The administrative complaint brought by the MassachusettsSecurities Division against Scottrade Inc. will more than likely befollowed by claims from other states, according to attorneysfamiliar with the matter.

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In court papers filed last week, the Office of the Secretary ofthe Commonwealth alleged Scottrade violated Massachusetts'securities laws by failing to comply with the impartial conduct standards of the Labor Department's fiduciary rule.

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According to the complaint, the discount broker-dealer knowinglyviolated the fiduciary rule by running sales conteststargeting retail investors' assets in qualified retirementaccounts.

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The contests also violated the internal compliance policies thecompany put in place after the impartial conduct standard went intoaffect in June of 2017, the complaint says.

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Under the fiduciary rule's impartial conduct standards, anyrecommendation to buy a security with assets in IRAs or 401(k)plans must be made in investors' best interests.

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Scottrade ran two sales contests—one launched days beforeimplementation of the impartial conduct standards, and one launchedin September of 2017.

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Those contests, which were common in what the claim says wasScottrade's “aggressive sales practices” prior to theimplementation of the impartial conduct standards, incentivizedbrokers to bring in new assets from customers, including throughrollovers from qualified retirement accounts.

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“Scottrade knowingly included retirement account clients in thescope of the contests,” the complaint says.

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In the first contest, Scottrade offered $285,000 in cash prizesto brokers that satisfied high cold-calling penetration benchmarks.In the second, brokers were awarded weekly cash prizes of $500 and$2,500 for recommending investors move to the firm's advisoryprogram.

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Under the fiduciary standard established by the impartialconduct standards, any compensation arrangement that creates apotential conflict of interest must be disclosed to investors.Massachusetts' complaint says Scottrade failed to inform clients ofthe conflicts arising from the incentives in the salescontests.

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Rumblings from other states

 

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Erin Sweeney, an attorney in the benefits practice of Miller& Chevalier, says there are rumblings that Massachusetts won'tbe the only state to bring a claim against Scottrade.

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“Other states are quietly indicating they are looking at theseissues,” Ms. Sweeney told BenefitsPRO. “These were nationwidecontests—a number of states believe they can bring a similarcomplaint.”

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Ms. Sweeney underscored that Massachusetts, and other states,can't enforce the Employee Retirement Income Security Act, thefederal law that Labor's fiduciary rule amended.

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Rather, Massachusetts is attempting to enforce its ownsecurities laws by showing that Scottrade's alleged violation ofthe fiduciary rule amounts to a breach of state ethicalstandards.

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“They are going to have to prove there was a violation of statelaw—that's the hook Massachusetts is looking at,” said Ms.Sweeney.

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Massachusetts is bringing its complaint under Section 204 of theUniform Securities Act, which gives the state power to bringadministrative actions against registered firms or individuals thathave “engaged in any unethical or dishonest conduct or practices,”according to one provision of the law.

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“Most states have broad provisions requiring good faith conductto participate in the securities industry,” said Brendan McGarry, asecurities attorney at Kaufman, Dolowich & Voluck.

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Mr. McGarry, who advises broker-dealers and RIAs on litigationand compliance issues, said the fact that a state is taking thefirst enforcement action under the fiduciary rule is a curve ballfew expected.

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“For all of the questioning on how the rule will be enforced, Idon't know that state claims were on the forefront of anyone'smind,” said Mr. McGarry.

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Scottrade, now an arm of TD Ameritrade, will face anadministrative hearing in Massachusetts. If the allegations areupheld, the firm potentially faces censure, disgorgement of profitsgained from the alleged breaches, and administrative fines.

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How Scottrade defends the claim—if it chooses to—could establisha roadmap for potential actions brought by other states against thefirm, or states alleging violations of the fiduciary ruleindustry-wide.

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One conceivable course will be for Scottrade to argue thatstates lack the authority to bring claims based on a federalstatute, said Mr. McGarry.

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No claim without a whistleblower

 

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Massachusetts' complaint is supported by internal documents fromScottrade, including sales directives instructing brokers to minefor clients' “pain” points, and amendments to compliance documentsprohibiting the use of contests and other forms of variablecompensation to incentivize sales.

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The complaint also cites internal emails from an unnamed seniorvice president, a compliance supervisor, a branch manager, aregional sales manager and a divisional vice president, as well asinternal reports on performance metrics.

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But the most damning evidence may be testimony of an unnamedbroker, who said that retirement assets were targeted, and that thecompensation incentives from the contests were not disclosed toclients.

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Most of the fiduciary rule's warranty and disclosurerequirements have been delayed until July of 2019. While theimpartial conduct standards have been in effect since last year,the question of how they will be enforced absent formal contractshas rankled supporters of a strong fiduciary standard.

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“It's hard to enforce a best interest standard when theimpartial conduct standards don't create a paper trail,” said Ms.Sweeney.

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The thorough paper trail Massachusetts establishes againstScottrade appears to have come from an inside whistleblower. Thatpresents another wildcard industry may not have expected—theprospect of brokers tipping off regulators as to alleged breachesof the fiduciary rule.

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“Without those internal documents, this isn't something thestate would have become involved with. It would be very hard topoint to something that would give the regulators traction,” saidMs. Sweeney.

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Massachusetts does not have whistleblower laws that incentivizeemployees to come forth with company violations. Nor are there lawsprotecting whistleblowers from company retribution in the privatesector; those laws only exist for public employees in theCommonwealth. Other states have stronger protections forwhistleblowers, said Ms. Sweeney.

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“Whoever did this won't have protection—they could get fired,”she said.

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A clear message to industry and an uphill battle forScottrade

 

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The fact that Scottrade amended its compliance manuals toaccount for the fiduciary rule, and then allegedly proceeded to actin direct violation of them, sends a clear message to industry.

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“If you make these amendments to your internal rules, you hadbetter be following them,” said Mr. McGarry. “Firms shouldn't takecomfort from the fact that DOL has taken a cooperative, instead ofpunitive approach to compliance with the rule. The action fromMassachusetts presents a picture that enforcement could come fromanywhere.”

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If the allegations in the complaint against Scottrade are true,the firm is facing an uphill battle, says Mr. McGarry. “Nothing hasbeen proven, and individuals have not been named, but on theirface, these allegations seem to be directly contrary to everythingthe fiduciary rule speaks to.”

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Ms. Sweeney is in agreement. “Unless the internal documents aresomehow illegitimate, this is a serious violation. It's hard to seehow Scottrade is able to defend itself.”

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The question of the fiduciary rule's restrictions on generalsales activity has been at the heart of several legal challenges tothe rule.

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So far, courts have upheld the rule; a decision on one appeal inthe 5th Circuit has not been delivered.

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Firms that use contests to incentivize sales on qualifiedretirement assets risk placing a clear target on their back, anddrawing the ire of Massachusetts, and potentially other states,said Ms. Sweeney.

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“The problem with contests is that they create sales incentives.How can you then say you are acting in the best interests of yourclients?” she said.

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Nick Thornton

Nick Thornton is a financial writer covering retirement and health care issues for BenefitsPRO and ALM Media. He greatly enjoys learning from the vast minds in the legal, academic, advisory and money management communities when covering the retirement space. He's also written on international marketing trends, financial institution risk management, defense and energy issues, the restaurant industry in New York City, surfing, cigars, rum, travel, and fishing. When not writing, he's pushing into some land or water.