FINRA and SIFMA win big for Wall Street with release of Senator Dodd's bill yesterday

Brooke’s Note: For much of the advisory industry, it takes days or weeks to get to the nub of what new proposals relating to brokers and Wall Street mean to the average consumer. Fortunately for us readers, Ron Rhoades is not one of those people. After taking a short time yesterday to read over Senator Dodds’ proposed bill on regulatory reform, he churned out this thorough and highly analytical piece. The news looks bad for fiduciary advocates but Rhoades is no pessimist. He offers some consoling thoughts toward the column’s end relating to how the Department of Labor could still prove to be a saving grace.

Wall Street, FINRA, and SIFMA are on the path to “success” with Senator Dodd’s bill, as it was released today. Consumers lost big today.

SEC PROVIDED AUTHORITY TO EMPOWER FINRA AND LOWER STANDARDS OF CONDUCT FOR THE DELIVERY OF INVESTMENT ADVICE. There are many aspects of financial services reform being addressed in Senator Dodd’s “Chairman’s mark-up” of the financial services reform bill which are praiseworthy.

However, in the final analysis the average consumer of financial services and products will see little added protection from the abuses which continue to occur at the hand of Wall Street’s large financial behemoths.

• Study = Delay. Instead of repealing the broker-dealer exclusion from the application of the Advisers Act to the investment advisory activities of broker-dealer firms, as a means of correcting the SEC’s flawed interpretation of the “solely incidental” and “special compensation” requirements for that exclusion to be applicable, Congress has punted. Section 913 calls for the SEC to conduct a study of the differences in broker-dealer and investment adviser regulation.

Delay tactic

Everyone knows that typically a study is just a delay tactic, and that Congress is highly unlikely to address financial services reform again until after another monumental crisis occurs. Everyone also knows that the SEC has been subjected to regulatory capture by the very industry it regulates, and that it remains today largely a pro-Wall Street and anti-consumer regulatory body.

• Yet, A Better Study by the GAO Would Occur. Section 763 of the bill provides for a study by the U.S. Comptroller General of “the benefits and drawbacks of harmonizing laws implemented by the Commodity Futures Trading Commission and the Securities and Exchange Commission, and merging those agencies.” The study also is to include “the benefits and feasibility of imposing a uniform fiduciary duty on financial intermediaries who provide similar investment advisory services.”

• A Devastating Grant of Authority to the SEC. Section 913 of the bill also mandates that the SEC, after conducting a study, “commence a rulemaking, as necessary or appropriate in the public interest and for the protection of retail customers, to address such regulatory gaps and overlap that can be addressed by rule, using its authority under the Securities Exchange Act of 1934 … and the Investment Advisers Act of 1940 …. Nothing in this section shall be construed to limit the rulemaking authority of the Commission under any other provision of Federal law.” In essence, Senator Dodd has delegated to the SEC the authority to write the rules – whether a fiduciary standard of conduct will be imposed on those who provide investment advice, and what that fiduciary standard will look like.

Party tonight

The large broker-dealer firms should be partying tonight, for they know that a majority of the current Commissioners favor both FINRA oversight of investment advisers and a “new federal fiduciary standard” that is anything but a bona fide fiduciary standard of conduct. We would see, in the end, greater disclosures of conflicts of interests and compensation. But Wall Street knows that disclosures, alone, are ineffective as a means to protect consumers, due to the huge knowledge gap which exists between financial advisors and individual investors and the ever-present behavioral biases.

Is there hope for Main Street? Perhaps.

• An extreme long-shot is the Financial Planning Coalition’s efforts to secure professional regulation, under a true fiduciary standard, for financial planners. This amendment has many hurdles to overcome to make it into the final legislation, including the lack of support by many other pro-consumer organizations.

• There is always the chance that amendments – during the Senate Banking Committee mark-up, on the Senate floor, or during the reconciliation process – will occur which would be pro-consumer. But such events are rare, especially as money continues to flow from insurance companies and Wall Street firms into the campaign coffers of incumbents in Congress.

• The authority of the States to combat fraud (including constructive fraud, a/k/a breach of fiduciary duty) has largely been spared from Federal preemption. This is important, as federal securities laws generally do not restrict the application of fiduciary standards of conduct by state statutory or common law. (ERISA, SLUSA, and certain other statutes do preempt certain state laws, however, as to specific types of accounts or in certain situations.) Note that state common law applies the fiduciary standard of conduct to all “financial advisors” those who enter into relationships of trust and confidence with their clients, using a facts and circumstances test. Hence, the courts – in the context of private securities litigation – will continue to record many instances of the application of fiduciary standards upon broker-dealers and their registered representatives. And state securities regulators (and state legislators) may feel compelled to finally break from the SEC’s path toward lowering of standards, in order to apply the fiduciary standard of conduct by state statute. Still, this issue is a “hot button” on Wall Street, and likely to be a focus of increased lobbying efforts in the future.

Saving grace: The Department of labor

• The real saving grace for consumers is the U.S. Department of Labor. Read: Why the DOL’s proposed 401(k) rules could ding brokers and leave the spoils to RIAs In the revised proposed regulations on retirement plan and IRA accounts, a form of fiduciary standard of conduct is essentially mandated. Essentially, those advisors providing investment advice to individual plan participants on ERISA and IRA accounts will be compelled to ensure that their compensation is level, unless a computer model is utilized to provide the advice. While these proposed rules, issued in late February 2010, have many unanswered questions surrounding them, they are definitely pro-consumer (in comparison to the prior DOL proposed rules issued under the Bush Administration), and they are very likely to be finalized. Additionally, soon the DOL will issue new proposed rules on new forms of disclosures to retirement plan sponsors, and thereafter promulgate new proposed rules on disclosures to retirement plan participants.

The DOL and the IRS understand the fiduciary standard of conduct far better than the SEC. Thankfully, the SEC has no authority to veto DOL rule-making.

Losers and Winers

Despite the probable positive outcomes consumers with retirement accounts will enjoy, many individual consumers will emerge from financial services regulatory reform with far less Federal protections than those which exist today, and certainly far less than our fellow Americans deserve.

Investment advisers “lost” today, in the sense that those who are stand-alone RIAs will likely continue to see consumers confused as to who they can trust. Yet, if (as I predict) standards of conduct are lowered by the SEC from the current high fiduciary standard of conduct (of the Advisers Act, as interpreted by the Courts, not the SEC), then a “winner” will be those firms and financial advisors who voluntarily assume a bona fide fiduciary standard of conduct. It may become more difficult for them to distinguish themselves from “all the rest” who don’t act as true fiduciaries, but they will find ways to do so. And, as a result, fee-only RIAs and other true fiduciary advisors will continue to gain market share from the large wirehouse and other BD firms who continue to resist and deny fiduciary status.

If consumers were the big losers today, who was the “big winner”? FINRA, the “self-regulatory organization” which is legislatively mandated to enhance standards of conduct for broker-dealers, but which has in reality lobbied successfully to keep standards low, is beginning to party tonight. At least, there is no doubt that more than a few glasses were raised in toasts this evening on K Street.

More direct path for FINRA

The large financial services firms, whose commercial interests are protected by FINRA’s inept efforts at rule-making and supervision, also sleep better tonight knowing that FINRA is on a more direct path toward oversight of investment advisers and defeat of the application of the Advisers Act’s true fiduciary standard upon their activities. FINRA’s role as the protector of a product-sales-driven, arms-length standard of conduct business model is not only preserved, but extended, by Dodd’s proposed bill.

While overall the overall financial services reform bill may be viewed as a step forward on many fronts, many other loopholes exist in Dodd’s new draft. This is especially true as to the feeble legislative attempts to overcome the moral hazards inherent in Wall Street’s systems of incentive-based compensation. One need only ask how large the financial crisis must be in order to enact all of the comprehensive reforms for effective oversight of our capital markets and their many participants

Ron A. Rhoades, JD, CFP® serves as Chief Compliance Officer and Director of Research for Joseph Capital Management, LLC, a registered investment adviser with offices in New York, North Carolina, Georgia and Florida. This article represents his views only, and not necessarily the views of any organization to which he may be affiliated.