operations and review them annually. “Halsey’s compliance manual did not have a section addressing performance calculation,” says Elliot’s ruling, also noting that no provision in the compliance manual addressed reconciliation of Axys data against custodial data from Schwab Advisor Services.
Calling out these facts in the ALJ decision could be taken as a signal to RIAs to establish written reconciliation procedures. If a firm like Halsey, which has $700 million under management, according to the ALJ’s filing, neglected to establish these policies and procedures to the satisfaction of the ALJ, it is a safe bet many smaller RIAs also lack such policies and procedures.
With the debate over how to regulate RIAs likely to continue for many months, RIAs should consider this case a warning and look for ways to tighten up performance reporting procedures and policies, reviewing these policies, and documenting them.