Legislation requiring securities advisers to perform suitability checks on prospective investors may put an unintended damper on the sales of mortgage-backed and other securities and could alter the way some issuers and dealers market their investment products.
The House provision, which proposes suitability regulations similar to those stock brokers must adhere to, would require securities advisers to investigate the financial and investment background of proposed investors, as well their investment objectives, to determine whether a sale could be made.
The Bill. H.R. 578, Investment Adviser Regulatory Enhancement and Disclosure Act of 1993, is intended to protect investors. But the legislation, depending on how restrictive Congress makes it, could also effectively shrink the customer base for these securities by removing some of the people and institutions that invest in them, as well as future investors that may be deemed suitable under current procedures.
Dealer business with many institutions governed by strict investment guidelines, such as banks, thrifts, municipalities and pension funds, would be hurt most by any such regulatory action, said one Wall Street dealer. Those institutions and agencies may be among the first excluded from business based on unsuitability factors. He said such rules "might be a little extensive."
The House approved the adviser legislation in May, but the provision wasn't part of the bill, S. 423 Investment Adviser Oversight act, approved by the Senate Banking Committee Nov. 10. However, pressure from the House and a recent flurry of potentially large losses being suffered by municipalities nationwide, especially in Ohio, may cause the Senate to rethink its position.
Rep. Paul Gillmor, R-Ohio, whose 5th District has been hit hard by municipality losses, will "insist that the suitability provision be included in the final draft" said Mike Gill, a Gillmor aide. Both bills are intended to strengthen oversight of investment advisers by increasing fees to regulators to support greater oversight and by requiring advisers to obtain a "fidelity bond" to insure clients against theft or embezzlement.
But Gillmor believes the House provisions could help stem the tide of losses suffered by some municipalities. Some of those losses were identified in an ongoing audit of 18 Ohlo counties, cities, villages and school districts, where the state auditor verified what he deemed as "illegal, highrisk investments' with potential losses that could exceed $13 million. Audits in Sandusky County, Ohio, uncovered large losses that could reach $2.5 million alone as a result of investments in a Fannie Maebacked interest-only strips, a derivative of mortgage-backed securities.
Further investigation by securities advisers might have helped some municipalities like Sandusky, which didn't fully comprehend the complexities of the investments it was buying. While Sandusky agrees its understanding of the derivatives it purchased was lacking, a lawsuit filed against Government Securities Corp. of Texas, a Houston-based securities dealer, alleges that its lack of understanding was because prospectus information about the security was never provided by GSC.
The complaint, which was filed in the U.S. District Court for the Northern District of Ohio, alleges that GSC advised Sandusky Treasurer Virgil Swartzlander to purchase the Fannie-backed IOs, which were "the same kind of security" as a Small Business Administration mortgage-backed security GSC had successfully recommended to Swartzlander eight years earlier. Although it had its own printed literature explaining the relative risks of various mortgage-backed securities it offered, the complaint alleges GSC never sent the documents and "contrary to the best interests of [Sandusky], [GSC] induced purchases and sales of Fannie Mae IOs to [Sandusky] which were unsuitable in light of the character of [its] account."
"[Sandusky] wants the money [they lost on the deal] back, and they want to rescind the deal." said Ronald Miyle, assistant prosecuting attorney for Sandusky, who added that an unspecified amount of damages were also being sought against the dealer.
GSC did not respond to requests for comments, but has filed a countersuit in the name of GSC, James W. Winter, who sold the 10s to Sandusky. and Donaldson, Lufkin & Jenrette Inc., an Equitable Co. unit that acted as a clearinghouse for GSC, to absolve a hability.
In a clarification issued Oct. 27, the Ohio attorney general determined that municipalities or political "subdivisions" may only buy investments redeemable within two years of the date of purchase, which would make any interest-only investments illegal investments for them. However, Miyle said that provision doesn't apply to Sandusky because state treasurers are governed by a different subsection of the Ohio Revised Code.
