Management or mismanagement?

How CPAs can help spot when client investments are being mishandled.

Certain investment management problems are difficult to overlook. The recent derivatives crisis affected both big and small investors and received considerable media attention. In the 1980s, junk bonds and limited partnerships caused similar turmoil. But spotting some problems requires greater scrutiny.

This article offers guidelines CPAs can use to advise clients about portfolio management concerns. To do so effectively, CPAs must be familiar with client investment needs and recognize several common warning signs that could signal potential difficulties.

KNOW THE CLIENT

A good starting point is to learn essential information about each client and his or her investment goals. For example, is a client willing to forgo a higher rate of return to avoid an unacceptable level of risk or does he or she seek a balance between risk and return? A CPA also should understand the client's level of investment knowledge. The questions in exhibit 1, page 67, can be helpful in assessing a client's investment skills.

UNDERSTAND CONFLICTS OF INTEREST

From stockbrokerage and investment managers to life insurance companies, financial planners and mutual funds, the best interests of clients are almost always in natural conflict with the financial interests of the investment industry. Almost every investment professional earns his or her living from transaction-based fees. This inherent conflict of interest can result in too much trading, using investments that are unacceptably risky.

Consider a well-known group of limited partnerships that offered returns from oil and gas development wherein an insurance company guaranteed certain amounts of oil would be pumped and sold. The marketing literature boasted of the program's safety and appropriateness for clients who needed reliable income. Unfortunately, the sale price of the oil was not guaranteed. As oil prices fell, the investment's value dropped to pennies on the dollar.

How could so much money be lost through a relatively modest decline in oil prices? The answer is buried in the partnership's prospectus. Many limited partnerships give investors little chance of earning a competitive return with only $.075 to $0.85 of each investment dollar going into the actual investment. Acquisition fees, management fees, liquidation fees, etc., reduce returns further.

THE CPA's ROLE

Many of the clients who seek help in monitoring their investment portfolios are those with whom CPAs already have a relationship--typically, tax return clients. To maximize the benefits they can offer such clients, CPAs should be aware of the common signs of investment mismanagement-but should take care to avoid false signals. Three investment myths are described below.

Myth no. 1: As long as trades are profitable, a portfolio is well managed. This usually is a myth because a mismanaged investment account often shows a profit or a small net loss on schedule D of form 1040. This occurs because the manager puts off selling the big losers so the investor is not warned of the portfolio's declining value.

In fact, tax loss selling often is a wise strategy--resulting in sales that record losses for tax purposes while retaining profitable securities. Thus, the short-term profitability on schedule D often is inversely related to investment problems. CPAs should look further when schedule D shows a high volume of trading with little or no net loss.

In addition to schedule D, CPAs and their clients should focus on changes in the net worth of the client's investment portfolio as an indicator of how well the account is managed. However, clients may need significant guidance in this area, particularly if securities were bought on margin. Because most brokerage statements indicate margin as a negative cash item, it isn't always possible to rely on the total portfolio value noted on the statement.

Myth no. 2: Most investment problems can be identified with the information reported for tax purposes. This often is not true because in certain cases, such as with limited partnerships, the information needed for tax purposes is not sufficient to spot mismanagement. In addition, timing often is a key constraint. Because schedule K-1 information on a limited partnership usually is received close to the tax filing deadline, clients are faced with either filing for extensions or hurriedly completing their returns. For clients who don't want to file extensions, there is an added element of risk because in the haste of completing the returns, analyses of transactions often are overlooked.

Myth no. 3: Investors usually know if their accounts are mismanaged or will be quick to investigate the possibility if it is suggested. Because many clients do not understand or fully review their investment statements, or because statement formats change frequently, it is difficult for clients to remain fully informed about their portfolios. This is particularly true if a client simply files the statements away until they are needed for tax purposes, making it difficult to investigate problems that occurred months earlier.

USEFUL WARNING SIGNS

CPAs can serve an important preventive role by alerting clients to potential investment mismanagement. Because such problems appear to be growing, CPAs are likely to find a number of opportunities when they can and should act. Consider these three ways to spot potential mismanagement.

1. Evaluate the volume of transactions. Ira client's schedule D indicates too many transactions relative to the size of the account, there may be reason to suspect a problem. This is particularly true if the transactions include high commission products, such as load mutual funds or low-priced stocks. Remember not to use schedule D's profitability as an indication of good management.

2. Look for substantial margin interest, option trading, limited partnership holdings, commodity trading or other unusual investments. While the presence of these items does not necessarily prove anything, it serves as a warning that high-risk transactions may be taking place. CPAs should always evaluate a clients' ability to understand trading on margin, buying or selling options and other high-risk transactions.

3. Determine the client's awareness of his or her investment holdings. A client's ignorance is dangerous and can result in the worst cases of investment mismanagement. Conversations with clients can provide CPAs with information on their financial sophistication and the extent to which they understand their investments.

CPAs can use the questions in exhibit 2, page 67, as a guide in identifying potential problems. A yes answer to these questions indicates a CPA has an opportunity, or perhaps even an obligation, to make additional inquiries. To prevent problems, CPAs should

* Encourage clients to review their investment account statements on a timely basis and to ask their brokers about transactions they don't understand. Resolving disputes that occurred three, six or nine months earlier can be extremely difficult. In fact, failing to lodge a timely complaint has been construed to be an investor's ratification of a transaction, even when the trade was unauthorized.

* Suggest that a client who is opening a new brokerage account try to eliminate the arbitration clause that appears in most new account agreements, or at least insist on using an independent arbitration organization, such as the American Arbitration Association. Industry-sponsored arbitration frequently is criticized as not adequately protecting the investor's interests, particularly in terms of full damage recovery (including legal fees and expenses). Since the new account agreement governs the contractual arrangement, the terms must be mutually agreeable to both parties. Although the broker is unlikely to agree to any modifications, the discussions might enhance the client's awareness of the clause and its implications.

* Recommend that tax clients review their brokerage account statements before preparing their tax returns. If they don't do so themselves, consider developing this expertise and offer to review the statements as part of preparing their returns. CPAs can market this as a value-added component of existing services or view it as an opportunity to provide additional client service. Either way, the client benefits.

OPTIONS FOR RESOLUTION

If questionable transactions are discovered, a client may ask for the CPA's advice on how to proceed. The first option is to recommend that the client ask an investment manager from another company to evaluate the transactions. In some cases, the CPA may offer to act on the client's behalf. The advantage of this low-cost approach is that most investment professionals are capable of detecting whether an account has been improperly managed.

However, this approach has some risk. One potential problem is that the investment professional selected may be reluctant to speak poorly of others in the profession. Alternatively, the professional may criticize good management in an effort to attract a new client. A competent and honest investment professional is the ideal answer. However, if investors were able to differentiate competent and honest from incompetent and dishonest, they would not need outside advice.

Another solution, similar to the first option, is to ask someone with little or no association with the investment industry--an academic, a retired investment professional, a regulator, a financial columnist, etc.--to analyze the investment. It is essential the individual be well trained and competent to perform a careful analysis. Some people claim to know more than they do or have a hidden agenda, such as selling another financial product. In the absence of an independent, honest and competent investment professional, CPAs may wish to refer the client to an attorney.

A client who pursues the legal route has two choices. The first is to use a latter specializing in contracts, since investment mismanagement disputes usually center on either the contract between the parties or on negligence claims. The second choice is an attorney specializing in securities litigation. CPAs can help clients select attorneys, focusing on those who have successfully handled similar cases. Although clients usually prefer to hire attorneys on a contingency basis, many will agree to a combination of reduced hourly rate billings and a percentage of any settlement.

The final solution is to have a frank discussion with the investment professional who managed the account or, possibly, with his or her supervisor. Because there are numerous problems with this approach, this option is not generally' recommended. One of the dangers is the investment manager has an opportunity to prepare a case in advance. This route should never be selected unless all facts are known before the discussion begins. An alternative or supplement to discussions with the local office is to complain in writing to the firm's compliance department and to one or more organizations with supervisory roles (the Securities and Exchange Commission, the National Association of Securities Dealers, the New York Stock Exchange, etc.).

Many claims are settled before arbitration. However, if settlement negotiations fail, the client will most likely face the arbitration process used by the securities industry, unless the clause was eliminated in the brokerage agreement. It is important for clients to recognize that in arbitration full relief--after fees and expenses--is unlikely.

AVOIDING COSTLY PROBLEMS

The recommendations in this article are designed to help CPAs provide their clients with better service. By working closely with clients and advising them before problems occur, CPAs can help them avoid costly investment management problems. The sidebar on pages 68-69 describes the approach some professionals take to identifying and handling investment management problems.

Online Information For additional information about securities law and the arbitration process, visit the securities law home page at http://www.seclaw.com.

EXECUTIVE SUMMARY

* WITH INVESTMENT MISMANAGEMENT problems regularly reported by the media, CPAs need to be able to advise their clients about their portfolio management concerns. An essential first step is getting to know the clients and their investment goals better.

* THE BEST INTERESTS OF CLIENTS ARE almost always in natural conflict with the financial interests of the investment industry. With most investment professionals earning their livings from transaction-based fees, this inherent conflict of interest can result in too much trading, sometimes with investments that are unacceptably risky.

* TO MAXIMIZE THE BENEFITS THEY CAN offer clients, CPAs should know the common signs of investment mismanagement. They also must be careful to avoid false signals. To spot potential problems, CPAs can evaluate the volume of client transactions; look for substantial margin interest, option trading and other unusual investments; and determine how aware a client is of his or her investment holdings.

* WHEN A CPA DISCOVERS QUESTIONABLE transactions, several options are available: asking someone who is independent to evaluate the transactions, consulting an attorney or approaching the investment professional who managed the account directly. Each of these options has pros and cons.

ROSE MARIE L. BUKICS, CPA, is a professor at Lafayette College, Easton, Pennsylvania, where she heads the Department of Economics and Business. DONALD R. CHAMBERS, PhD, is Walter E. Hanson/KPMG Peat Marwick Professor of Finance at Lafayette College. STANLEY E. STETTZ, Esq., is president of Teel, Stettz, Shimer & DiGiacomo, Ltd. in Easton.

Exhibit 1: Client Investment Skills Assessment

Evaluate a client's knowledge by answering these questions. Does the client

* Try to understand and evaluate the transactions in his or her portfolio?

* Trust the investment professional and pay less and less attention to investments as long as they appear profitable?

* Review the statements monthly, noting whether transactions involve new types of securities he or she knew nothing about or there was an unusual number of transactions in the account?

* Know that brokers must seek approval before every trade (unless clients have specifically requested a discretionary relationship in writing)?

* Require justification before consenting to a purchase? Is he or she, in fact, informed enough to evaluate the justification?

* Have frequent discussions with the investment professional that indicate all is well?

* Simply refer to his or her tax return to "prove" the portfolio was profitable and therefore well managed?

* Feel comfortable because he or she promptly receives the desired amount of cash asked for?

* Know the net worth of the account, especially if securities are purchased on margin?

* Know that when the account was opened, he or she signed agreements to arbitrate disagreements within a system organized and managed by the securities industry itself?

* Realize that it is very difficult to fully recover money lost due to broker mismanagement through industry-sponsored arbitration?

* Know that he or she must pay, and rarely can recover, legal and expert witness fees in arbitration?

Exhibit 2: Indicators of Potential Investment Management Problems * Does schedule D of the client's form 1040 show numerous trades given the total amount of money involved?

* Does schedule A indicate substantial margin interest expense? Does the client appear to have the financial means to bear the associated risks?

* Does schedule B report income from sources that appear speculative, such as high-yield bond funds, small company stocks or nondiversified holdings for a client known to seek stability in his or her investments?

* Does schedule K-1 show a significant limited partnership investment for a client with limited financial sophistication and resources?

CASE STUDY

Identifying Investment Management Problems:

Two Perspectives

A PROFESSIONAL APPROACH

How do the pros spot investment management problems? Christopher M. Flanagan is senior vice-president and division manager of Mellon Private Asset Management in Boston. In his view, accountants have a better grasp of investment performance and how to measure it and bring a much higher level of reality than many other professionals. CPAs also are better at looking at the cost of investment management--the cost of missed opportunities as well as actual trading costs.

According to Flanagan, the first thing CPAs can look at is whether the client is getting a consistent or a disciplined approach to investment management. If there are changes, the client should know the reason why. Flanagan said, "CPAs are in a good position to get underneath and see if the investment manager has a good explanation."

A second important factor Flanagan cited was keeping an eye on the cost of investing. Many clients, he said, are unaware of how much investment management costs. "In the marketplace, some believe that there is a free lunch. The first rule of economics is that there is no such thing." Flanagan said anyone who invests in something with that kind of promise probably has made a mistake. The cost of acquiring or disposing of assets through trading must be monitored. And, Flanagan said, the investor also has to look at turnover. "If you are trading too much to achieve a particular return, there are going to be tax consequences."

A third concern of Flanagan's is that clients don't pay enough attention to the reversibility of investments. "In our business, we have to be able to react to contingent events, such as death or divorce, so investments have to be reversible." Clients have to be able to liquidate at least part of their portfolios without penalty. Flanagan's company likes to take the position that no matter when a client gives it money or takes money away, there won't be a lot of volatility in between.

Something else CPAs can look for, Flanagan said, is a fixed-income portfolio with an overly extended maturity. "People chase a high yield but at a high cost." Most high-yield mutual funds, for example, are composed of 25- to 30-year bonds. As soon as interest rates go up, he said, principal starts eroding. "People think that if they buy bonds, they can't lose anything. They wake up one morning and realize their $50,000 investment is worth only $42,000." The reason is they went after the highest yield they could get--using long-term fixed income securities--and interest rates went against them. Flanagan sees more people get hurt in fixed-income investing than he does in equity investing.

Flanagan said many CPAs recommend professional managers to their clients instead of individual brokers. "Accountants tend to be sensitive to costs and managers tend to be popular because the costs are relatively low," he said. CPAs also see that money managers can make order out of chaos and that helps them, too. Accountants encourage people to use providers like Mellon because it ensures that assets are registered, corporate actions are properly tracked, dividends are projected and tax information provided in an easy-to-use format. As Flanagan said, "Having good ideas isn't the only thing in the investment management world; it's also being able to execute them."

THE BENEFITS OF EXPERIENCE

How does an experienced CPA-financial planner approach clients with investment management problems? Lyle Benson, CPA, president of L. K. Benson & Co. in Baltimore, said he sits down with the client first to explore some basic investment issues and asks some open-ended questions. He thought it would be hard to go to a client and say something was inappropriate or to make accusations without first knowing more about the client's investment goals and objectives. In meeting with a client, Benson focuses on four areas.

1. Asset allocation. Benson said many clients--particularly older ones--work with several different brokers and lack a coordinated approach. Clients must understand the need to diversify and why asset allocation is the most important part of this process. One of the first things Benson does is help the client develop a "basic overall game plan of what he or she is trying to do in allocating assets."

2. Investment performance. Benson said 7 out of 10 clients probably don't know how their investments are performing, particularly if they use several brokers, "Clients get brokerage statements they don't really understand," Benson said. "They know the value of the securities and the income they produce but really don't know what the performance has been." Clients need to better understand how their investments are doing in comparison with established indexes.

3. Investment goals. Benson believes this is an area in which CPAs have an advantage because they can spend the time necessary to understand clients' financial planning goals. Many of the clients who come to Benson with investment questions have not gone through the process of setting goals and understanding what they have to do to achieve them.

4. Communication. It's important for the CPA to understand how often the client and the investment manager talk and what advice the client gets. There is a difference, Benson pointed out, between a broker who calls with a hot stock pick and someone who really takes the time to understand the factors discussed above. "I've often found 1 didn't understand the relationship between the client and the investment adviser." Many times the problem is that although the client has been working with someone for a long time, the two parties have never sat down to review the client's goals and objectives. A manager can do his or her job much better, Benson said, if the communication improves. "The manager may not necessarily be a bad adviser; he or she just may not have had good direction from the client."

--Peter D. Fleming