After almost a decade of lobbying, arguing, and posturing, the long fight on Capitol Hill over who will regulate RIAs and how to define "fiduciary" is approaching a close. Within the next six months, there will no longer be any real excuse to put off a decision, and new players, both in Congress and at the SEC, will be eager to start fresh.
By April, the SEC will have completed most of its backlog of Dodd-Frank-related studies. It will have a new chairperson at its helm. Expect it to promulgate new fiduciary rules, which are likely to be largely dictated by SIFMA lobbyists but perhaps softened by the SEC's fear of losing yet another lawsuit in the DC District Court.
Meanwhile, Spenser Bachus will no longer chair the House Financial Services Committee next year. With the first warm winds of spring, expect whoever replaces him to introduce a bill that will represent everything that FINRA has learned from all its years of trying to convince Congress that it is an appropriate regulator of non-sales activities.
At stake is the redefinition of what constitutes a fiduciary – if not the survival of the concept itself. Other likely outcomes include a heavier regulatory burden and efforts by Congress and the regulators to "level the playing field" so as not to “disadvantage” the brokerage industry (laughable though that notion may seem).
The fiduciary advisory profession has one last shot at making its case. We should spend the next few months injecting into the discussion what it has lacked all along: a focus squarely on what benefits the consuming public. Everyone involved – Congress, the SEC, even fiduciary advisors themselves – has been asking all the wrong questions and focusing all of our attention on the wrong solutions.
If we take a few steps back and look at the bigger picture, we can change the terms of the debate by asking several pointed questions.
Is "more of the same" really the right solution?
The baseline assumption of the current regulatory debate is that advisory offices are not being visited by SEC examiners nearly often enough. Estimates vary, but it appears that you can expect a visit once every 11 or so years. All parties – even advisors themselves – seem to agree that every four years would be a more reasonable approach.
But has anybody stopped to examine the logic behind this goal? The right question to ask about SEC audits is not how often they should be performed, but whether these visits are useful regulatory tools in the first place.
There is strong evidence that they are not. Examiners visited Bernie Madoff's and Allen Stanford's offices. While they were checking whether the procedures manual matched up with the business continuity document, did they pick up on the fact that billions of dollars were being siphoned from client accounts?
In fact, can any of us recall a single instance where an SEC examination uncovered a Ponzi schemer? People whose trade blotter is not signed within 30 days get tripped up by these audits. People who are actively stealing money do not.
The regulators typically find out about fraud and investor abuse through consumer complaints or an internal whistle-blower. Has anybody proposed an initiative that would strengthen those functions of the SEC?
I'm not sure when it became an accepted article of faith that a certain number of regulatory inspections is what it takes to protect the public. But before we all jump on the bandwagon, shouldn't we ask for the evidence that demonstrates the effectiveness of this proposed solution? Taking even a cursory look at the SEC's track record catching Ponzi schemers and fraudsters, "more of the same" is not the solution that jumps out at you.
Instead of handing over RIA regulation to FINRA, let’s make the SEC more efficient
As the global economy teetered on the brink of collapse – thanks to toxic securities recklessly created and sold on the SEC's watch – as it was discovered that Ponzi schemers had operated with impunity for decades, more than a few of us wondered whether our financial regulators were operating at peak efficiency. Probes of the SEC to figure out why it was ignoring all the whistles that were being blown on Bernie Madoff confirmed some of those suspicions. Investigators found a bizarre culture where government employees were being paid six-figure incomes for downloading porn and carting it home in boxes full of CD-ROMs.
Meanwhile, the Boston Consulting Group conducted a research report on the cost of enhanced regulation and found that the average SEC examiner conducts slightly fewer than three on-site audits a year. The next time the SEC screams to Congress for more funding, or for permission to "self-fund" by charging new fees to the RIA community, it might be helpful to remember that its manpower issues – as every advisory firm knows – are entirely a problem of focus, not of personnel. Even when he does rouse himself from his desk to perform one of those three audits, that SEC examiner spends days looking for fussy procedural foot-faults. Lunches are long and relaxed, travel is prolonged and leisurely, and the really important issue – whether the client's money is actually at the custodian, rather than in some offshore account – could be checked electronically, without anybody having to travel anywhere.
Now that Congress has raised the threshold for SEC registration to $100 million, some 6,000 advisory firms remain under SEC jurisdiction. The SEC currently has 425 examiners assigned to RIAs – one examiner for every 14 advisory firms. That means that next year, theoretically, an examiner could spend three weeks visiting every RIA location every year, and they would all still have plenty of time left over to download porn.
Instead of wasting resources so egregiously, perhaps the SEC should reduce the number of field examiners, so that each is responsible for 50 to 70 firms, which they could visit once or twice annually for (at most) a day each, logging into the custodian and brokerage house data and comparing what they find with the advisor's client statements and transactions. After that, the examiner could take a quick look at office security (is client privacy being treated carelessly?) and perhaps a firm's marketing materials and web site, to see if any outrageous or illegal promises are being made. They could also take a more detailed look at the process by which client portfolios are created and investments are selected. If all of that takes more than a day, then there was at least one nap involved.
A few of the remaining personnel could then be reallocated to more precise and detailed monitoring of those firms that engage in high-risk activities: either they self-custody client accounts, create in-house partnership investments or otherwise have an opportunity to touch the client's money (a la Bernie Madoff), or they engage in very active investment or market-timing activities. Of the 300 or so examiners we just freed up from field RIA work, maybe 30 can be put to work staying on top of these higher-risk firms. (I would guess that this level of scrutiny, all by itself, would cause many of those firms to rethink their activities, reducing further the enforcement workload.)
That leaves approximately 270 examiners free to take on other responsibilities, plus another 365 examiners who are currently focused on examining broker-dealer organizations. It's really not our job to figure out how the SEC should deploy its excess manpower; only to point out that it would have an embarrassment of resources already if its employees were more efficient or possessed a normal work ethic.
Shouldn't regulators give everybody the same treatment?
In the financial planning/RIA space, advisors have to put up with intrusive exams conducted by SEC staffers who have little understanding of their business models. The main point of these efforts seems to be to find something – anything, no matter how small or off the subject of consumer protection – to write up as a deficiency.
At the top end of the size spectrum, the securities regulators take a very different approach. Rules can be changed at the whim of the company, and when a company behaves in heinous ways, the regulators sternly apply a light tap on the wrist.
Consider a recent article in the Washington Post by Barry Ritholtz, which notes that in 2010, Jon Corzine, CEO of the now-infamous MF Global organization that somehow “misplaced” billions of dollars of its clients’ money, successfully lobbied to prevent the Commodities Futures Trading Commission (CFTC) from imposing regulations against borrowing client assets to buy risky European sovereign debt. MF Global also successfully petitioned the CFTC to roll back rules concerning segregation of customer accounts and let commodity brokers perform "internal repos of customers' deposits," – the sort of off-balance-sheet maneuver that, among other things, eventually allowed Lehman Brothers to hide $100 billion in debts during the 2008 market meltdown.
Before that, in 2004, the five largest U.S. investment banks successfully petitioned the SEC to waive their net capitalization rules. The ironically-named "Bear Stearns exemption" opened the doors to 40-1 leverage.
Meanwhile, there are endless examples of "light wrist tap enforcement" for larger brokerage firms, starting with the fact that no executives of the firms who sucked trillions of dollars out of the global financial system have ever been hauled before a jury of their peers. To take a single example that illustrates the larger problem, consider how the regulatory “hammer” fell on Citigroup after it sold $1 billion in securitized junk mortgages and its brokers bet heavily against their own creation’s viability, calling their own investment, in chortling internal e-mails, "the best short ever." Investors lost $700 million, but the SEC proposed a $95 million fine that was considerably less than the $160 million in fees and trading profits that Citigroup made off of its elegant bet against its customers. The SEC also, as is its habit, allowed the company to neither admit nor deny guilt.
The only thing unusual about this particular case was that U.S. District Judge Jed S. Rakoff questioned whether the SEC was too lenient, suggesting that the regulatory body should, at the very least, require Citigroup to at least confess that it did, in fact, do the things it was paying a modest fine for.
The response from our regulators? Instead of going back to the drawing board or toughening its enforcement, the SEC decided to fight to preserve its tepid penalty by appealing the judge's review.
We should all pause and consider this. The SEC decided to go to the courts and fight against actually requiring one of the large investment banks to admit what it actually did.
Here's the point: What small advisory firm would be allowed to negotiate treatment like that? What RIA firm could successfully petition for exemptions to consumer protection rules, or maximum leverage requirements, or permission to create sneaky off-balance-sheet entities? When has a smaller advisory firm ever been the subject of enforcement that the courts believed was too lenient?
And, more broadly, how is it possible that FINRA failed to notice that Jon Corzine was making those enormous, risky bets with investor assets? Who at the SEC was crawling through MF Global's books and records looking for some way to sanction the company?
If we truly want to level the regulatory playing field, as the large brokerage firms keep proposing, then perhaps we should take a broader look, beyond just the fiduciary standard, and recognize that the SEC and FINRA have gotten in the habit of behaving like bullies toward the smaller firms in their regulatory domain, even while they allow themselves to be routinely bullied by the larger firms. Any truly objective, big-picture evaluation would reveal a very different picture from the one the lobbyists have been painting in Congress: a regulatory regime that is much too onerous on the advisors who don't have a lot of clout and lobbying money and far, far too lenient on the larger firms.
There’s no evidence FINRA can be an effective regulatory body
FINRA is aggressively lobbying to become the SRO for financial advisors, and we can expect that Congress next spring will attempt to rewrite the Investment Advisers Act of 1940 in order to make this happen. FINRA's chief argument for taking on this important job seems to be that the SEC can't visit advisor offices every four years, while FINRA has enough resources that it could.
But isn’t this taking too narrow a view of FINRA's qualifications? The far more relevant issue is FINRA's track record of actually uncovering malfeasances, which is poor. Madoff and Stanford were regulated by FINRA as well as the SEC, and, if anything, FINRA seems to have done less to bring either of them to justice than even the inept SEC did.
In fact, there is some evidence that FINRA actually imposes a very light regulatory hand on the organizations whose representatives sit on its board and control its behavior. As Exhibit A, I would point to the SEC’s and FINRA's new branch inspection guidelines for securities firms, issued last November to help broker-dealers improve their supervision systems.
The good news is that the SEC and FINRA did manage to find a few areas to shore up. But what qualifies as “improvements” to this scheme is not encouraging.
For instance, whenever routine inspections of a branch office (every three years) reveal a high level of repeat deficiencies, or serious deficiencies, from now on the brokerage firm or broker-dealer will be required to conduct re-audits of those branch offices, to determine whether or not they're still ignoring FINRA regulations.
The new guidelines also recommend that brokerage firms and independent broker-dealers should look at the results of previous exams, and conduct surprise exams wherever they find "risk factors.” These surprise exams, the guidelines tell us, may reduce the risk that individuals at the office will falsify, conceal or destroy records, as they otherwise might when the inspections are announced in advance.
Can it be that FINRA-regulated broker-dealers or wirehouses were not, before now, required to check in to see if their branches were no longer committing "serious deficiencies?" Were they previously free to ignore the risk that records were falsified, concealed or destroyed, such that this has to be specifically required going forward?
From now on, per the new guidelines, the findings of these inspections should be shared with the branch or compliance managers (they weren't before?), and these off-site supervisors will now be required to take corrective action and document it. The new guidelines go on to say that each brokerage firm or broker-dealer should, from now on, keep track of all corrective action taken at those branches where "serious deficiencies" were uncovered.
Imagine that! I suspect many fiduciary advisors would be a bit stunned that FINRA's vigilant regulatory staff hadn't thought of requiring these things before.
These guidelines offer all of us a surprisingly clear window into the “stringent” regulatory standard that lobbyists at SIFMA and the Financial Services Institute have been holding up to Congress as the highest standard of consumer protection in our marketplace. As we expand the debate, fiduciary advisors should applaud FINRA and the SEC for promulgating these rather basic consumer protections.
But let’s take a step back. What, exactly, were the broker-dealer and brokerage lobbyists smoking when they told Congress, with a straight face, that the regulatory playing field – before these new guidelines were put in place – was unfairly tilted against them? If their lobbyists continue to mount that argument, perhaps we can draw a simple analogy, and imagine new regulations for, say, the medical profession, where hospitals would, for the first time, be required to follow up with doctors found to be ignoring basic medical guidelines. From now on, hospitals would have to start determining whether those doctors were still violating their duties as medical professionals.
Is there any other profession where these basic consumer protections are only now being introduced?
The truth is that the existing standards governing the RIA community are far stronger than what brokers have faced. If you step back and look at the bigger picture, the debate is really about whether RIAs should be governed by FINRA or whether the SEC should govern brokers. Suddenly, you can see why the brokerage firms whose executives sit on the board of FINRA want FINRA governance for all, rather than to have to live under the SEC rules that advisors follow. For an industry that thinks that following up to make sure brokers actually stop violating laws is a novel idea, the SEC’s regime of occasional nitpicking vigilance tilts too far toward consumer protection.
Why are we only applying a fiduciary standard to advisors?
If we take a step back and look at the bigger picture, everything we’ve discussed so far barely touches one hundredth of a percent of the bad investment advice that consumers receive as a matter of daily routine. Advisors can plausibly ask: if the goal of this debate is to protect consumers from bad advice, why are we focusing on a single grain of sand and not on the beach?
In the quaint old days of the late 1980s and early 1990s, advisors used to complain about the conflicts of interest at Money magazine and the other financial publications, which breathlessly reported on "the best mutual funds to buy now" every six months or so. Money's editors faced the obvious conflict of advertising dollars; you need to be touting the products whose sponsors pay the bills. Less obvious was the fact that Money needed, as a matter of business survival, to be seen as the key source of financial information. So its writers had to keep everybody excited about changing their portfolio and continuing to read about what to buy next.
Today, the cable financial channels have taken such investment pornography to striking new levels. Jim Cramer screams at the audience, analysts predict the future, and reporters tell us what happened ten minutes ago as if that news is relevant to the viewer's portfolio. Then come the commercials, which straightforwardly tell us we can beat the market if we will sign on to self-churn our portfolios. We can own our own island! These various frauds and subtle dishonesties get far more attention, individually and collectively, than the honest advisors who, somehow, Congress has identified as the parties most in need of additional regulatory scrutiny.
As we move into the endgame of the fiduciary debate and FINRA regulation, it would be helpful if, this time around, advisors suggest that the regulators and Congress take a step back and consider better regulation for all sources of investment advice in America. Let's examine whether the net result of each provider's advice proves to be helpful or harmful when scrutinized by even the most basic research.
We have similar guidelines in place for medical advice, so we know that a broader system can work. Of course, the SEC, FINRA and the various lobbyists will try to narrow the focus back down by arguing that all those media/advertising purveyors of routinely bad advice are specifically exempted from the 1940 Act. But wait; aren't we rewriting the 1940 Act? Is that not what this debate is all about?
In conclusion
The RIA community has so far allowed the terms of the long-running regulatory debate to be imposed by its competitors in the marketplace. To put it mildly, this has not served the profession well.
We only have a few months to redefine the debate and focus on what, supposedly, we have been talking about all along: creating real protections for the investing public. We have a short window of time to question numerous assumptions that have been accepted as if they were facts.
Fiduciary advisors have a lot of powerful arguments at their disposal that have never been used. Let's make sure we get them heard before the discussion is over.
Bob Veres's Inside Information service is the best practice management, marketing, client service resource for financial services professionals. To invest in your practice and professional career, the annual cost is $299 a year with discount code 55DF: www.bobveres.com .
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