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“KYC” and “Suitability” Violations Occur All Too Often on Wall Street

Posted by Larry Doyle on October 26, 2009 9:33 AM |

“We’re in the moving business, not the storage business!!”

If I had a nickel for the number of times I heard that line on Wall Street, I’d have a lot of nickels. That statement would coarse across many trading floors to push salespeople to sell, sell, sell and sell some more.

The sales process on Wall Street is not supposed to be the ‘boiler-room’ operations as so often depicted in films and books. Wall Street sales is not supposed to be a mere “dialing for dollars.” Prior to engaging prospective clients, salespeople and sales managers are obligated to address certain requirements. What may they be? The two primary requirements are:

1. KYC, an abbreviation for “know your customer.” This requirement addresses the need to fully understand the client’s business, its source of funds, its investment objectives, and much more. This requirement is extremely important, but regrettably often not fulfilled. Instead of “KYC,” many salespeople and sales managers view customers more from the standpoint of “he has money, I like him.” Given that shortsighted view, Wall Street often violates the second cardinal rule of sales.

2. Suitability addresses the requirement that an investment product meets the objectives of the customer. Interpreting this requirement is not as easy as some may believe. Where is the line drawn? What product may fit? What products definitely do not fit? All too often, the topic of suitability is addressed after the fact rather than prior to sale. Why does this happen?

Based on my experience, I believe salespeople themselves are not fully familiar with embedded risks in certain products. How does that happen? Those structuring deals on Wall Street are keenly aware of where and how to bury or disguise risks. In the process, although salespeople are held responsible for knowing all the risks of products being sold, they do not. As a result, those risks are not reviewed with clients prior to sale. Why are deals structured in that fashion? Maximize revenues for Wall Street and maximize proceeds for issuers.

Are portfolio managers at a wide array of clients incapable of assessing these risks? Regrettably, all too often that is the case. I am reminded of this all too common occurrence in a Bloomberg article this morning, Back-Door Taxes Hit Americans With Public Financing In The Dark:

Salvatore Calvanese, the treasurer of Springfield, Massachusetts, for four years, had a ready defense for why he risked $14 million of taxpayer money on collateralized-debt obligations laden with subprime mortgages in 2007.

He didn’t know what he was buying, he says, and trusted the financial professionals who sold them and told him they were safe.

“I thought they were money markets that were just paying more,” Calvanese said in an interview. “Nobody ever used the term ‘CDO,’ and I am not sure I would have known what that was anyway.”

Such financial mistakes, often enabled by public officials’ lack of disclosure and accountability for almost 90 percent of government financings in the $2.8 trillion municipal bond market, are costing U.S. taxpayers as much as $6 billion a year, according to data compiled by Bloomberg in more than a dozen states.

The money lost to taxpayers — when the worst recession since the Great Depression is forcing local governments to cut university funding, delay paying bills and raise taxes — is enough to buy health care for everybody in Minneapolis; Orlando, Florida; and Grand Rapids, Michigan, according to figures from the U.S. Census Bureau and the U.S. Department of Health and Human Services.

Where does the fault lie? In my opinion, every step in the process is culpable. The steps include:  those structuring the deal, salespeople, sales management, regulators charged with overseeing the markets and protecting investors, and clients themselves who are not aware of how to review specific products.

Over and above these shortcomings, if not outright violations, do not discount that there are illegal payoffs both to issuers and investors to facilitate transactions. The world of municipal finance has been rife with these payoffs for far too long. Why? Municipal issuers and investors hold the purse strings on millions in fees paid to Wall Street while these individuals themselves often take home less than six-figure checks.

That dynamic has always been a recipe for corruption.


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