by John Lounsbury
The Dodd-Frank Act is supposed to reform the way Wall Street works. It is supposed to correct abuses that led the world to the brink of disaster. After passage the intricate details to be implemented required the formation numerous study groups to make recommendations about how to proceed. Some of those studies are now reporting and the recommendations are not all that clear.
In this discussion I will address three of the major areas covered by the new law: (1) regulation of investment advisers, (2) the Volcker Rule and (3) determining systemic risk. All three areas will require new regulation rules and enforcers.
First, the full title of the act is the “Dodd-Frank Wall Street Reform and Consumer Protection Act.” Remember all parts of this title as you read the following discussion.Fiduciary Responsibility or Suitability?
In one area, the SEC was charged with determining how investment advisors should be regulated. The commission has thrown the ball back to Capital Hill. In a report this week, the SEC’s recommendations were the following:
- Imposing user fees on SEC-registered advisors to pay for SEC exams;
- Authorizing one or more self-regulatory organizations (SROs), under SEC oversight, to examine advisors; or
- Authorizing the Financial Industry Regulatory Authority (FINRA) to examine dually-registered advisors who both sell products and dispense investment advice.
A follow-on report from the SEC was released Saturday which recommended that all investment advisors and retail securities brokers should be held to the same standard, a fiduciary standard. Fiduciary responsibility requires that all actions be justified on the basis of what is best for the client. Suitability responsibility (see further discussion below) requires that actions be justified as generally suitable for an individual fitting into a general category; no individual assessment of what is best need be undertaken. From Financial Planning magazine:
A study released by the Securities and Exchange Commission Saturday has recommended that a single fiduciary standard be created for brokers and investment advisers.
As part of the Dodd-Frank law, the SEC was told it could hold brokers to a higher standard, forcing them to put their client interests above their own. Advisors are already held to that standard.
The much-anticipated study found that many investors are confused about the roles of brokers and advisors and are unsure of their protections when they receive advice. The study recommended the SEC create a uniform standard to simplify the client experience.
“Retail customers should not have to parse through legal distinctions to determine whether the advice they receive was provided in accordance with their expectations,” the study said.
The two Republican commissioners on the panel, Kathleen Casey and Troy Paredes, balked at the findings. They issued a joint statement that said there wasn’t enough evidence from the study to authorize a total overhaul. They argued that the SEC needed to do further study and analysis to make certain these changes wouldn’t hamper investors.
The report released earlier in the week focused on implementation details and largely produced the opinion that the SEC was throwing responsibilty for defining implentation back to Congress. From Financial Advisor magazine:
The study was commissioned out of concern that the agency doesn’t have sufficient resources to adequately examine the 11,888 SEC-registered investment advisors. That’s up from 8,581 advisors in 2004. Meanwhile, the number of exams conducted by the SEC have decreased––from 18% of advisors in 2004 to 9% in 2010.
In the study, the agency said user fees imposed on RIAs would provide scalable resources to enable the SEC to “achieve an acceptable frequency of examinations.”
The SEC noted that user fees might be less costly than creating an SRO to oversee advisors, although it hadn’t crunched the numbers on how much it would cost to establish an SRO.
Regarding an SRO, which is an entity with market specific expertise funded by membership fees, the SEC said establishing one or more SROs under SEC oversight could boost the frequency of advisor exams. Multiple SROs could target specific types of investment advisors. For example, there could be different SROs for financial planners and money managers.
But the SEC study noted that multiple SROs could be more costly than a single SRO because it would be harder for them to achieve economies of scale. In addition, they could muddle the picture by developing their own approach and rules to applying the Investment Advisers Act.
As a result, the SEC said it might be better to designate a single SRO for investment advisors. And the likely candidate would be FINRA. One reason, according to the study, is that creating another single SRO for investment advisors other than FINRA would mean dually-registered advisors would be subject to more than one SRO––one for broker-dealers, one for investment advisors). As the existing SRO for broker-dealers, FINRA already has that segment covered.
The problem with FINRA regulating advisors is that the organization doesn’t have a satisfactory implementation of fiduciary responsibility. FINRA is the self-regulatory agency of the NYSE (New York Stock Exchange) and the NASDAQ Exchange. Conduct of registered representatives of NASD (National Association of Security Dealers) broker-dealers is regulated by an organization of their employers. Registered reps are held subjected to a “suitability” standard which is much looser than a “fiduciary” standard.
FINRA is the successor to the NASD (National Association of Security Dealers), and, as such, is an industry self-regulatory group. Their primary objective is to protect the interests of broker-dealers and their agents. In protecting those interests, they will, with great fanfare, reveal disciplinary actions from time to time. The most effective actions are taken against brokers (Registered Reps) when they, as individuals, are found to have commited fraud. When action is announced against broker-dealers, it is often token wrist slapping.
The CFP Board, with their associated industry professional association, the FPA, have long taken a position that financial planners have a fiduciary responsibility. (CFP is Certified Financial Planner and FPA is Financial Planning Association.) The NASD, and now FINRA, has taken the position that Registered Reps who are CFPs, even when they offer financial planning advice, should be exempt from fiduciary responsibility under the code of ethics provisions (of the CFP Board) and the SEC requirements for investment advisors under The Investment Advisors Act of 1940. In other words, Registered Reps should have no more responsibility to their clients than a used car salesman. If they blatantly misrepresent something, that is wrong. If they are subtly misleading, well, caveat emptor.
FINRA is on one side of this fiduciary responsibility argument and the FPA and the CFP Board are on the other. This conflict has been going on for many years. Having observed this debate, originally being in both houses (a CFP who was a Registered Rep), and for the past eight years as only a CFP registrant, I have come to a very low opinion of FINRA when it comes to customer protection. The litany of details you have outlined in this article are no surprise to me, even though a couple of them are new news.
Putting FINRA in charge of investor consumer protection is a joke. Subtile misrepresentation can easily pass a suitability test but can never pass a fiduciary test.
The Volcker Rule is named for former Obama presidential advisor, Paul Volcker, who left that position recently. Volcker is most famous for being the Federal Reserve Chairman who broke the back of high inflation in the late 1970s and early 1980s during his term from 1978-84.
The Volcker rule restricts how a bank or institution that owns a bank can engage in proprietary trading that isn’t at the behest of its clients, and from owning or investing in a hedge fund or private equity fund, as well as limiting the types of liabilities that the largest banks can hold. What is generally considered to be a weakened form of what Volker originally proposed was included in the Dodd-Frank act.
The implementation of the Volker rule as defined in the Dodd-Frank act was referred for study to the Financial Stability Oversight Council, which has put out a study and recommendations on the Volcker Rule, providing a road map toward the rules that will come out within a few months. According to an article in Wall Street Technology:
According to the New York Times, the hurdle they face is simple: there is no easy way to tell a proprietary trade from another kind of trade, particularly given the exemptions worked into the law.
Yet in the end, the Volcker Rule may work, even if there are ways around it, says Times columnist Floyd Norris, who interviewed 83-year-old Paul Volcker.
“I may not understand modern financial attitudes,” Volcker said, “but I don’t think a bank wants to be conducting financial activities that will be revealed as simply skirting the law.”
As stated in the New York Times:
[It] is worth noting that regulators are being asked to do a lot without a commensurate increase in resources. That may not hurt the Fed, which sets its own budget, but the Securities and Exchange Commission is getting stretched very thin and the new Republican House leadership shows no interest in fixing that.
What about he third important area of Dodd-Frank highlighted at the beginning of this article? No word yet, but based on what has happened with the other two, this area will get little definition from study groups.
It’s All About the Money
One SEC commissioner, Elisse Walter, voted to release the study but argued that it did not go far enough. “We need to address this issue now,” she concluded. “For far too long, in the investment advisory area, the commission has been unable to perform its responsibilities adequately to fulfill its mission as the investor’s advocate, and investment advisory clients have not been adequately protected. This must change.” And there is political opposition to making any implementation that might hinder the furtherance of “financial freedom for a few.” (Words in quote are the author’s characterization.)
The SEC is dodging responsibility for proper regulation of investment advisors. It appears to lack the resources to implement even a watered down Volcker rule or to address consumer interests in the financial advisory arena. The third area mentioned at the beginning, controlling systematic risk, may well be deterimined to fall in the purview of the Fed. Now isn’t the Fed essentially a self-regulating authority for the banks?
What was my earlier comment about used car salesmen?
Or should I have said something about foxes and chicken houses?
Between the lack of sufficient funding of a government agency like the Securities Exchange Commission and the revolving door that keeps moving people between the regulators and the regulated, the problems come down to being all about the money.
The author was formerly a Registered Rep with a NASD broker-dealer and also an SEC registered and a New York State registered investment advisor. He has been a CFP Board Certified Financial Planner and a member of the Financial Planning Association and retains both relationships today.
FINRA vs. FPA (GEI Opinion)