Amid heightened scrutiny by regulators, small to midsize broker-dealers will likely begin imposing tougher restrictions on investments held in self-directed individual retirement accounts.
On Sept. 23, the Securities and Exchange Commission and the North American Securities Administrators Association Inc. jointly issued an investor alert warning about risks associated with self-directed IRAs.
Such accounts differ from traditional IRAs in that they allow owners to invest their retirement savings in a variety of unusual investment vehicles, including raw real estate, life settlements, limited partnerships and private placements. Investors in traditional IRAs are generally limited to stocks, bonds and mutual funds.
About $94 billion is estimated to be in self-directed IRAs, making up about 2% of the total $4.7 trillion in all IRAs, according to NASAA.
Fraudsters exploit self-directed IRAs because owners are allowed to hold unregistered securities in them, and custodians often fail to performed adequate due diligence on the offerings, according to regulators. And because there is a penalty for making early withdrawals from an IRA, investors caught in a scheme might actually be encouraged to keep the money in the account even longer.
Regulators, arbitration panels and judges typically have taken a hard stance on fraud involving self-directed IRAs, said plaintiff's attorney Andrew Stoltmann.
“Advisers are held to a higher duty when they're managing tax-qualified money, and in terms of merits, cases involving IRAs are very good cases,” he said.
Recently, there has been a surge in cases involving self-directed IRAs holding failed private placements offered by Medical Capital Holdings Inc. and Provident Royalties LLC, Mr. Stoltmann said.
“Those were allowed to be recommended into IRAs, and we saw hundreds of millions of dollars wiped out in self-directed IRAs and fraudulent private placements,” he said.
Although many big broker-dealers have already imposed restrictions or increased their due diligence on investments made through self-directed IRAs, some small and midsize firms haven't, according to industry experts.
That is because smaller firms haven't wanted to give up the higher profit margins that typically come with the riskier product offerings some self-directed IRA owners want to buy, said John Simmers, co-founder of Pension Resource Institute LLC, a broker-dealer consulting firm.
“A lot of [bigger] firms stopped selling high-risk investments, moved toward higher liquidity and were collecting 12(b)-1 fees and revenue share,” said Mr. Simmers, a former chief executive of the ING Advisors Network. “That's why more distribution of risky investments is done by small to midsize firms.”
In today's tough regulatory environment, however, firms that aren't paying close attention to what is in their clients' self-directed IRAs are playing with fire.
MANY OPTIONS
“Any indie broker-dealer that allows these investments is asking for trouble, since supervision over indie reps is difficult enough as it is,” said Amy Lynch, president of FrontLine Compliance LLC. “Adding a complex product like this to the mix is only making matters worse.”
Broker-dealers have many options for restricting the kinds of securities available to self-directed IRA holders.
LPL Financial, for example, doesn't permit its affiliated advisers to sell self-directed IRAs at all.
At Commonwealth Financial Network, traditional IRAs are common. The investments that go into them — which include private placements — are subjected to due diligence by Commonwealth and must be approved and available at the clearing firm, said compliance chief Paul Tolley.
Fidelity Investments, meanwhile, will allow self-directed IRA holders to purchase only nontraded real estate investment trusts — provided certain criteria are met.
A spokesman for the company, Mike Shamrell, declined to disclose what those criteria are.
Other firms have either stopped allowing nontraditional investments in self-directed IRAs or they have gone to great pains to make sure that they aren't held liable if investments in those accounts go bad.
“If you have an account with real estate holdings, not a lot of mainstream firms will facilitate that,” said Jason C. Roberts, co-founder and chief executive of Pension Resource Institute. “If a firm takes the account, it will issue a special contract that says it's not responsible for it and the firm won't provide the rep with support.”
In fraud cases involving self-directed IRAs, regulators appear to be mainly going after the representatives who recommend the troubled securities. So far, relatively few cases have involved custodians or trust companies that are holding the funds.
“Custodians are the first to tell you they have a limited role in the review and analysis of the securities and products,” said Matt Kitzi, securities commissioner in Missouri and head of NASAA's enforcement section. “Most everyone in the industry is going to disclaim any obligation for that and point to a more administrative role.”
For financial advisers, offering guidance to clients holding nontraditional assets in self-directed IRAs can be a headache. Often, it requires a thorough understanding of tax law, they say.
“Someone who wants to invest in property needs to be mindful of [their own] liquidity provisions, time horizons and whether they require [required minimum distributions],” said Paul Jarvis, vice president and portfolio manager at State Bank & Trust in Fargo, N.D.
In one situation, Brad Borncamp, a certified public accountant who owns an eponymous firm, had a client who bought four viatical life settlements in a self-directed IRA. The investment ran into trouble when one of the insured people — whose life insurance premiums were funded by the client through the IRA — lived too long and required deposits to the IRA that exceeded the contribution limit.
Mr. Borncamp didn't sell the investments to the client but noted that she had to let two of the policies lapse because making the large IRA contributions would have triggered a penalty.
“IRAs have a specific purpose: long-term investment for retirement,” he said. “It's really easy to mess up these transactions, and there's more than meets the eye.”
dmercado@investmentnews.com
