Ron's note - This is the white paper, unedited and with citations, which was published as a four-part series in June and July 2013, courtesy of www.RIABiz.com. The last installment of the four-part series, which contains links to the earlier parts, can be found at http://www.riabiz.com/a/23015131/what-the-8-pillars-of-a-finra-replacing-entity-for-ria-oversight-look-like-and-how-personal-accountability-is-key
I offer this unabridged version for those who are interested in the sources of authority, and for those who may seek to undertake further analysis or discussion of the issues involved.
Thank you. - Ron
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Disband FINRA - PART ONE. THE DECLINE OF TRUST;IMPLICATIONS FOR AMERICA’S ECONOMIC
FUTURE
FINRA is Hungry
That big
Gorilla called FINRA - facing a continued decline in its membership (consisting
of all broker-dealer firms conducting business with the public) – is hungry. Sitting nearby are registered
investment adviser (RIA) firms – appearing to FINRA as juicy, growing bananas
and a perfect treat to be consumed, chewed up, and digested.
Yet, we
must ask - if you are a consumer, or if you are a registered investment adviser
(RIA) or an investment adviser representative (IAR), would FINRA’s desired
takeover of RIAs be a good thing? Not on
your life. Permit me to explain why.
In this
series for articles, I propose that, for long-lasting reforms, FINRA possesses
fatal flaws and must be dismantled. In its place should arise a true
professional regulatory organization bound to a bona fide fiduciary standard of conduct and to promoting the best
interests of clients at all times and without exception. Only then will our
fellow Americans receive the ongoing certainty of the substantial protections
of the fiduciary standard that they so justly deserve.
I first explore
the diminished trust in financial intermediaries, and its dire consequences for
the future economic prosperity of all Americans.
FINRA Keeps the U.S. Economy
Struggling
In over
seven decades of existence, the Financial Industry Regulatory Authority, Inc.
(FINRA) (formerly known as the National Association of Securities Dealers, or
NASD) has failed to provide the essential safeguards necessary to limit its
large Wall Street member firms’ ability to underwrite or sell investment
products with exorbitantly high fees and costs. The result has been the
preservation of an oligopoly of investment banks, as well as the preservation
of conflicted broker-dealer business models long overdue for an extinction
event. More importantly, FINRA’s long-standing protection of its members’
excessive rent-taking has led to a crisis in American capitalism, negative
implications for U.S. economic growth, and a dismal personal financial outcome
in retirement for tens of millions of Americans.
By way of
explanation, American business is the robust engine that drives the growth of
our economy and delivers prosperity for all. An important component of the fuel
for this engine is monetary capital. Yet, this monetary capital is not
efficiently delivered to the engine of business … it’s as if the engine is
stuck using an outdated, clogged carburetor, in the form of substantial
intermediation costs by current investment banking firm practices.
More
importantly, the transmission system of our economic vehicle is failing,
leading to far less progress in our path toward personal and U.S. economic
growth. The transmission system is large, heavy and unwieldy; its sheer weight
slows down our vehicle’s progress. Through costly investment products and
hidden fees and costs, this transmission system unnecessarily diverts much of
the power delivered by American business’ economic engine to Wall Street,
rather than deliver it to the investors (our fellow Americans) who provide the
monetary capital.
The
ramifications of this inefficient vehicle, with its clogged carburetor and
faulty transmission, are both numerous and severe. The cost of capital to
business is much higher than it should be, due to the exorbitant intermediation
costs Wall Street imposes during the raising of capital and its diversion of
the returns of capital away from individual investors.
In fact, Wall
Street currently diverts away from investors a third or more of the profits
generated by American publicly traded companies. As Simon Johnson, former chief
economist of the International Monetary Fund, observed in his seminal May 2009
article “The Quiet Coup” appearing in The
Atlantic, wrote: "From 1973
to 1985, the financial sector never earned more than 16 percent of domestic
corporate profits … In 1986, that figure reached 19 percent. In the 1990s, it
oscillated between 21 percent and 30 percent, higher than it had ever been in
the postwar period. This decade, it reached 41 percent."
More recently the financial services sector’s bite into corporate profits has
been estimated at one-third or higher.
Investor Distrust = Less Capital
The
siphoning of profits by Wall Street, away from the hands of individual
investors, has led to a high level of individual investor distrust in our
system of financial services and in our capital markets. In fact, many
individual investors, upset after finally discovering the high intermediation
costs present, flee the capital markets altogether. (Many more would flee if
they discovered all of the fees and costs they were paying, and realized the
substantial effect such had on the growth or preservations of their nest eggs.)
The effects of greed in the financial services industry can be profound and
extremely harmful to America and its citizens. Participation in the capital
markets fails when consumers deal with financial intermediaries who cannot be
trusted.
As a result
of the growth of investor distrust in financial intermediaries, the capital
markets are further deprived of the capital that fuels American business and
economic expansion, and the cost of capital rises yet again. Indeed, as high
levels of distrust of financial services continue,
the long-term viability of adequate capital formation within the United States
is threatened, leading to greater reliance on infusions of capital from abroad.
In essence, by not investing ourselves in our own economy, we are selling our
bonds, corporate and other assets to investors abroad.
Less Capital Formation = Reduced
Economic Growth
It is
well documented that public trust is positively correlated with economic
growth.
Moreover,
public trust is also correlated with participation by individual investors in
the stock market.
This is especially true for individual investors with low financial
capabilities – those who in our society are in most need of financial advice;
policies that affect trust in financial advice seem to be particularly
effective for these investors.
The
lack of trust in our financial system has potential long-range and severe
adverse consequences for our capital markets and our economy. As stated by
Prof. Ronald J. Columbo in a recent law review article: “Trust is a critical,
if not the critical, ingredient to the success of the capital markets (and of
the free market economy in general). As Alan Greenspan once remarked: ‘[O]ur
market system depends critically on trust-trust in the word of our colleagues
and trust in the word of those with whom we do business.’ From the inception of
federal securities legislation in the 1930s, to the Sarbanes-Oxley Act of 2002,
to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, it
has long been understood that in the face of economic calamity, the restoration
and/or preservation of trust – especially investor trust – is paramount in our
financial institutions and markets.”
There
is no doubt that “[t]rust is a critically important ingredient in the recipes
for a successful economy and a well-functioning financial services industry.
Due to scandals ranging in nature from massive incompetence to massive
irresponsibility to massive fraud; investor trust is in shorter supply today
than just a couple of years ago. This is troubling, and commentators,
policymakers, and industry leaders have all recognized the need for trust's
restoration ….”
Less Trust = Less Use of Financial
Advisors
The issue
of investor trust in financial intermediaries does not just concern asset
managers and Wall Street’s broker-dealer firms; it affects all investment
advisers and financial advisors to individual clients. As Tamar Frankel, a
leading scholar on U.S. fiduciary law, once observed: “I doubt whether
investors will commit their valuable attention and time to judge the difference
between honest and dishonest … financial intermediaries. I doubt whether
investors will rely on advisors to make the distinction, once investors lose
their trust in the market intermediaries. From the investor’s point of view, it
is more efficient to withdraw their savings from the market.”
Harmful Impact on Americans’
Retirement Security
Even more
severe are the long-term impacts of the high intermediation costs imposed by
Wall Street firms on individual investors themselves. Individual investors, now
largely charged with saving and investing for their own financial futures
through 401(k) and other defined contribution retirement plans and IRA
accounts, reap far less a portion of the returns of the capital markets than
they should. These substantially lower returns from the capital invested, due
to Wall Street’s diversion of profits, result in lower reinvestment of the
returns by individual investors; this in turn also leads to even lower levels
of capital formation for American business.
It must be
remembered that, fundamentally, an economy is based upon trust and faith.
Continued betrayal of that trust by those who profess to “advise” upon
qualified retirement plans and IRA accounts, while doing so under an inherently
weak standard of conduct, only serves to destroy the essential trust required
for capital formation, thereby undermining the very foundations of our modern
economy.
Burdens Placed Upon Governments – and
Taxpayers
As
individual Americans’ retirement security is not adequately provided through
their own investment portfolios, saddled with such high intermediation costs,
burdens will shift to governments – federal, state and local – to provide for
the essential needs of our senior citizens in future years. These burdens will
likely become extraordinary, resulting in far greater government expenditures
on social services than would otherwise be necessary, precisely at the time
when our governments can ill afford further burdens and cannot solve these
burdens through the issuance of debt.
Consequentially,
higher tax rates become inevitable, for both American business and individual
citizens alike. This in turn consumes a greater share of our economy, leading
to further economic stagnation, and perhaps to the permanent decline of America
in the 21st Century and beyond.
We, the People: Servants of Wall
Street
In essence,
American business has become Wall Street’s servant, rather than its master. The
excessive rents extracted at multiple levels by Wall Street fuels excessive
bonuses paid, in large part, to young investment bankers.
Wall Street
also drains some of the best talent away from productive businesses, as well. Far
too many of our graduates of math and engineering programs make their way to
Wall Street, and even more pursue finance majors rather than pursue studies in
the STEM disciplines. This further distorts the labor market, as shortages of talent
in our important information technology and engineering sectors continue.
Consequently,
Wall Street has become a huge drain on American business and the U.S. economy.
It derives excessive rents at the expense of corporations and individuals. The
financial services sector, rather than providing the grease for American's
economic engine, instead has become a very thick sludge.
Wall Street’s Control of Our
Government
Wall Street
and the large U.S. banks have “captured”
our regulatory bodies and Congress, to the detriment of individual American
investors.
As
economist Simon Johnson also observed: “The (2008-9) crash has laid bare many
unpleasant truths about the United States. One of the most alarming, says a
former chief economist of the International Monetary Fund, is that the finance
industry has effectively captured our government—a state of affairs that more
typically describes emerging markets, and is at the center of many
emerging-market crises. If the IMF’s staff could speak freely about the U.S.,
it would tell us what it tells all countries in this situation: recovery will
fail unless we break the financial oligarchy that is blocking essential reform
… we’re running out of time.”
The Solution
There is
but one solution to fix the affliction affecting our country’s capital markets,
and the resulting lower levels of capital formation and economic growth. The
compelling reply to the current state of affairs lies in the application of a bona fide fiduciary standard of conduct
to all providers of personalized investment advice. Simply put, this
broad-based fiduciary standard requires that financial advisors act in the best
interests of their clients, and to subordinate their own interests (and those
of their firms) in order to keep the best interests of the client paramount at
all times.
Instead of
preserving the economic interests of conflict-ridden investment banks, the best
interests of individual American investors would be advanced under the fiduciary
standard. This in turn would free America from the grip of Wall Street, and
free individual Americans from personal financial prospects that are far too
often dismal and bleak.
____________________________________________________________________
Disband FINRA - PART TWO. THE EARLY HISTORY OF FINRA:ENABLING LOW STANDARDS OF CONDUCT
Why was the
fiduciary standard not implemented in the early days of securities regulation,
for brokers? The answer lies in FINRA, its inherent conflicts of interest, and
its failure to protect the individual investor. Let’s examine FINRA’s early history,
and the evidence of FINRA’s massive flop. To do so, we must first explore the
relationship between brokers and their clients that existed prior to FINRA’s
existence.
Brokers as Fiduciaries: Pre-FINRA
History
At the beginning of the 20th
Century, in “the United States the business of buying and selling stocks and
other securities [was] generally transacted by Brokers for a commission agreed
upon or regulated by the usages of” a stock exchange.”
Indicative of the known distinctions between brokers and dealers, an early
Indiana law provided for the licensing of brokers but not for “persons dealing
in stocks, etc., on their own account.”
During the early part of the 20th
Century, stockbrokers were known to possess duties akin to those of trustees,
including the duty of utmost good faith and the avoidance of receipt of hidden
forms of compensation. As stated in the 1905 edition of an early treatise:
He is a Broker because he has no interest in the transaction, except to
the extent of his commissions; he is a pledgee, in that he holds the stock,
etc. as security for the repayment of the money he advances in its purchase; so
he is a trustee, for the law charges him with the utmost honesty and good faith
in his transactions; and whatever benefit arises therefrom enures to the cestui que trust.
By the early 1930’s, the fiduciary duties of brokers (as
opposed to dealers)
were widely known. As summarized by Cheryl Goss Weiss, in contrasting the duties of an broker vis-à-vis
a dealer:
By the early twentieth century, the body of common law governing brokers
as agents was well developed. The broker,
acting as an agent, was held to a fiduciary standard and was prohibited
from self-dealing, acting for conflicting interests, bucketing orders, trading
against customer orders, obtaining secret profits, and hypothecating customers'
securities in excessive amounts -- all familiar concepts under modern
securities law. Under common law, however, a broker acting as principal for his
own account, such as a dealer or other vendor, was by definition not an agent
and owed no fiduciary duty to the customer. The parties, acting principal to
principal as buyer and seller, were regarded as being in an adverse contractual
relationship in which agency principles did not apply. [Emphasis added.]
The
fact that stockbrokers
were known to be fiduciaries at an early time in the history of the
securities industry (when acting as brokers and not acting as dealers) should
not come as a surprise. To a degree it is simply an extension of the laws of
agency. One might then surmise that, if the
broker provides personalized investment advice, then a logical extension of the
principles of agency dictates that the fiduciary duties of the agent also extend to those
advisory functions, as the scope of
the agency has been thus expanded.
While agency law provides one basis
for the imposition of broad fiduciary duties upon brokers, early court cases
confirmed the existence of broad fiduciary duties upon brokers in situations
where brokers possessed relationships of trust and confidence with their
clients. For example, In the 1934 case of Birch v.
Arnold,
in a case which did not appear to involve the exercise of discretion by a
broker, the relationship between a client and her stockbroker was found to be a fiduciary one, as it was
a relationships based upon trust and confidence. As the court stated:
She had great confidence in his honesty, business ability, skill and
experience in investments, and his general business capacity; that she trusted
him; that he had influence with her in advising her as to investments; that she
was ignorant of the commercial value of the securities he talked to her about;
and that she had come to believe that he was very friendly with her and
interested in helping her. He expected and invited her to have absolute
confidence in him, and gave her to understand that she might safely apply to
him for advice and counsel as to investments … She unquestionably had it in her power to
give orders to the defendants which the defendants would have had to obey. In
fact, however, every investment and every
sale she made was made by her in reliance on the statements and advice of
Arnold and she really exercised no independent judgment whatever. She
relied wholly on him. [Emphasis added.]
In this case the Massachusetts Supreme Court held that, in these
circumstances, facts “conclusively show that the relationship was one of trust
and confidence” and therefore the broker
could not make a secret profit from the transactions for which the advice was
provided.
In another early (1938) pre-FINRA case the broker’s
customer, “untrained in business – she had been a domestic servant for years –
was susceptible to the defendant's influence, trusted him implicitly ….” The court stated: “We are persuaded from the facts
of the case that a trust relationship existed between the parties … The
[broker] argues that he was not a trustee but a broker only. This argument
finds little to support it in the testimony. He assumed the role of financial guide and the law imposed upon him the
duty to deal fairly with the complainant even to the point of subordinating his
own interest to hers. This he did not do. He risked the money she entrusted
to him in making a market for hazardous securities. He failed to inform her of
material facts affecting her interest regarding the securities purchased. He
consciously violated his agreement to maintain her income, and all the while
profited personally at the complainant's expense. Even as agent he could not
gain advantage for himself to the detriment of his principal.” [Emphasis added.]
Hence,
while under the Securities Exchange Act of 1934 and FINRA rules, broker-dealers
are not subject to an explicit fiduciary standard, in private litigation
between customers and brokers and in some arbitrations fiduciary standards are
applied when a relationship of trust and confidence is found. As noted in a
recent law review article, “Notwithstanding the absence of an explicit
fiduciary standard, broker-dealers are subject to substantially similar
requirements when they act as more than mere order takers for their customers’
transactions.”
This appears in accord with the original intent of Franklin D. Roosevelt and the
United State Congress: “Roosevelt and Congress used the 1934 Exchange Act to
raise the standard of professional conduct in the securities industry from the
standardless principle of caveat emptor to a ‘clearer understanding of the
ancient truth’ that brokers managing ‘other people's money’ should be subject
to professional trustee duties.”
The fact
that broker-dealers may, when providing more than trade execution services to
individual investors, possess broad fiduciary duties was confirmed by the SEC Staff Study on Investment Advisers and
Broker-Dealers (As Required by Section 913 of the Dodd-Frank Wall Street Reform
and Consumer Protection Act) (Jan. 2011), which stated: “Broker-dealers
that do business with the public generally must become members of FINRA. Under
the antifraud provisions of the federal securities laws and SRO rules,
including SRO rules relating to just and equitable principles of trade and high
standards of commercial honor, broker-dealers are required to deal fairly with
their customers. While broker-dealers are generally not subject to a fiduciary
duty under the federal securities laws, courts have found broker-dealers to
have a fiduciary duty under certain circumstances … This duty may arise under
state common law, which varies by state. Generally, broker-dealers that
exercise discretion or control over customer assets, or have a relationship of
trust and confidence with their customers, owe customers a fiduciary duty
similar to that of investment advisers.”
What about
the Investment Advisers Act of 1940 (“Advisers Act”)? At the time of its
enactment it was designed to apply to investment
counsel, a relatively new type of professional whom was paid directly by
the customers for his or her advice. It required investment counsel (i.e.,
investment advisers) to register wFith
the SEC. Moreover, Section 206 of the Advisers Act imposed a fiduciary duty
upon investment advisers. Brokers were exempted from the registration requirements of the Advisers Act, provided that their
investment advice remained “solely incidental” to the brokerage transactions
and they received no “special compensation.” But here’s the key – the Advisers
Act never stated that brokers
providing personalized investment advice (whether “solely incidental” or
otherwise) were not fiduciaries. The law applicable to brokers remained
the same.
The Securities Markets Study (1935)
An influential early study of the securities market was conducted
following the 1929 stock market crash. Written in large part prior to the
adoption of the Securities Exchange Act of 1934, the
entire study was published by Twentieth Century Fund in 1935. Entitled “The
Securities Market,” the study provided a long review of the functions of the
securities markets and the activities of their various actors and participants
(including brokers and “investment counsel”).
The authors of the study described the “brokerage-firm-customer
relationship” as follows:
A brokerage firm
stands in a four-fold relationship toward its customer.
1.
It
acts as his broker in the purchase and sale of securities and in the borrowing
and lending of stocks.
2.
It
acts as a pledgee, in which capacity it either advances its own capital to
finance his margin transactions, or, much more commonly, advances capital
borrowed from banks.
3.
It
is the custodian of his securities and cash.
4. It exercises, to some extent, the function of an investment counsel to
him.
These relationships imply
great responsibilities and obligations on the part of a brokerage firm. Under
these circumstances the customer is entitled to expect the fullest possible
protection … To the greatest extent
possible, a condition should be created where the conflict of interest between
broker and customer is reduced to the minimum.
[Emphasis added.]
The Securities Market study went further in suggesting protections for
conflicts of interest for investment
counsel – those individuals who were paid directly by their clients –
stating:
We believe that anyone
who entrusts his investment problems to an investment counsel is entitled to
protection ... He should be assured that his financial advisor is possessed of
at least certain minimum qualifications and, in addition, that he is free from all entanglements that might
divide his loyalties …
No individual should be
granted, or permitted to retain, a license to practice as investment counsel
for pay who is in the business of underwriting, distributing, buying or selling
securities either as a broker or principal; or who is in the employ of, or is
in any way affiliated with, or is a stockholder or partner in, any
organizations engaged in any manner whatever in such activities … No licensed
investment counsel should be permitted to employ, or to retain in his
employment, any one in any way connected with any activity or implied [in the
foregoing sentence]; or to associate himself as a partner, joint stockholder,
or otherwise with any such disqualified person.
[Emphasis added.]
In essence, the Securities Market study recommended that brokers be held
to the “best interests” fiduciary standard of conduct, with conflicts of
interest minimized. Also, the study recommended the separation of brokers and
dealers (who deal in their own securities, or who sell offerings of securities
firms in initial or subsequent public offerings).
The Securities Market study also, in essence, recommended that investment
counsel be held to the “sole interests” fiduciary standard in which avoidance
of all conflicts of interest was required. Additionally, no “dual registration”
(as exists today) as both a broker (or dealer) and investment adviser
(“investment counsel” in 1935) would be permitted, given the insidious
conflicts of interest under such affiliations.
1938 Maloney Act: A Noble Attempt to
Raise Standards
By the
mid-1930’s broker-dealer firms were subject to registration requirements, but
the attributes of a profession were sorely lacking. Partly to escape from
direct government regulation,
but also as a result of the aspirational desires of the Maloney Act’s primary
author to create a true profession, the Maloney Act of 1938 amended the
Securities Exchange Act of 1934 and created the authority for the recognition
of a self-regulatory organization.
Public
policy makers in 1938 clearly understood that the goal of the Maloney Act was to
create a true profession, bound by fiduciary standards. In 1938, the Assistant
General Counsel of the SEC stated that the “Commission has concluded that the
next stage in the job – the job of
raising the standards of those on the edge to the level of the standards of the
best – can best be handled … by placing the primarily responsibility on the
organized associations of securities dealers throughout the country.”
[Emphasis added.]
The theme
of continually raising the standards of the industry was repeated in a speech
by SEC Commissioner George C. Matthews, shortly after the Maloney Act was
passed in Congress, in which he stated, “Ideally, the industry should
eventually play the predominant role in its own regulation and development ...
It should in the largest possible measure achieve that ideal under democratic
institutions which Josiah Royce described as the forestalling of restraint by
self-restraint … I wish to re-emphasize the evolutionary character of the
program provided for in the [Maloney] Act … it is our hope … that the work of
construction [of regulation] will continue through the years until there shall
finally have been erected a professional edifice commensurate with the
importance of the investment banking and over-the-counter securities businesses
in our national economy.”
Even Senator
Francis Maloney, for whom the Maloney Act of 1938 was named, stated that the Maloney
Act had, as its purpose, “the promotion of truly professional standards of
character and competence.”
FINRA’S Very Early Statements
Confirmed Fiduciary Duties of Brokers
Early
statements by NASD (now FINRA) confirmed the existence of high, fiduciary
standards of conduct for brokers in the very early days of FINRA’s existence. In only the second
newsletter for its members issued by the self-regulatory organization for
broker-dealers, the NASD unequivocally pronounced that brokers were
fiduciaries: “Essentially, a broker or agent is a fiduciary and he thus stands in a position of trust and
confidence with respect to his customer or principal. He must at all times,
therefore, think and act as a fiduciary.
He owest his customer or principal complete obedience, complete loyalty,
and the exercise of his unbiased interest.
The law will not permit a broker or agent to put himself in a position
where he can be influenced by any considerations other than those to the best
interests of his customer or principal … A broker may not in any way, nor in
any amount, make a secret profit … his commission, if any, for services rendered
… under the Rules of the Association must be a fair commission under all the
relevant circumstances.”
A little more than a year later, in discussing the decisions of two
cases, the NASD wrote that it was “worth quoting” statements from the
opinions: “In relation to the question
of the capacity in which a broker-dealer acts, the opinion quotes from the
Restatement of the law of Agency: ‘The understanding that one is to act
primarily for the benefit of another is often the determinative feature in distinguishing
the agency relationship from others. *** The name which the parties give the
relationship is not determinative.’ And again: ‘An agency may, of course, arise
out of correspondence and a course of conduct between the parties, despite a
subsequent allegation that the parties acted as principals.’”
When Chairman Benjamin Howell Griswold, Jr., called to order the first
meeting of the NASD Board of Governors, he described the Association as a
"worthwhile experiment" that would succeed only through "coordinated
effort, careful study, good will, and hard thinking.” “If you do succeed,” he
told the Board, "then both the Securities and Exchange Commission and
yourselves are entitled to the credit for the development of a plan that may
tend more than anything else to restore confidence, remove the legal obstacles
that now alarm you, and re-establish the capital issues market of this
country.”
The Tide Turns in 1942:
FINRA Enacts Low Standards of Conduct
By 1942 the
committee appointed by the NASD (now FINRA) to enact rules of conduct for its
members had finished its work, and NASD’s (now FINRA’s) rules of conduct (via a
“Uniform Practice Code” and “Rules of Fair Practice”)
were adopted. Yet, despite the clear pronouncements by early NASD writers in
FINRA’s 1940 and 1941 newsletters, the aspirations of SEC Commissioners and
Senator Maloney himself for adoption the highest professional standards, and
case law clearly setting forth that a broker was a fiduciary when in a
relationship of trust and confidence with a customer, NASD’s rules of conduct omitted any reference to the fiduciary
duties of brokers when providing personalized investment advice.
Yet, in
1942, and now, there exists little doubt that the relationship between most
clients and their brokers, when personalized investment advice is provided, is
a personal one.
Indeed, as recognized by the SEC Staff as recently as 2005, “[f]ull-service
broker-dealers have always sought to develop long-term relationships with their
customers who often come to rely on them for expert investment advice.”
In such relationships a broker “does not simply execute orders at a client's
command, but rather renders investment advice to the client ….”
Such brokers are not simply functionaries, but rather "are clearly
fiduciaries in the broadest sense."
Yet FINRA’s
omission of any mention of fiduciary standards in its rules for its brokerage
firms and their registered representatives continues to this day. By, in
effect, ignoring the law and the statements of the Maloney Act’s principal
author, FINRA continues to keep the standards for brokers at the very low level
of suitability.
In fact,
the true purpose of FINRA was revealed early on. “In October, 1943, the NASD
Board adopted a policy that set general guidelines for markups in customer
transactions. Members' reactions to it ranged from endorsement to opposition,
leading Executive Director Fulton to further explain the policy: ‘The NASD did
not and does not seek to regulate, let alone curtail, profits of its members. [The NASD, now FINRA] is devoted to the
principle that its members are in business to make money.’”
[Emphasis added.]
This
devotion by NASD and its firms to protection of their profits was strongly felt
in 1943, when the SEC sought to impose a rule requiring disclosure by dealers
of all of their profits from any transaction. The securities industry reacted most
sharply, and by 1947 the SEC’s proposal was abandoned.
As will be
seen, FINRA and its member firms have continued their fight, for more than
seven decades, against heightened standards of conduct or other restrictions
which might impede their outsized profits.
The Disastrous Suitability Standard
There exist
a broad range of consumer protections available to regulate the sale of
securities and/or the delivery of investment advice, ranging from the
arms-length standard generally applicable to contracts between parties with
relatively equal knowledge and bargaining power, to the strict “sole interests”
fiduciary standard of conduct.
The Arms-Length Standard. In most
commercial transactions, the consumer and the merchant of securities operate at
arms-length. In these arms-length relationships of parties, such as exists for
most sales and purchases of everyday products, the relationship can be
characterized as follows:
PRODUCT
MANUFACTURERS ⇒
MANUFACTURERS’
(SALES) REPRESENTATIVES ⇒
CUSTOMER
Suitability. Sometimes the consumer is
aided (or denied protections) by specific laws which impose some additional
duties on one party, other than just by those duties which the general common
law might provide. For example, upon broker-dealers there is imposed the
requirement that investment products sold to an investor be “suitable,”
at least as to the risks associated with that investment. In essence,
suitability requires an effort on the part of the broker to “match” customers
to particular products, by matching products to objectives.
The duties relate mainly to the risk assumed by the customer; the broker must
ascertain the risk-return characteristics of the security against the
particular characteristics and objectives of the customer.
The
“suitability doctrine,” explicitly set forth as a rule by FINRA, and recognized
by the SEC as a "fundamental duty of brokers" enforceable by FINRA
under the securities laws' general antifraud rule (Rule 10b- 5). However, the suitability doctrine demands
only that a broker/brokerage firm “will make specific recommendations of
securities only if it has a reasonable basis for believing that they are
suitable for the customer.”
Yet
suitability, while imposing upon brokers the responsibility to not permit investors
to “self-destruct,” confines the duties of brokers to their customers, with
respect to the broad common law duty of due care. With the rise of the concept
of the due care and actions for breach of one’s duty of due care (via the
negligence doctrine that saw accelerated development in the early 20th
Century), brokers sought a way to ensure they would not be held liable under
the standard of negligence. After all, “[t]o the extent that investment
transactions are about shifting risk to the investor, whether from the
intermediary, an issuer, or a third party, the mere risk that a customer may
lose all or part of its investment cannot, in and of itself, be sufficient
justification for imposing liability on a financial intermediary.” This appears to be a valid view as to the
duty which should be imposed upon brokers; provided,
however, that the broker is only providing execution services to the
customer.
Yet the
sales of mutual funds and other pooled investment vehicles exploded
following the SEC’s abolition of all fixed commission rates, which was
effective on May 1, 1975. In effect, no longer were brokers performing
execution services, but they were, in fact, recommending investment managers.
Yet, FINRA permitted the suitability doctrine to be extended, over the decades,
to incorporate recommendations of investment managers. In essence, brokers
continue to operate with a free hand today – unburdened by the duty of nearly
every other person in the United States with respect to their activities – which,
at a minimum, require adherence to the duty of due care of a reasonable person.
The Limited Disclosure Obligations of Brokers
and their Registered Representatives. Federal and state securities laws
also impose, at times, various disclosure obligations upon broker-dealers
beyond the “no-lying baseline” which exists in arms-length transactions. Yet,
there is no obligation of a broker, generally, to disclose to customers all of
the compensation that it, or its registered representatives, receives.
“Neither the SEC nor [FINRA] have required registered representatives of
broker/dealers to disclose their own compensation in a securities transaction,
although both have been fully aware that registered representatives often
received special incentives beyond the normal compensation to sell a particular
product – such as differential compensation resulting from soft dollar payments
and payment for shelf space, management bonuses, and sales contests.
Moreover, brokers and their registered representatives don’t even possess a
duty to disclose the receipt of additional compensation for selling proprietary
mutual funds than other funds.
Briefly Contrasting the Fiduciary Relationship.
The fiduciary relationship arises in situations where the law has clearly
recognized that fiduciary duties attach, such as principal and agent
relationships, or where there exists the actual placing of trust and confidence
by one party in another and a great disparity of position and influence between
the parties. Under the fiduciary standard of conduct the financial advisor
possesses both a duty of due care (judged by comparison of the financial
advisor’s acts to other professionals, not consumers), as well as a fiduciary
duty of loyalty. Under the fiduciary duty of loyalty there arises a duty to
disclose all material facts.
Yet even
then the fiduciary standard requires more, as mere disclosure of material facts
is thought to be inadequate as a means of consumer protection for clients in a
relationship of trust and confidence with their advisor.
Stated differently, even with full disclosure of conflicts of interest and specific
compensation amounts, disclosure does not come close to being a substitute for
the protections offered by a bona fide
fiduciary standard of conduct.
The
relationship of the parties in a fiduciary relationship is reversed from that
of an arms-length relationship. The fiduciary relationship can be illustrated as
follows:
CLIENT
⇒
FIDUCIARY
ADVISOR (CLIENT’S REPRESENTATIVE) ⇒
INVESTMENT
PRODUCT PROVIDERS
In summary,
the low standard of conduct possessed by brokers under the suitability standard
continues despite the fact that the negligence standard today applies to govern
the duties of care owed by most of us in our society. In contrast, the
fiduciary standard for professional advisors requires adherence to a
professional duty of care, as well as mandatory disclosure of all material
facts (including compensation). Even then, the fiduciary standard requires much
more of the advisor providing personalized investment advice.
The Maloney Act Failure
Why has FINRA had so many documented
failures? Because — at its core — FINRA acts as the protector of its member
firms, rather than protecting the public interest. As Tamar Frankel, America’s
leading scholar on fiduciary law as applied to the securities industry, wrote
in 1965:
NASD … [does] not, as do
the professions, consider the public interest as one of [its] goals … Let us
consider the attitude of the professions toward the public interest. The goal
of public service is embedded in the definition of a profession. (Pound, The
Lawyer from antiquity to modern times 5 1963). A profession performs a unique
service; it requires a long period of academic training. Service to the
community rather than economic gain is the dominant motive. We may measure the
broker-dealer’s activities against these criteria … Although at least part of
his trade is to give service, profit is his goal. The public interest is stated
in negative terms: he should refrain from wrongdoing because it does not pay.
This attitude is the crux of the matter, the heart of the difference between a
profession and the broker-dealer’s activity … The industry emphasizes its merchandising aspect, and argues that the
broker-dealer is subject to the duties of a merchandiser even when he is also
acting is his advisory capacity … the NASD [has] proved incapable of
establishing accepted standards of behavior for the activities of the trade …
Past experience has proved that it is unrealistic to expect the NASD to
regulate in the public interest ….
[Emphasis added.]
Sadly, Professor Frankel’s
observations from nearly five decades ago continue to ring true.
FINRA: A Sad Excuse for a Regulator
FINRA possesses an inherent conflict
of interest because, at its core, FINRA remains under the control of its large Wall
Street broker-dealer firms, while also regulating those same broker-dealers.
This means that FINRA will always be an ineffective protector of consumers, and
that its rules and regulations will instead foster the excessive profits of its
members.
The adoption of the failed
suitability standard, and its extension to broker-dealer’s advisory activities,
rather than an appropriate professional standard of due care, insulates FINRA’s
broker-dealer firm members from much of the liability which might otherwise
attach to their recommendations. FINRA’s failure to recognize, or enforce, the
fiduciary duties of brokers when providing personalized investment advice
(rather than trade execution services) remains a dismal omission from the rules
of conduct which govern its members. Even the failure to simply mandate
specific disclosures of compensation by broker-dealers, in all circumstances,
is another black eye on FINRA’s over seven decades of oversight of its member
firms.
While FINRA prides itself on the
robustness of its broker-dealer examination program, including the frequency of
examinations, no amount of examinations will serve to protect the public
interest adequately if the standards to which brokers are held remain
inherently weak and flawed.
As FINRA itself has noted, it exists
to preserve the profits of its members. Sadly, FINRA’s continued existence, and
the weak conduct requirements it imposes upon its members, do not serve the
public interest.
____________________________________________________
Disband FINRA - PART THREE. FINRA’S LITANY OF FAILURES
“Americans
are angry at Wall Street, and rightly so. First the financial industry plunged
us into economic crisis, then it was bailed out at taxpayer expense. And now,
with the economy still deeply depressed, the industry is paying itself gigantic
bonuses. If you aren’t outraged, you haven’t been paying attention.” - Paul
Krugman
Here we stand, more than seven
decades after FINRA’s creation, and we see that FINRA has resisted nearly every
attempt to raise the standards of conduct for its members above the low
standard of suitability. The organization has completely neglected its mission
to protect consumers, and instead has fostered conflict-ridden business
practices and the lax regulation of its members. To observe these failures one need
only view this litany of failures by FINRA.
FINRA’s Opposition to Broker vs. Dealer Segregation
The 1936 Securities Market study recommended a complete separation of the
functions of broker and dealer. A
later study by the SEC also recommended further study of the possibility of
separation of broker and dealer functions,
with the SEC conceding “that some of the abuses in the securities industry are
the direct result of the combination of broker and dealer functions: namely,
the inducement of brokerage customers to buy the securities which the broker
dealer had underwritten or in which he has a trading position; the persuasion
of a customer to sell good securities in order to buy securities in which the dealer
has an interest and the difficulty for the unsophisticated customer in
distinguishing between the two functions and their implications.”
However, under intense pressure from FINRA and its member firms this separation
of function was never achieved.
Troubles continue today for even
sophisticated investors in protecting themselves when dealing with brokers who
also act as dealers. There is an inherent conflict of interest in functioning
as both a dealer (and trading for its own account, as well) and as a broker;
one need only recall the recent sale by Goldman Sachs to its customers of
mortgage-backed securities it manufactured, while simultaneously making bets
that these securities would fail. Goldman Sachs executives’ recent testimony to
Congress revealed the confusion customers of the firm faced, as these
executives professed that the firm acted in the “best interests” of their
customers as a broker, yet also defended their ability to manufacture and sell
“sh***ty products.”
Early in the 1940s, shortly after its
formation, FINRA (then the NASD) hailed its achievement in preventing the
possible mandated split of “dealer” (including investment underwriting)
functions from the functions of a broker (i.e., undertaking trades as an
agent). “Mr. Wallace H. Fulton, in his address on the twentieth anniversary of
the NASD, considered the successful combatting of the segregation proposals as
one of the chief achievements of the NASD.”
This author believes FINRA’s actions to preserve the existence of brokerage and
dealer functions within the same firm is not an achievement, but one of FINRA’s
colossal failures and a cause for many of the ills which pervade U.S. financial
services today.
FINRA Defended Price-Fixing by Its
Member Firms
NASD/FINRA failed to prevent — and
even defended — the price-fixing activities of its market-making member firms
in the mid-1990’s. Former SEC Chairman Arthur Levitt stated that the evidence
showed FINRA “did not fulfill its most basic responsibilities” and concluded
that by FINRA’s failure “American investors — large and small, sophisticated
and inexperienced, institutional and individual — all were hurt by these
practices.” Levitt further stated that FINRA was “the cop on the beat” that
“simply looked the other way.”
FINRA Abets Fraudulent Use of Titles
and Descriptors
FINRA continues to permit its members
and their registered representatives to use the titles “financial consultant,”
“financial advisor,” and “wealth manager.” Yet, these terms infer a
relationship based upon trust and confidence, when such relationship of trust
and confidence is later denied by the broker and its registered representative.
FINRA has the ability to combat fraud
by its member broker-dealer firms and their registered representatives.
Exchange Act Section 15A(b)(6) requires the rules of an association be designed
to promote just and equitable principles of trade. FINRA satisfies this
statutory requirement in part through FINRA Rule 2010, which reads: “A member,
in the conduct of its business, shall observe high standards of commercial
honor and just and equitable principles of trade.” The SEC has held that
FINRA’s authority under Rule 2010 relating to “just and equitable principles of
trade” permits FINRA to sanction member firms and associated persons for a
variety of unlawful or unethical activities, including those that do not
implicate “securities.”
Additionally, Exchange Act Section
15(c) prohibits any broker-dealer firm from effecting any transaction in or
inducing or attempting to induce the purchase or sale of any security by means
of any manipulative, deceptive, or other fraudulent device or contrivance.
Under this prohibition, broker-dealers are precluded from making material omissions or misrepresentations
and from any act, practice, or course of business that constitutes a
manipulative, deceptive, or other
fraudulent device or contrivance.
Earlier this year Gil Weinrich quoted
Dalbar’s CEO Lou Harvey as stating: “Imagine, for example, if anyone could
describe themselves as ‘doctor’ or ‘attorney’ but the real ones were ‘fiduciary
doctor’ and ‘fiduciary attorney’ ….”
The article goes on to state: “The heart of Harvey’s proposal is to restrict
the use of the word ‘advisor’ (or ‘adviser’) to fiduciaries alone, leading to
prosecution for non-fiduciaries using that label.” At the fi360 Annual
Conference in April 2013, Skip Schweiss, President of TD Ameritrade Trust
Company, pointed out Lou Harvey’s suggestion during a panel discussion in which
this author participated. Skip Schweiss also suggested that anyone calling
himself or herself a “financial advisor” or “financial consultant” be held to
the fiduciary standard of conduct.
The view that one holding out as an
advisor should be governed by the fiduciary standard of conduct finds recent
support in academic literature: “The relationship between a customer and the
financial practitioner should govern the nature of their mutual ethical
obligations. Where the fundamental nature of the relationship is one in which
customer depends on the practitioner to craft solutions for the customer’s
financial problems, the ethical standard should be a fiduciary one that the
advice is in the best interest of the customer. To do otherwise – to give biased advice with the aura of advice in the
customer’s best interest – is fraud. This standard should apply regardless of
whether the advice givers call themselves advisors, advisers, brokers,
consultants, managers or planners.” [Emphasis added.]
There exists authority, as well, on
the inappropriate use of titles, from the SEC itself. Very early on the SEC
took a hard line on representations made by brokers. In its 1940 Annual Report,
the U.S. Securities and Exchange Commission noted: “If the transaction is in
reality an arm's-length transaction between the securities house and its
customer, then the securities house is not subject to a fiduciary duty.
However, the necessity for a transaction to be really at arm’s-length in order
to escape fiduciary obligations has been well stated by the United States Court
of Appeals for the District of Columbia in a recently decided case: ‘[T]he old
line should be held fast which marks off the obligation of confidence and
conscience from the temptation induced by self-interest. He who
would deal at arm's length must stand at arm's length. And he must do so openly as an adversary, not
disguised as confidant and protector.
He cannot commingle his trusteeship with merchandizing on his own
account…’” [Emphasis added.]
Additionally, in its 1963
comprehensive report on the securities industry, the SEC stated that it had
“held that where a relationship of trust and confidence has been developed
between a broker-dealer and his customer so that the customer relies on his
advice, a fiduciary relationship exists, imposing a particular duty to act in
the customer’s best interests and to disclose any interest the broker-dealer
may have in transactions he effects for his customer … [BD advertising] may create an atmosphere of trust and confidence,
encouraging full reliance on broker-dealers and their registered
representatives as professional advisers in situations where such reliance is
not merited, and obscuring the merchandising aspects of the retail securities
business … Where the relationship between the customer and broker is such
that the former relies in whole or in part on the advice and recommendations of
the latter, the salesman is, in effect, an investment adviser, and some of the
aspects of a fiduciary relationship arise between the parties.”. [Emphasis added.]
The fact that misrepresentations of
one’s status amounts to fraud is reflected in a recent regulatory action filed
by the State of Illinois Attorney General, who sought civil penalties against
Mr. Richard Lee Van Dyke, Jr. (a.k.a. "Dick Van Dyke"), a seller of
fixed indexed annuities. Mr. Van Dyke is alledged to have stated in
advertising: “If you want a successful financial plan, you need a financial
advisor you can really trust … He believes in principles like full disclosure and
transparency and he doesn’t sell investments on commission which means he’s on
your side so you get to reach your goals first before he does. When’s the last
time an investment advisor put you first?” The basis of the complaint is a
violation of Illinois’ Consumer Fraud and Deceptive Business Practices Act. The
Attorney General’s complaint notes: “The representations cited above, on which
Defendants intended consumers will rely, as well as others on Defendants’
website, lead consumers to believe Defendant Dick Van Dyke is an objective,
knowledgeable and unbiased financial services expert for consumers facing
retirement, when in fact he is an insurance salesman.”
As a result of regulatory missteps by
FINRA over many decades, substantial consumer confusion now abounds as to the
standard of conduct consumers can expect from their providers of investment
advice. In large part this is due to the improper use of titles by registered
representatives, which, as discussed above, rises in the view of many to the level
of intentional misrepresentation (i.e., fraud). Yet FINRA does nothing to
prevent this ongoing fraud from occurring.
FINRA Permits the Use of the Fraudulent Term “Fee-Based”
As knowledgeable consumers became
more aware that true fiduciary advisors, with few conflicts of interest, were
available, Wall Street re-doubled its efforts to obfuscate and confuse
consumers, in a valiant but ill-advised attempt to preserve its archaic
business model.
The past few decades have seen a
small but now significant rise in the number of fee-only financial advisors,
such as those who are members of the National Association of Personal Financial
Advisors, www.napfa.org and/or those advisors who are members of the Garrett
Planning Network, www.garrettplanningnetwork.com). These personal financial advisors
eschew all commissions and material third-party compensation paid by product
manufacturers (including 12b-1 fees). Instead, they choose to accept reasonable
fees paid directly by the clients. In this manner, they avoid many of the
conflicts of interest found in Wall Street's large broker-dealer firms. These
independent, fee-only and fiduciary financial advisors act solely as the “client’s
representative,” researching and then choosing far-lower-cost investments and
investment products (and insurance products) for their clients.
Fee-only advisers continue to thrive
within their own small universe of clients.
Yet attracting tens of thousands more advisors to the “fee-only” trusted
advisor space has been difficult. Why? The reasonable compensation these
fee-only advisers receive is insufficient to fund promotional efforts
sufficient in quantity to counter the huge marketing budgets of the
broker-dealer firms. Wall Street’s marketing machine, fueled by the high
diversion of returns from individual investors, is extremely powerful.
For example, in recent years Wall
Street’s promotional machine has further confused consumers (and even advisors)
by adopting the term “fee-based” to refer to advisors who receive both fees
(paid by clients) and commissions (through product sales). Originally the term “fee-based” referred to
fee-based brokerage accounts, which by virtue of a 2007 U.S. Court of Appeals
decision were shut down.
Following that decision, Wall Street firms embraced using the term
"fee-based" to refer not to a type of account, but rather to many (if
not most) of its dual registrants.
FINRA failed to step in to warn that
the use of “fee-based” to describe an advisor (as opposed to an account), where
the advisor was also receiving commission-based compensation, is inherently
misleading. While a dual registrant might accurately portray herself or himself
as “commission-and-fee-based” or “fee-and-commission-based” (depending upon
which form of compensation received was predominant), the exclusion of the word
“commission” from the term “fee-based” is nothing more than an omission
designed to mislead individual investors. Since the term “fee-based advisor” is
intended to obfuscate, confuse, and lead to greater business, the necessary
intent requisite for actual fraud likely exists through the use of the term, at
least in most instances.
In essence, the use of common or
similar titles, and the high fees received by those operating under a
conflict-ridden standard of conduct (which in turn funds Wall Street's
marketing efforts) results in the inability by consumers to distinguish
higher-quality advisors from lower-quality advisors, leading to pernicious
effects upon both consumers and true professionals
alike. Of course, such insidious results are adored by Wall Street, as its
preserves the archaic, conflict-ridden, business model which extracts high
levels of rent from individual investors and, indeed, from our economy.
Still today, FINRA, the regulator of
its broker-dealer firm members, does nothing to stop this continued obfuscation
– and by all accounts intentional fraud – by its member firms.
FINRA Fails to Oversee Derivatives
FINRA failed to seek appropriate
supervision of derivatives created and sold by its members, a regulatory
oversight which was a substantial cause of the 2008-09 Great Recession from
which America still suffers today. FINRA has failed to be held accountable for
these many failures to protect the public interest and the financial crisis
caused by its failure to regulate its member firms.
An Alliance for Economic Stability
report,regarding NASD/FINRA’s failure
to assure proper supervision of the OTC derivatives market and other failures
(hereafter “AES Report”), detailed two other specific major failures by the
SRO:
First, FINRA had the most expansive
jurisdiction of any regulator. It can request whatever information it sees fit
about its members’ business affairs or even personal affairs, without the same
constraints of due process imposed upon government agencies. As such, it could
have initiated investigations into the activities surrounding mortgage-backed
securities. It failed to do so.
Second, FINRA failed to take any
disciplinary action against Joseph Cassano from American International Group
Inc.'s financial products division. Even if Cassano did not willfully intend to
act as recklessly as he did, his behavior nonetheless shows a gross negligence
which has had an impact upon the world financial system whose cost is beyond
estimation.
According to AES’ report, “The reason
for FINRA not taking steps to address its apparent deficiencies is that FINRA
serves to benefit the interests of its members. FINRA worked for the interests
of its members to the detriment of the public in the price-fixing in the OTC
stock market; it did the same in the OTC derivatives market; FINRA continues to
do so now by not addressing its mistakes and toughening its rules.”
The Alliance for Economic Security
concluded, in a Jan. 4, 2010 proposal for new FINRA rules, that “FINRA is not a
reliable regulatory authority.”
The Stock Analyst Conflict of Interest Scandals
FINRA failed to prohibit the
promulgation of stock analyst conflicts of interests, leading to the many
scandals of nearly a decade ago. Only actions by state securities regulators
(finally joined by the SEC), resulting in a 2003 landmark settlement with ten
of the nation’s top broker-dealers, forcing these Wall Street firms to address
conflicts of interest between their equity research analysts and investment
bankers.
However, FINRA’s rule-making in this
area continued to stall. A 2012 GAO Report found that “FINRA has not yet
finalized its 2008 proposal designed to consolidate the SRO research analyst
rules and implement recommendations made by NASD and NYSE staff in 2005 … FINRA
staff, as well as most market participants and observers we interviewed,
acknowledged that additional rule making is needed to protect investors,
particularly retail investors. In that regard, until FINRA adopts a
fixed-income research rule, investors continue to face a potential risk.”
FINRA’s Opposition to a True
Fiduciary Standard
Unlike the aloofness expected of a
regulatory organization, NASD/FINRA engaged in a decade-long advocacy promoting
fee-based brokerage accounts without subjecting its members to the fiduciary
standard of conduct required under the Advisers Act.
Indeed, at one time FINRA even argued
that its conduct rules were superior to broad fiduciary duties, stating: “[T]he
contours of an adviser’s ‘fiduciary duty’ are imprecise and indeterminate.
Indeed, these contours have been developed unevenly over time, and much of what
the FPA describes as an adviser’s fiduciary duty is more implied than
expressed. This general, implied duty simply cannot afford retail investors
with the same level of protection as the explicit regulatory standards
governing the conduct of business as a broker-dealer, which are developed after
extensive public comment and Commission approval. In clearly articulating the
obligations of a broker-dealer, SEC and NASD rules provide much better
assurance that brokerage customers will be protected.” [Please …!]
FINRA’s Leading Role in the Financial
Crisis of 2008-'09
In 2008-09, a massive financial
crisis shook the United States and the world. Mortgage-backed securities
created from toxic mortgages — the “sh***y products,” as Sen. Carl Levin
(D-Mich.) famously demeaned them in the Goldman Sachs hearings in April 2010 —
became increasingly devalued. Wall Street’s investment banks made billions
packaging toxic mortgages into pooled MBS investment vehicles, then selling
them to unsuspecting investors — both institutional investors and individual
consumers.
It is well-documented that the
largest and most powerful FINRA members worked in the late 1990’s to ensure
that the over-the-counter derivatives market would be kept out of the purview
of government agencies. Counter-party risk rose even further due to the prevalence
of credit default swaps, the holdings of trillions of dollars of which made
capital in the investment banks impossible to accurately judge, and credit
markets froze.
As the financial crisis and its
resulting Great Recession continued, hundreds of largely innocent community
banks were seized. The larger investment banks, most with large broker-dealer organizations,
were bailed out by Congress — and subsequently thrived and further expanded
their already huge market share of the banking sector of the economy.
The cause of the financial crisis lay
squarely in the hands of one regulator — the Financial Industry Regulatory
Authority Inc., formed in 2007 by the merger of NASD and the enforcement arm of
the New York Stock Exchange.
At its core, FINRA was charged with
the regulation of brokers and dealers and their related business activities.
Yet FINRA, being a membership organization heavily influenced by the same large
Wall Street firms which it also regulated, largely ignored the mounting risks
to America’s economic vitality and failed to regulate the market-making
activities of its member broker-dealer firms. FINRA’s failure to perform its
direct oversight duty led to the spectacular and costly collapse of two of its
larger members, including the largest bankruptcy in U.S. history.
As the Alliance for Economic
Stability, a nonpartisan economic policy organization dedicated to promoting a
fair financial marketplace, subsequently observed: “FINRA, as an SRO, has the
closest relationship with and most direct scrutiny of Wall Street investment
banks. When these investment banks initiated discussions on policy regarding
OTC derivatives in 1994, FINRA [then NASD] was in the best position among
regulators to intercede and assure appropriate supervision. FINRA failed to do
this, even after recommendations for oversight from the GAO.”
AES also noted that despite its
expansive powers over broker-dealers, “FINRA failed to oversee the risks posed
by OTC derivatives, though all transactions were carried out through FINRA member
broker-dealers or their affiliates.”
Finally, AES observed: “FINRA has
shown itself to be inept at properly addressing gross negligence done by its
members, even when that negligence impacts the entire world economy.”
FINRA’s Role in the Bernie Madoff Scandal
An internal report found that FINRA
didn’t fully probe Bernard Madoff’s firm (despite inspecting it annually). When
FINRA officials initially denied any wrongdoing in the failure to detect
Madoff’s Ponzi scheme, Coffee, a securities law scholar, said in his testimony
before the Senate Banking Committee that “Madoff’s brokerage business was by
definition within … FINRA’s jurisdiction.”
FINRA Blew It (Big) Again: Stanford
Additionally, in an internal report
FINRA admitted that it repeatedly failed to investigate tips about R. Allen
Stanford’s alleged $7 billion fraud.
FINRA Misleads Congress
FINRA lay largely silent in the two
years following the financial crisis, and by means of its silence largely
escaped congressional scrutiny for its key role in effecting the financial
crisis. But then, in 2011 and 2012, FINRA began to lobby Congress extensively
for an expansion of FINRA’s powers, under the pretense that such an expansion
would have prevented Bernie Madoff’s massive Ponzi scheme. Yet many industry
observers noted that it was FINRA’s own failures as a regulator which enabled
Madoff’s Ponzi scheme to grow to such massive proportions.
FINRA acknowledged that “Mr. Madoff
engaged in deceptive and manipulative conduct for an extended period of time….” FINRA
even acknowledged that during the 20 years before the Madoff scheme was
revealed, “FINRA (or its predecessor, NASD) conducted regular exams of Madoff’s
broker-dealer operations at least every other year.”
Yet, instead of acknowledging its key failures, FINRA instead asserted that it
“regulates broker-dealers, but not investment advisers,” and complained that it
could not have detected Madoff’s massive fraud.
But many industry observers note that
FINRA’s own failures were largely responsible for enabling Bernie Madoff to
perpetuate its fraud. As Professor John C. Coffee Jr. testified before
Congress: “Prior to 2006, Madoff Securities was only a broker-dealer and not a
registered investment adviser. Thus, during this period, I see no reason that
FINRA (or at that time NASD) should have abstained from examining and
monitoring the advisory side of Madoff Securities. This side was never formally
separated in a different subsidiary; nor was it even geographically remote.”
Professor Coffee continued: “Madoff
Securities had no right or privilege to resist any inspection by NASD (or later
FINRA) or to fail to provide information on the ground that its investment
advisory business was exempt from NASD oversight. If it resisted on this
ground, the NASD and FINRA had full power to discipline it severely. NASD Rule
8210 makes it clear beyond argument that NASD can require a member firm to
permit NASD to inspect its books, records and accounts, and to provide other
information. As NASD further advised its members in its Notice to Members 00-18
(March 2000): 'Implicit in Rule 8210 is the idea that the NASD establishes and
controls the conditions under which the information is provided and the
examinations are conducted.’”
Furthermore, as noted in the AES
Report: “In addition to Coffee’s testimony, Peter J. Chepucavage, general
counsel at Plexus Consulting Group LLC; Pete Michaels, partner at Michaels Ward
& Rabinovitz LLP; and Samuel Y. Edgerton, partner at Edgerton and Weaver
LLP; all of whom are competent to opine on FINRA’s jurisdiction, have made
statements concluding that FINRA had jurisdiction over Madoff.”
Over the 20-year span of its multiple
examinations, all NASD/FINRA had to do was to ask Bernie Madoff one or two
simple questions, which should have been discerned from even a cursory review
of the Madoff Securities’ firm’s operations: “Why is Madoff Securities not also
registered as an investment adviser?” and “Where are all of the trades you
state you make as an investment adviser?” (These trades didn’t show up in the
records of Madoff Securities’ clearing arm, as would be expected.)
Even though Bernie Madoff’s
investment scheme was uncovered in the year after Madoff Securities finally
registered with the SEC as an investment adviser, Rep. Spencer Bachus bemoaned
the “lack of oversight [of investment advisers] particularly in the aftermath
of the Madoff scandal” in proposing a bill to effect FINRA’s power grab over
investment advisers. In so doing, Rep. Bachus perpetuated FINRA’s inappropriate
characterization of the Bernie Madoff scandal as a “regulatory gap” — rather
than, as so many experts have in essence opined, a colossal failure by FINRA
itself.
Many More Scandals at FINRA’s
Doorstep
Through its lax regulatory practices
and oversight, NASD/FINRA failed to prevent a number of other often-repeated
industry-wide scandals that have plagued the broker-dealer industry over the
last decade — from the insider trading scandals to penny stocks, limited
partnerships, sales of unsuitable mutual fund share classes,
and inappropriate sales of auction-rate securities.
FINRA’s Fines Support Its Members!
When FINRA does act against its
member firms, the fines it imposed on its member broker-dealer firms are paid
to FINRA — to fund FINRA’s activities itself. In essence, its member firms
indirectly benefit from their own fines, which serve to lower the annual fees
the firms pay for their “self-regulation.”
FINRA Lied to the SEC
In 2011 the SEC stated that FINRA
provided “altered documents” during SEC inspections. According to the SEC’s
order, the production of the altered documents by FINRA’s Kansas City district
office was the third instance during an eight-year period in which an employee
of FINRA or its predecessor, NASD, provided altered or misleading documents to
the SEC. The SEC ordered FINRA to hire an independent consultant and “undertake
other remedial measures to improve its policies, procedures and training for
producing documents during SEC inspections.”
FINRA Refuses to Share With State Regulators
FINRA’s continues to largely refuse
to share information with state securities regulators, important government
authorities in protecting consumer interests and the successful identification
and prevention of fraud.
FINRA Wants BDs to Regulate Their
Competition
FINRA, a “self-regulatory
organization” for broker-dealer firms, essentially proposes that broker-dealer
firms would regulate their competition — independent registered investment
advisory firms. It’s like drug companies being given control over the
regulation of physicians. Only here, investment product manufacturers and their
distributors would take over the regulation of fee-only independent financial
advisors. It does not take a rocket scientist to realize that the role of the
independent financial advisor would be diminished, through regulation, in favor
of the product-sales-driven broker-dealer firms.
FINRA’s proposal does not expand, but
rather destroys, the concept of “self-regulation.” In this instance,
independent small financial advisors would be regulated not by their own
professional leaders, but rather by the conflict-ridden large Wall Street
broker-dealer firms with which they compete. And since these large
broker-dealers and their regulator, FINRA, would love to stem the flow of their
customers and their employees from expensive product-sales-oriented
broker-dealers to lower-total-fee-and-cost fiduciary fee-only registered
investment advisers, there is no doubt that regulation after regulation would
be adopted to make it onerous for investment advisers to survive, much less
thrive. Consumers would be forced back into the hands of profit-driven,
conflict-ridden Wall Street firms.
FINRA seeks to impose an additional
layer of costs and bureaucracy on registered investment advisers, who have been
directly overseen by the SEC for more than seven decades. Even if FINRA’s own
estimates of the additional costs of its regulation were believable, the small
businesses which make up the core of the registered investment advisory
community would pay thousands and thousands of dollars a year in additional
fees. These fees would be the death knell for many of the small, professional
firms that seek to provide low-cost investment and financial advice to their
clients. The remaining firms would have to raise their fees to their clients
substantially to pay the increased registration fees and the attendant
compliance costs. Consumers of modest means, such as the young couple starting
a family, or the single mother struggling to save and invest for her future
retirement needs and the educational futures of her children, would be unable
to afford to pay these resulting higher costs.
FINRA, Long Opposed to the
Application of a True Fiduciary Standard, Seeks to Redefine the True Fiduciary
Standard Out of Existence
FINRA and its members seek to
redefine the highest standard of conduct under the law — the fiduciary standard
— as a much lower “new federal fiduciary standard.” In essence, they want the
low standard of conduct for their members to be one in which conflicts of
interest are not avoided — or even brought out into the open.
All Wall Street desires to occur, in
connection with the SEC’s current Dodd-Frank Act Section 913 rule-making
efforts, is the imposition of “casual disclosures” such as: “The interests of
my firm may not be the same as yours.” Of course, such disclosures don’t
adequately inform the consumer. Nor are casual disclosures even remotely close
to a true fiduciary standard.
Moreover, Wall Street firms are
keenly aware of the large body of academic research which reveals that even
robust disclosures are ineffective to protect the interests of individual
investors in today’s highly complex modern financial world. That’s why a true
fiduciary standard which requires keeping the best interests of the client
paramount even after disclosures are undertaken — long opposed by FINRA — is so
important to consumers.
The Failed “Suitability Doctrine” Continues
to Permit “S***y” Products to be Sold to
Individual Consumers
The failed doctrine called
“suitability” would continue to permit broker-dealer firms to manufacture and
sell to their customers “sh***y products” (as Sen. Carl Levin called them),
such as securities stuffed with junk mortgages.
Broker-dealer firms desire to escape
these higher standards by controlling FINRA and
the continued development of standards — not only for themselves, but also for
the trusted investment advisory profession which is their competition. For more
than seven decades FINRA and its predecessor, NASD, have resisted efforts to
raise the standard of conduct of its broker-dealer members above the failed,
horrendously low standard of “suitability.” FINRA desires to preserve this
failed standard, which offers little protection for the customers of
broker-dealers and instead preserves the high profits of broker-dealer firms.
FINRA Attempts to Redefine “Best Interests”
FINRA recently appeared to embrace
the duty of a broker to act in the “best interests” of its customers,
similar to the language contained in Section 913 of the Dodd Frank Act.
Does this recent pronouncement by FINRA herald a fiduciary duty, imposed by
FINRA, upon brokers?
After all, it has been stated that, “The centerpiece of the fiduciary duty is
the requirement that investment advisers act in the best interest of their
clients.”
FINRA’s member firms fear that the
phrase “best interests” may not be in accord with current broker-dealer business
practices,
although FINRA has stated that its member’s business practices are still
permitted. In
essence, FINRA touts that its members are required to act in the “best
interests” of their customers, yet does little to give true meaning to, or enforce,
that standard. In fact, FINRA’s understanding of
its own “best interests” standard – based upon mere disclosure of conflicts of
interest and not requiring full disclosure of compensation received by the
broker-dealer and/or its registered representative (certainly a material fact
which should be disclosed) – is not in accord with consumer or advisor
understanding of the fiduciary standard of conduct, nor in accord with recent
judicial pronouncements, not only under the Advisers Act
but also in other contexts applying the “best interests” standard in fiduciary
law.
In fact, FINRA recently stated in a
letter to the SEC that it believed “it would be a mistake to … impose the
investment adviser standard of care and other requirements of the Advisers Act
to broker-dealers,”
seemingly setting the stage for defining a “fiduciary standard” which is
anything but the real thing.
This all begs the question. Shouldn’t the phrase: “Member, FINRA”, be
viewed like the warnings on cigarette packages – i.e., as a consumer warning
sign?
Consolidating power in FINRA over all
investment business would give Wall Street increased control over America’s
economy
FINRA would continue as the most
powerful organization affecting nearly all aspects of the securities industry.
Yet it is an organization whose failure to achieve the purposes for which it
was created makes it highly questionable whether it should even continue.
Individual Americans denied
affordable, trusted advice
Individual Americans — all of whom deserve
trusted, independent advice — would be denied the protections of the true
fiduciary standard and access to professional investment advice — a woeful
prospect for the future economic security of all Americans — and America
itself. “[E]ffective financial planning is important to the success of a
free-market economy. If people do not make careful, rational decisions about
how to self-regulate the patterns of consumption and savings and investment
over their life cycles, government will have to step in to save people from the
consequences of their poor planning.”
FINRA’s Dishonesty – Even with
Respect to its Own Name
FINRA has been dishonest.
In 2007, NASD and NYSE’s member
regulation, enforcement and arbitration functions merged to form FINRA, the primary
securities industry SRO responsible for overseeing broker-dealers. At the time
of its formation, an objection was made by the Financial
Planning Association
(FPA) to FINRA’s all-encompassing name, “Financial Industry Regulatory
Authority.” The FPA stated that the name implied that the self-regulatory
organization would have jurisdiction over more than just the brokerage industry
and hence was “misleading to the public.”
FINRA’s response? “I would need a degree in psychology to comment on the level
of paranoia,” stated a FINRA spokesman.
Yet, despite its assertion FINRA shortly
thereafter, and to this day, lobbies for oversight over registered investment
advisers, a direct contradiction to its earlier statements.
While one might seek to ascribe such
action to a “change of heart” by FINRA, in September 2007 this author was
approached by a FINRA vice-president who admitted that not only had FINRA
contemplated within the preceding year oversight of registered investment
advisers, but that FINRA even had a committee explore the resources needed for
such a task.
Not “paranoia.” Rather, a simple conclusion
that FINRA cannot be trusted.
__________________________________________________________________
Disband FINRA - Part Four. Planning for
the Next Opportunity with a
PRO.
The next
financial crisis will come. The reforms instituted, and which remain to be
instituted, during the legislative and regulatory processes following the
2008-9 financial crisis have been severely watered down. As a result, Congress
and regulatory agencies have laid the foundation for yet another resurgence of
excessive greed, with its ultimate dire consequences for the capital markets
and our economy.
The U.S.
Congress rarely acts until a crisis has occurred. So, sitting here in mid-2013,
we must ask whether we can outline the reforms that can voluntarily be adopted,
in preparation for such an event. Why? So we can, as a profession, be prepared when
the next crisis triggers Congress to take action.
Embrace the Fiduciary Principle
Given the complexity and global nature
of the modern financial market, attempts to regulate the provision of
personalized investment advice by specific rules as utilized by FINRA under its
current regulatory regime will fail. Such an approach will inevitably encounter
the fundamental problem of regulatory arbitrage. Such specific rules should
just permit “financial institutions find new ways to get around government
rules, thus creating a never-ending spiral of rulemaking and rule evading.”
Instead, we must embrace principles-based
regulation, and in particular the fiduciary principle. While there have been
many judicial elicitations of the fiduciary standard, including Justice
Benjamin Cardozo’s lofty elaboration, a relatively recent and concise
recitation of the fiduciary principle can be found in a case in which Lord
Millet undertook what has been described as a “masterful survey”: “A fiduciary
is someone who has undertaken to act for and on behalf of another in a
particular matter in circumstances which give rise to a relationship of trust
and confidence. The distinguishing
obligation of a fiduciary is the obligation of loyalty. The principle is entitled to the
single-minded loyalty of his fiduciary.
This core liability has several facets.
A fiduciary must act in good faith; he must not place himself in a
position where his duty and his interest may conflict; he may not act for his
own benefit or the benefit of a third person without the informed consent of
his principal. This is not intended to
be an exhaustive list, but it is sufficient to indicate the nature of the
fiduciary obligations. They are the
defining characteristics of a fiduciary.”
Disband FINRA
“[A] cursory examination of FINRA’s current
leadership paints a clear picture of a regulator that is still captured by the
[broker-dealer] industry it is tasked with regulating … Effective, independent
and efficient government regulation is the only proper way to safely oversee
our markets. Our economy is too important to be left in the hands of the very
financial industry that brought us to the brink of collapse … [FINRA CEO
Robert] Ketchum argued that FINRA has a ‘strong track record in our examination
and enforcement oversight.’ However, POGO believes that FINRA’s track record
tells a very different story. In fact, financial sector self-regulators,
despite the power vested in them by the federal government, have failed to
prevent virtually all of the major securities scandals since the 1980s.”
Even in 1941, FINRA (NASD) commented
upon the necessity of raising the standards of conduct, when the Chairman of
the NASD early on opined: “[T]he time may come when we can arrive at a more
professional status and we can give more of our attention as to who should be
in the investment business ... The principal by-product [of formation of the
SRO], which I don’t believe the founding fathers of this Association ever
thought of, is that for the first time in history the securities dealer begins
to see what he looks like and it hasn’t been altogether a pleasing sight.”
Of course, as discussed over the past several days in this series of articles,
FINRA has failed miserably to attain "professional status" for the
"securities profession," primarily because it has never raised its
standards of conduct for its members and has never put the interests of the
consumer first.
The Maloney Act is a failed
experiment. Congress should disband FINRA and return broker-dealers to direct
oversight by the SEC. Certainly, FINRA’s failures should not be rewarded.
A New Professional Regulatory Organization: 8 Key Attributes
To replace FINRA, with regard to the
market conduct regulation of those brokers and advisors providing financial
planning and/or personalized investment advice, I propose the formation of a Professional Regulatory Organization
(PRO), similar to the organizations which exist today for lawyers and certified
public accountants.
How would a PRO be different from
FINRA? Through these eight key attributes:
First and foremost, the PRO would
have as its members individuals (not firms) who are qualified to become members
of the profession. History has shown that individuals, when guiding
professional organizations (assisted by consumer representatives), seek to
preserve and enhance professional standards of conduct. In contrast, firms as
members of an SRO seek to consistently lower standards of conduct. (This is,
perhaps, the primary reason for FINRA’s abject failure to raise standards over
the past seven decades.)
Second, the PRO would possess a clear
and unambiguous adherence to a bona fide
fiduciary standard for its members. The principles of the fiduciary standard
would be clearly stated. As part of same, it would be recognized that, under
the fiduciary duty of loyalty, disclosure of the conflict of interest is only a
minor part of the fiduciary’s obligation. Such disclosure must be affirmatively
and comprehensively made in a manner in which the financial advisor ensures
client understanding of the conflict of interest and its possible
ramifications. Thereafter, the client’s informed consent (not mere consent)
must be secured. Even then the transaction must remain substantively fair to
the client. In other words, it would be recognized that no client would voluntarily
provide consent to be harmed; clients are not that gratuitous toward their
financial advisors.
Additionally, removal of the
fiduciary “hat,” while not impossible, would be restricted to those situations
in which is was likely that no further personalized investment advice would be
provided to the client. Moreover, the fiduciary obligations would extend to the
entire relationship with the client; the fallacy that a dual registrant can
wear two hats at once will be forever buried.
Third, the PRO would possess as its
primary purpose the protection of the public interest.
Fourth, a four-year college degree
from accredited institution would be required, plus an advanced course of study
in financial planning and investments.
Passage of comprehensive entrance exam would also required for licensure to
provide "personalized investment advice" to "consumers."
Consumers reasonably expect that their financial and investment advisors are
experts; we should educate and test to ensure a baseline level of expertise
exists, rather than permitting nearly anyone to become licensed to provide
financial advice following a couple of weeks of study of an exam manual.
Continuing education would also be required.
Fifth, peer review of alleged
violations would be initiated. One of the problems of securities regulation
today is its focus on disclosure; in part, this is because securities examiners
can test adherence to disclosure obligations fairly easily. Yet, evaluation of
adherence to the full extent of the fiduciary’s duty of loyalty, and adherence
to the fiduciary’s duty of due care, will usually require the judgment of
professionals with substantial experience in the field. Hence, mandatory peer
review of disciplinary matters should occur.
Sixth, all fines imposed would be
paid to U.S. Treasury and/or to the states, as appropriate, to avoid the
inevitable conflict of interest arising from using fines imposed upon members
to pay any expenses of the professional organization. Only the costs actually
incurred by the professional organization in undertaking an investigation and any
enforcement action could be recovered against a firm found to have committed a
breach of duty.
Seventh, either mandatory pro bono
hours each year, or a mandatory annual contribution to a not-for-profit
providing such services, would be required of all members. Because, in the end,
the profession must serve the public, including those who may be unable to
afford (even on an hourly basis) the services of professional advisors.
Eighth, through legislative fiat (at
the national and/or state levels), only professionals duly licensed as
financial and investment advisors would be permitted to hold out as such
(including a prohibition on the use of similar titles, or designations, by
non-licensed individuals). Only those persons duly qualified would be permitted
to practice and be allowed to utilize titles denoting professional status.
The Journal of Financial Planning initially published Dick Wagner's seminar article, "To
Think...Like a CFP" over 30 years ago, in 1980. Dick Wagner called for
financial planning to become a true profession. Mr. Wagner observed: "A
true profession and its standards are important enough that its principles
generally will prevail—often at the expense of apparent self-interest. Certain
types of employment will be refused, certain procedures will be unacceptable
under any circumstances. Financial sacrifices will be made in the course of
these decisions. However, the ultimate financial impact will be positive
because consumers will know what to expect and will have made the informed
decision to pay for it!"
In other words, should consumers
finally be able to trust all financial and investment advisers, as would exist
if a true profession exist founded upon the fiduciary principle, demand for
financial and investment advice in today’s complex financial world would soar.
Additionally, the profession would attract more and better new entrants, to
assist in serving the burgeoning demand for advice.
Can’t FINRA Change?
This is doubtful, even if legislative
action and SEC rule-making occurs which enables FINRA to achieve all of the
foregoing attributes of a true Professional Regulatory Organization.
At its core, FINRA does not
understand a true fiduciary standard of conduct, nor does it embrace a true
fiduciary standard. It would take years, if not decades, to effect the culture
change within FINRA necessary to effectuate the adoption, promulgation and
enforcement of a true fiduciary standard of conduct.
Many a time I have seen a
non-fiduciary broker hired by a registered investment adviser (not dual
registrant) firm. And many a time I have seen the non-fiduciary broker unable
to adjust, even after a year or more, to the strict ethical code to which true
fiduciary advisors adhere. FINRA would encounter even more difficulties in this
regard.
Of course, the SEC could compel FINRA
to adopt Rules of Conduct which embrace all of the attributes of a true
fiduciary standard of conduct. If FINRA refused to do such, the SEC could
proceed administratively against FINRA as a substandard SRO, applying
Securities Exchange Act § 19(9)-(h).
Yet, realistically, given the close relationship between the SEC and FINRA,
movement of personnel back and forth between the SEC, FINRA, the law firms serving
Wall Street, and large Wall Street firms themselves, this does not appear to be
an option. It would take tremendous courage for three SEC Commissioners to
force through such changes, as well as a Congress which understood the
importance of the fiduciary standard of conduct for all Americans.
Hence, the far better approach is to
“start over” and form a true Professional Regulatory Organization.
Can a PRO Be Formed Now?
Not right away. It would likely
require action by Congress (although enactment one state at a time is an
alternative). And, as we know, Congress does not usually act until a major
financial crisis comes along.
But we can’t wait until the next
financial crisis to begin the process of forming a Professional Regulatory
Organization. It must begin soon, if not now.
What Can We Do to Prepare?
We must, as professionals, define and
embrace bona fide fiduciary standards
of conduct.
Currently financial and investment
advisors have several voluntary organizations. Some of them award
certifications and designations; some do not. Many of them have ethical codes
of conduct, but I would argue that most of these ethical codes fail to set
forth the parameters of fiduciary obligations correctly, or in sufficient
detail.
If we are to achieve a true
profession, at the time of the next financial crisis, we must prepare, and
voluntarily unite around, robust Rules of Professional Conduct in which a true
fiduciary standard is embraced by all of the members of such an organization
and enforced through appropriate peer review. Then, armed with experience over
the years in applying such a standard, the organization and its professionals
would be well-equipped to petition and inform Congress of the merits of a true
PRO at the time of the next major financial crisis.
What About the Dodd Frank Act?
It is possible that a bona fide fiduciary standard can be
imposed by the SEC on all those who provide personalized investment advice
under Section 913 of the Dodd Frank Act. I (and many others) will continue to
advocate for this, through comment letters, other writings, and visits to the
SEC. I will also continue my advocacy in support of the DOL’s re-proposal of
its “Definition of Fiduciary” – in which the strict “sole interests” standard
would be applied to nearly all providers of investment advice to defined
contribution plans and IRA accounts.
Yet, as seen in the SEC’s March 2013
Request for Information (“RFI”), major economic interests (Wall Street firms
and insurance companies) have influenced the SEC to “assume” various parameters
for a “fiduciary standard” that is not really a fiduciary standard at all – at
least in the context of the world of professional advisors. Rather, the SEC’s
RFI posits a standard which is more akin to the very weak fiduciary standard
seen in the world of employer-employee relationships, applying only basic principles
of agency law. The SEC’s RFI ignores the stricter fiduciary law requirements
found in professional advisor-client relationships
and reflects an inadequate understanding of the substantial public policy
rationale leading to the imposition of fiduciary status upon the professional
advisor.
While the chance exists to “turn the
tide” of rule-making at the SEC, and hence we should work diligently for the
SEC’s enactment of an appropriate and bona fide fiduciary standard. However, we
must be prepared for the more likely outcome that the SEC will fail to act
appropriately.
Take the Next Step
Hence, in the event (as appears
likely at present) that the “fiduciary standard” is either not imposed upon
brokers providing personalized investment advice by the SEC, or some weaker
standard is imposed, as professionals we must be prepared to take the next
step.
We must be prepared to embrace,
voluntarily, through an existing organization (which possesses the courage to
step up to the table) or a new organization, bona fide fiduciary obligations similar to those seen for other
professional advisors (such as attorneys). We must be prepared to hold that,
while reasonable restrictions can be imposed upon the scope of an engagement,
that such professional, core fiduciary obligations cannot be waived.
We must be prepared to approach
Congress, when the next financial crisis occurs. Only we, as professionals, if
armed with a history of its practical application, will be able to call upon
Congress to implement a true fiduciary standard and the formation of a
Professional Regulatory Organization. It may take years, if not decades, for
the opportunity to arise … but it will.
Hopefully the opportunity to spur
Congress to act will occur soon (although I don’t wish for another financial
crisis and its dreadful effects on our society), in order that our fellow
citizens no longer suffer the harm they currently endure, far too often, at the
hands of those not currently bound by a fiduciary standard.
Hopefully the opportunity will appear
soon, in order that trust can be restored to our system of capital markets,
greater capital formation occur, and we enter into a new era of American
economic prosperity as a result.
Hopefully a true fiduciary standard
and a Professional Regulatory Organization will come to fruition soon, for the
benefit of all providers of investment and financial advice, in order that we
may then walk the streets proudly as the members of true profession.
Hopefully this vision will achieve
reality, and soon. For the benefit of all consumers of financial and investment
advice. For the sake of the financial futures of our fellow Americans. For the
economic stability and vitality of America itself.
Ron Rhoades, JD, CFP® serves as Chair of the Steering Committee of The
Committee for the Fiduciary Standard. He
is an Asst. Professor of business law and financial planning at Alfred State
College, Alfred, NY.
Putnam, R., 1993, Making Democracy Work: Civic Traditions in
Modern Italy, Princeton University Press, Princeton, NJ.; La Porta R., F.
Lopez-de-Silanes, A. Shleifer, and R. Vishny, 1997, “Trust in Large
Organizations,” American Economic Review, 87, 333-338.
In an influential paper, Knack and Keefer found that a
country's level of trust is indeed correlated with its rate of growth. Knack,
S. and Keefer, P. (1996). "Does social capital have an economic payoff?: A
cross country investigation," The Quarterly Journal of Economics, vol 112,
p.p 1251. See also Zak, P., and S. Knack, 2001, “Trust and Growth,” The
Economic Journal, 111, 295-321.
Guiso, L., P. Sapienza, and L. Zingales, 2007, “Trusting the
Stock Market,” Working Paper, University of Chicago.
SEC Staff
Study (Jan. 2011) at pp. iv, 51. See
also Arleen W. Hughes, Exchange
Act Release No. 4048 (Feb. 18, 1948) (Commission Opinion), aff’d sub nom. Hughes v. SEC, 174 F.2d 969 (D.C. Cir. 1949)
(“Release 4048”) (noting that fiduciary requirements generally are not imposed
upon broker-dealers who render investment advice as an incident to their
brokerage unless they have placed themselves in a position of trust and
confidence).
N.A.S.D. News,
published by the National Association of Securities Dealers, Volume II, Number
1 (Oct. 1, 1941).
“The Madoff Investment Securities Fraud: Regulatory
and Oversight Concerns and the Need for Reform,” Testimony of John C. Coffee
Jr., Adolf A. Berle professor of law, Columbia University Law School, before
the Senate Banking Committee, Jan. 27, 2009.
Recently FINRA opined: “In interpreting
FINRA’s suitability rule, numerous cases explicitly state that ‘a broker’s
recommendations must be consistent with his customers’ best interests.’ The suitability requirement that a broker
make only those recommendations that are consistent with the customer’s best
interests prohibits a broker from placing his or her interests ahead of the
customer’s interests.” FINRA, Notice to Members 12-25,“Frequently Asked
Questions FINRA Rule 2111 (Suitability)”
(Dec. 20, 2012), citing: Raghavan
Sathianathan, Exchange Act Rel. No. 54722, 2006 SEC LEXIS 2572, at *21 (Nov. 8,
2006) [, aff’d, 304 F. App’x 883 (D.C. Cir. 2008)]; see also Scott Epstein, Exchange Act Rel. No. 59328, 2009
SEC LEXIS 217, at *40 n.24 (Jan. 30, 2009) (“In interpreting the suitability
rule, we have stated that a [broker’s] ‘recommendations must be consistent with
his customer’s best interests.’”)[, aff’d,
416 F. App’x 142 (3d Cir. 2010)]; Dane S. Faber, 57 S.E.C. 297, 310, 2004 SEC LEXIS 277, at
*23-24 (2004) (stating that a “broker’s recommendations must be consistent with
his customer’s best interests” and are “not suitable merely because the
customer acquiesces in [them]”); Wendell D. Belden, 56 S.E.C. 496, 503, 2003 SEC LEXIS
1154, at *10-11 (2003) (“As we have frequently pointed out, a broker’s
recommendations must be consistent with his customer’s best interests.”); Daniel R. Howard, 55
S.E.C. 1096, 1100, 2002 SEC LEXIS 1909, at *5-6 (2002) (same), aff’d, 77 F. App’x 2 (1st
Cir. 2003); Powell &
McGowan, Inc., 41 S.E.C. 933, 935, 1964 SEC LEXIS 497, at *3-4
(1964) (same); Dep’t of
Enforcement v. Evans, No. 20006005977901, 2011 FINRA Discip.
LEXIS 36, at *22 (NAC Oct. 3, 2011) (same); Dep’t of Enforcement v. Cody, No. 2005003188901, 2010
FINRA Discip. LEXIS 8, at *19 (NAC May 10, 2010) (same), aff’d, Exchange Act Rel.
No. 64565, 2011 SEC LEXIS 1862 (May 27, 2011); Dep’t of Enforcement v. Bendetsen, No. C01020025, 2004
NASD Discip. LEXIS 13, at *12 (NAC Aug. 9, 2004) (“[A] broker’s recommendations
must serve his client’s best interests[,]” and the “test for whether a broker’s
recommendation[s are] suitable is not whether the client acquiesced in them,
but whether the broker’s recommendations were consistent with the client’s
financial situation and needs.”); IA/BD Study, supra note [68], at 59 (“[A] central aspect of a
broker-dealer’s duty of fair dealing is the suitability obligation, which
generally requires a broker-dealer to make recommendations that are consistent
with the best interests of his customer.”); also
See Epstein, 2009 SEC LEXIS 217, at *42 (stating that the broker’s “mutual
fund switch recommendations served his own interest by generating substantial
production credits, but did not serve the interests of his customers” and
emphasizing that the broker violated the suitability rule “when he put his own
self-interest ahead of the interests of his customers”).
Through elaboration in English law and U.S. law, fiduciary duties
find their origin in a mix of the laws of trust law, tort law, contract law, and agency law. And,
through the gradual
expansion of the situations in which fiduciary duties are required as our society evolves, today
fiduciary status attaches to many different situations. In each instance
fiduciary duties are calibrated to meet the needs of the entrustors, taking
into account the asymmetry of power, knowledge and sophistication of the two
parties to the relationship.
By way of explanation, in the employer-employee
context, the employer or entrustor is nearly always in a position of greater
power and knowledge and sophistication. In contrast, the employee (the
fiduciary) usually possesses limited power and weaker knowledge. Hence, a weak
form of fiduciary obligations exist in which the consent of the employer may
easily occur to an employee’s casting off of fiduciary obligations through
“waiver.” In contrast, in an advisory-client relationship, in which the
asymmetry of information strongly favors the advisor, and the client is placed
at great risk of abuse by the fiduciary of his, her or its powers, the
fiduciary duty is calibrated and is much more strictly applied. In such
circumstances, the doctrine of informed consent if enforced robustly, and
courts invalidate consents if the client is shown to have consented to a
harmful action (for what client, if any, would be gratuitous toward their
advisor).
