The ongoing financial meltdown dominating the news has led to calls for more regulation. While we might debate whether better enforcement of existing regulations will better avoid future harm to investors than new regulation, let’s look instead at whether one specific proposal floating about would help or hurt investors.
I’m referring to the call by some to put all purveyors of investments, including investment advisers, under a single regulatory umbrella. That single umbrella the proponents refer to is the Financial Industry Regulatory Authority, or “FINRA” for short.
FINRA’s slogan is “Investor Protection. Market Integrity.” Its website tells us: “FINRA is the largest independent regulator for all securities firms doing business in the United States. We oversee nearly 5,000 brokerage firms, 173,000 branch offices and 656,000 registered securities representatives. Our chief role is to protect investors by maintaining the fairness of the U.S. capital markets.” Sounds pretty good…so far.
The problem is, FINRA is a self-regulatory organization. And FINRA, formerly known as the National Association of Securities Dealers, or NASD, hasn’t done a very good job of protecting investors. Consider the Bernie Madoff affair, the largest Ponzi scheme on record. Throughout his career, Madoff was subject to regulation by NASD/FINRA, which took no action against him. It now appears Madoff was already working his Ponzi magic even while he served as chairman of the NASD!
FINRA, and NASD before it, has long been dominated by the large Wall Street brokerage firms. These firms are steeped in a sales culture that FINRA hasn’t reined in effectively.
Although they sport a variety of titles such as “financial adviser” and “financial consultant,” the folks at Wall Street firms most investors call “brokers” are, in fact, salesmen. Their legal title is “registered representative,” but it’s the broker/dealer they represent, not the customer.
In Wall Street jargon, these folks belong to the “sell side” of the business, meaning their job is to sell financial products (stocks, bonds, mutual funds, variable annuities and such) to their customers. And their compensation is usually based on their “production,” meaning how many commission-generating products favored by their employer they can push out the door. All those complex subprime mortgage securities that led to our global financial crisis were products of this sales culture; they generated enormous revenues for the broker/dealers marketing them and exorbitant compensation for their reps.
As expected, FINRA strongly favors expanding its authority to cover independent investment advisers. And the new chair of the SEC, Mary Shapiro, who served as chair of FINRA during a time it failed to protect investors from Bernie Madoff, has also publicly stated she favors this proposal.
How could this possibly be good for investors? Independent investment advisers have been regulated by the SEC since passage of the Investment Adviser Act of 1940. In contrast to the intricate (but ineffective) rule-based regulatory scheme used by FINRA, regulation under the 1940 Act is primarily principle-based. And the most important principle of the 1940 Act is that it explicitly holds independent advisers to a fiduciary standard.
A fiduciary standard requires an adviser to put the client’s interest ahead of the adviser’s. Here are but two examples. First, as to any investment recommendation, an adviser must disclose all conflicts of interest, including those generated by his compensation. Second, investment advisers are required to disclose their disciplinary history.
FINRA-regulated broker/dealers have long resisted application of a fiduciary standard to their registered reps. Instead, the FINRA scheme requires that investments chosen by the broker/dealers’ for their customers be “suitable” for them. In practice, the suitability standard allows unscrupulous broker/dealer reps to recommend any investment they believe they can get away with.
Suppose an investor would be well-served by investing in a mutual fund. In a given category, suppose there are two funds, one with mediocre returns that charges a front-end sales load, a recurring “12b-1” fee and has high internal expenses. The other has excellent returns, charges no sales load or 12b-1 fees and has low internal expenses. The independent adviser will choose the latter as best for his client. But the broker/dealer rep will choose the former, because it counts toward his production, while the excellent no-load fund doesn’t. The mediocre fund will pass the suitability test even though it may not pass the smell test.
As for disciplinary history, in its April 13 issue, Forbes tells the story of broker “Bambi” Holzer. The public knows Holzer through her four books and television appearances. What Forbes reveals is that, during the three-decade course of her employment by firms such as Oppenheimer & Co., Shearson Lehman Hutton, Bear Stearns and A.G. Edwards, Holzer has been the subject of complaints by 54 investors. Holzer was fined $100,000 and suspended for misrepresentations in the sale of variable annuities while she worked at Paine Webber. UBS forked over $1.4 million to settle a claim by one of Holzer’s disgruntled clients. According to Forbes, information about wayward reps like Bambi Holzer is hard to come by because of loopholes in the FINRA reporting requirements.
In contrast, the SEC requires its registered investment advisers to provide a detailed history of discipline, civil complaints and criminal convictions. This history is easily available to the public on the SEC’s website at http://www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.aspx.
If FINRA succeeds in gaining authority over them, expect it to burden the independent advisers with rules governing the minutia of their practices, while looking the other way at the harm to the investing public resulting from the ingrained sales culture of the big Wall Street firms. As Bob Veres, a writer for Financial Planning magazine recently put it, it would be comparable to having drug companies oversee the medicines doctors prescribe. Or having the foxes guard the henhouse. Not a great idea.
