January 25th, 2011
in Op Ed

finra and fpa logos by John Lounsbury

Okay, so you can't understand the alphabet soup title. That's where I'll start.

FPA = Financial Planning Association, a professional orgaization for financial planners.

FINRA = Financial Industry Regulatory Authority, an industry self-regulation organization for broker-dealers. It was created in 2007 by the consolidation of NASD (National Association of Securities Dealers) and the member regulation, enforcement and arbitration functions of the NYSE (New York Stock Exchange).

SEC = Securities and Exchange Commission, a government agency charged with enforcing the securities laws of the Untided States and protecting the investor from abuse.

CFP Board = Certified Financial Planning Board of Governors. This is an industry self regulatory group. with responsibilty for qualifying and licensing certified financial planners and enforcing a code of ethics.

The SEC delivered a report to congress yesterday (January 24) recommending that stock brokers and registered investment advisors be covered by the same legal standard of conduct.  That standard should be, according to the SEC, the more rigorous fiduciary requirement for investment advisors.  To understand the importance of this SEC recommendation, it is necessary to go back and review the history of a nearly decade long debate between FINRA), and it's NASD predecessor, and the FPA.

In an August 17, 2009 letter to the SEC, the FPA asked that the Commission clarify and restrict the scope of authority of FINRA related to financial planning services.

Follow up:

The letter states:

FINRA has long warned against the problems of brokers engaging in questionable mortgage practices and, in particular, investing the proceeds in annuities or securities," said FPA President Richard Salmen, CFP®, CFA, EA. "As the primary regulator of Wall Street, we commend FINRA for cracking down on unsuitable sales of investment products within its regulatory authority. However, due to FINRA's absence of legal authority to regulate broad financial planning activities, and to its inability to impose a fiduciary standard that would enhance investor protection, we believe this task is best carried out by the SEC.

The actions referred to in the quote involve FINRA sanctions against a broker-dealer and one of its registered reps (who was not registered as an investment advisor or investment advisor representative, as required by law) for preparing "financial plans" that resulted in clients removing available equity in their homes and investing in retirement and college savings products.

It is a long-time practice among some who are compensated by commissions to emphasize transaction counts in the "advice" they give. This is not true of all (perhaps not even a majority) of such people, but it is done with a significant incidence. It gives a bad name to the majority who do practice a reasonable level of fiduciary responsibility. In the case referred to in the disciplanary action above, I do not have a bill of particulars, so I will give a hypothetical example of how such a "financial plan" might have been presented. I'll just give bullet highlights. Remember, this is a hypothetical example.

  1. Take out a second mortgage to remove $150,000 in available equity from the client's residence. Note: An unscrupulous operator would steer the second mortgage business to a partner who would pay him a 1% "finders fee" of $1,500. Time frame: 2006. Market value of home $350,000, with $200,000 balance outstanding on first mortgage and $150,000 balance on second mortgage.
  2. Invest the $150,000 in high sales charge investment vehicles, such as mutual funds with a front load sales charge or variable annuities. Commissions received, $7,500.

In the case of this particular disciplinary action, the registered rep is purported to have dealt with 220 clients in such a program. Using my hypothetical example as an average case, this would amount to approximately $2,000,000 in income to the "perpetrator". The FINRA imposed sanction was a fine of $100,000 for the broker-dealer and suspension and fine (amount unspecified) for the registered rep.

So, in the subject letter, the quote compliments FINRA on taking action to crack down on this type of abuse. But the FPA requests that future authority in these areas be taken by the SEC, using the authority granted under the Investment Advisors Act of 1940. This act requires licensed securities representatives to exercise fiduciary responsibility.

Self regulation by the industry organization FINRA represents a potential conflict of interest. It is in the interest of the industry to maximize transactions and fees; whereas, it is in the interest of the client to acheive his goals with a minimum of transactions and fees. The potential for conflict of interest is obvious. It is a credit to the character of many of the people in the brokerage business that reasonable fiduciary responsibility is execised by many. It is the minority that needs closer regulation. And, I believe the FPA has a good point in that the SEC is in a better position legally and by charter than is FINRA.

The debate can be joined by those who ask how the SEC can be expected to police tens of thousands of registered reps with potential fraudulent acts of millions when they couldn't detect the Madoff scheme of many billions over a 20 year period and only discovered it when the perpetrator basically turned himself in. That is a good point.

I believe the SEC can only perform its legislated function if the penalties for detection are sufficiently stiff at the broker-dealer level that self policing prevents most of the unethical (and illegal acts). In the situation referred to in the FPA letter, the firm penalty was $100,000. To be an effective deterrent, the penalty to the firm should be recision of all commisions, payable to the investors, and restitution of any losses incurred.

The loss incurred in the hypothetical case could be calculated as follows:

  • Condition (with no transaction) would have amounted to a loss equal to the loss of market value of the house. Let's assume this is $100,000, with the current market value of $250,000.
  • Condition as a result of the transaction would have amounted to loss of $100,000 on the house plus loss on the investments sold to the client. If the loss averaged 30%, the additional loss would be $60,000.

The loss as a result of the transaction is $60,000.

Thus, the fine would amount to about $15,000,000. This would indeed be a powerful motivator for compliance, because failure to be compliant will quickly put a firm out of business. A fine of $100,000 is less than one mosquito bite.

As a sidebar, historically NASD had objected to a fiduciary standard of conduct being applied to stockbrokers giving advice on financial matters. This has long been a bone of contention beyween the FPA and the CFP Board on one hand and the NASD on the other. The two former groups, who have long had NASD licensed reps as members, have argued that registered reps should be held to the same fiduciary code of ethics as all other financial planners. The NASD had argued for an SEC exemption. The current letter is merely an extension of a battle that has been going on for years.

Disclosure: The author was licensed by the NASD as a registered rep from 1992-2001. He has also been a member of the FPA and certified by the CFP Board for 16 years (and currently). He has served on committees for the CFP Board over the years, primarily in the area of review of the CFP certification exam and has taught in CFP Board recognized courses to prepare candidates for the exam.

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