It’s one of those scams that give regulators — and the investing industry in general — nightmares. The Mutual Fund Dealers Asso-ciation of Canada is currently grappling with a fraudulent scheme that is surprisingly simple and effective: corrupt advisors exploit loopholes in the regulatory system to redirect a client’s mail. They then siphon money from the mutual fund account of the trusting client.
“It’s an internal control weakness, to the detriment of the investing public,” says Karen McGuinness, vice president of compliance for the MFDA.
This fraud — perpetrators have been dubbed “rogue reps” — depends on clients and companies who still rely on paper-based communications. Unscrupulous advisors deliberately circumvent their dealers and instruct mutual fund companies to change a client’s address without the client’s authorization.
With the addresses altered so that information flows only to the rogue rep, money is stolen from the client’s account, sometimes in small withdrawals that are less likely to draw the attention of fund administrators. Some instances, however, involve large amounts.
Usually, the thefts occur before clients have even noticed that they are no longer receiving their account statements.
It’s a problem that must be stopped by both the MFDA and the Ontario Securities Commission, says McGuinness. But the issue is being complicated, she says, by what appears to be a failure of regulatory sectors to work together.
Certainly, some steps are being taken to address the problem. The MFDA is investigating a number of such cases that deal with large withdrawals. Shaun Devlin, vice president of enforcement at the MFDA, refers to these cases as the “big chunk at once” scenarios.
“When they take out noticeable amounts, there’s usually a false explanation, such as a processing error that goes along with it,” Devlin says. “The advisor will say, ‘We are working to correct that. It was a mistake on your statement’.”
So, exactly how does this scheme work — and why, with all the safeguards now in place, is it successful? The rogue reps have figured out how to take advantage of a gap between MFDA Rule 2.2.4, the requirement that all changes to client account banking and address information be made through a dealership’s head office; and the OSC’s NI 81-102, which requires fund companies to carry out their clients’ instructions.
The loophole creates a window for fraud when a rogue rep bypasses the dealership and sends “client” instructions directly to the mutual fund company.
The rep appears to be acting on behalf of a client within the OSC rules, because requests are usually on paper forms displaying a dealer logo. Most fund companies receive thousands of such forms every day, with some fraudulent paper forms slipping through.
“The requirement for fund companies is that they must act on client instructions: but there’s no legislation requiring them to verify that those changes [to account information] are, in fact, coming from clients,” says McGuinness. “Instead, they [improperly] rely on the dealers to do the verification; meanwhile, the transactions are going through.”
Once a fraudulent change to a client’s address has been made and a client no longer gets his or her statements, the rogue rep typically takes two more steps to complete the scheme. “The bank account number will [be changed by the rep], so any redemptions made will flow to a new account, which is typically in the advisor’s name,” says McGuinness.
Because the fund company receives instructions to change only a bank account number, and not a name, the account change might go undetected for some time.
The final step can follow one of two patterns: small, periodic withdrawals that can be easily overlooked; or a large bite is taken out of the account all at once.
The small withdrawals are the more difficult to track. John De Goey, vice president, assistant branch manager and investment advisor with Toronto-based Burgeonvest Securities Ltd., notes that this type of activity would not cause the compliance department of a dealership to raise an eyebrow.
“You see many types of transactions on a daily basis,” he says. “[Smaller withdrawals] aren’t big enough numbers to draw any sort of attention.”
Although direct dealing between advisors and fund companies does not, in itself, indicate a fraud, it’s a widespread practice that should be eliminated, says McGuinness. The MFDA has already taken action by amending its Rule 2.2.4; in the past, dealers weren’t required to check for client authorization when reps made non-financial changes to accounts, such as client name, banking or address information. Now, dealers will be required to have written client authorization or internal controls in place to ensure that clients have authorized all such changes.
@page_break@However, without more help from securities regulators, the rule change will go only so far to contain the fraud, says McGuinness: “We are trying to address it on our end. It would be nice to get all parties involved.”
But the OSC disagrees. “We still see it as a [responsibility] of the dealer,” says Leslie Byberg, director, investment funds, at the OSC, “to ensure that business is being conducted appropriately through the dealership.”
There is also another option: requiring that all changes to accounts be made electronically. That would plug the loophole on both sides, says Brian Gore, president and CEO of Toronto-based FundSERV Inc. The company acts as the central computer hub for the head offices for almost all non-bank-owned mutual fund companies and dealers that trade funds in Canada: it cannot deal directly with advisors. Any attempt to make changes without going through a dealership would be spotted immediately as coming directly from the advisor. The issue potentially affects about 5.1 million paper-based transactions — approximately one-fifth of FundSERV’s transactions.
“If the [regulators] were able to put in some rule that says all transactions have to be electronic,” says Gore, “it would prevent a lot of fraud from happening.”
The OSC’s Byberg counters that she’s aware of the advantages of going electronic. But, she notes: “Our rule provides flexibility, and there’s never been an impediment to anyone transacting electronically.” IE
MFDA raises warnings about “rogue reps”
How unscrupulous advisors use a regulatory loophole to skim money from client accounts
- By: Olivia Glauberzon
- June 1, 2009 June 1, 2009
- 13:14