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Regulatory Wire: How Goldman Sachs' fraud case will redirect the regulatory debate

Two Senators to offer amendment; plus, how many arbitration cases are filed because of breach of fiduciary duty? It's a lot.

Friday, April 23, 2010 – 6:01 AM by By Sara Hansard
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Goldman Sachs' Lloyd Blankfein has said the investment bank is not a fiduciary. What is at issue, then, is what the suitability standard really is.

Investment advisor advocates hope the blockbuster Securities and Exchange Commission fraud case against Goldman Sachs Group Inc. will highlight the need to impose fiduciary duties on brokers who give investment advice as the Senate moves to take up the Restoring American Financial Stability Act (S. 3217).

As RIABiz’s regulatory wire reported last week, there are plans afoot to include the standard in the financial reform bill now in the Senate. In the latest development, the offices of Sens. Daniel Akaka, D-Hawaii, and Robert Menendez, D-N.J., confirmed they plan to offer an amendment to the bill that would replace a provision to study broker regulation with House language that would impose fiduciary duties on brokers who act as investment advisers.

How the Goldman case – which hinges on whether Goldman acted in its clients’ best interests — will impact the fiduciary debate remains unclear. The first vote in the Senate is scheduled for late Monday afternoon to limit debate on the bill. That vote will be an indicator of whether the Democrats can muster enough votes to move forward on the bill without a filibuster by Republicans

While support for the fiduciary amendment is fluid, “We do think what is at least a loose connection to the Goldman Sachs case would help the amendment,” wrote Afshin Mohamadi, spokesman for Menendez, in an email.

In a press conference on April 21, members of the Committee for the Fiduciary Standard argued that the Goldman case is bolstering the argument that brokers who give investment advice should be held to legal fiduciary standards. “Goldman has been clear that it regards its relationship as a caveat emptor situation more so than a trusted advisor situation,” said Knut Rostad, chairman of The Committee for the Fiduciary Standard and compliance officer with Rembert Pendleton Jackson investment advisory firm in Falls Church, Va. The committee has about 750 members.

Goldman has an obligation to disclose: Blankfein

Goldman Sachs was charged April 16 by the SEC with misleading investors by not disclosing that hedge fund Paulson & Co. influenced the selection of subprime mortgage-backed securities that were included in collateralized debt obligations Goldman sold from 2005-2007. Paulson & Co. bet against the securities in the CDO, the SEC said in its complaint. Goldman has denied any wrongdoing.

Goldman Sachs Chief Executive Officer Lloyd Blankfein testified in January to the Financial Crisis Inquiry Commission that the investment bank is not a fiduciary, Rostad noted.


Goldman was dealing with institutional clients, not retail clients, in connection with the civil charges brought by the SEC. However, Rostad said, “The principles, caveat emptor versus a trusted advisor, and practices that flow from each of these principles for either retail or institutional clients can apply similarly,” Rostad said.

At the heart of the SEC case is what conduct is permitted under broker regulations requiring that they sell securities that are suitable, according to Rostad. In its complaint the SEC claims that Goldman’s conduct is not permitted, while Goldman maintains that its conduct is within the boundaries permitted in law. “Here we have a piece of a picture of what Wall Street’s most esteemed banking firm seems to believe is a suitability standard,” Rostad said.

Moreover, Goldman may be able to fend off the charges. If the SEC does not win a clear victory, “What we will have then is an unvarnished picture of some of the principles and practices that would appear to be affirmed in meeting the suitability standard’s requirements,” Rostad said.

A spokeswoman for Goldman Sachs said the company has no comment on the position that the Fiduciary Committee is taking.

While brokers are required by current law to make disclosures about securities that are offered to investors, they are not required to make disclosures about their own conflicts of interest, commented Boston University law professor Tamar Frankel, who spoke at the Wednesday press conference.

However, whether Congress changes the law regarding broker advisers, Frankel suggested that investors choose advisers who are registered as investment advisers under the Investment Advisers Act of 1940. All investment advisers are required to act as fiduciaries under that law.


Enactment of fiduciary requirements for all advisers still faces rough sledding. With senators focused primarily on finding ways to end a regulatory system that allows financial institutions to be “too big to fail” and how to regulate derivatives, the fiduciary issue has received little attention. State securities regulators, the Consumer Federation of America, the Investment Adviser Association and the Financial Planning Coalition are trying to drum up support for the planned Akaka-Menendez amendment.

While Senate Banking Committee Chairman Christopher Dodd, D-Conn., initially proposed strong fiduciary requirements in a draft bill last November, an amendment sponsored by Sens. Tim Johnson, D-S.D., and Mike Crapo, R-Idaho, replacing Dodd’s provision with a study was substituted in the bill approved in March by the Banking Committee.

If the financial service reform legislation is approved by the Senate and a conference committee between the House and the Senate negotiate a reconciled bill, that could work in favor of fiduciary standards for broker advisers. House Financial Services Committee Barney Frank, D-Mass., who wants to have a conference committee to work out differences on the bills, is pushing for the House version.

But Dodd is less likely to push as strongly for a fiduciary standard. Sen. Johnson, who has been a strong advocate for the insurance industry that backs the study provision, appears to be more committed to his amendment than Dodd is to fiduciary requirements. And, with Republican support still wavering, Dodd may be willing to trade the fiduciary provision in order to get bipartisan agreement needed to enact the legislation. Further, there will be pressure on the House to go along with whatever the Senate approves in order to win final passage.


State securities regulators also cite arbitration statistics to bolster the call for requiring brokers who provide advice to act as fiduciaries.

Data collected by the Financial Industry Regulatory Authority for 2009 show that breach of fiduciary duty was cited far more than any other complaint in arbitration cases brought last year.

Arbitration Cases Served by Controversy Involved — by far the largest number of arbitrations were brought for breaches of the fiduciary standard

Type of Controversy* 2006 2007 2008 2009 Feb. 2010
Margin Calls 103 45 64 128 12
Churning 257 133 212 306 55
Unauthorized Trading 242 174 248 478 66
Failure to Supervise 1,425 830 1,029 2,691 403
Negligence 1,619 891 1,602 3,405 457
Omission of Facts 588 275 1,201 2,453 339
Breach of Contract 1,397 953 1,658 2,802 341
Breach of Fiduciary Duty 2,621 1,616 2,836 4,206 523
Unsuitability 1,347 695 1,181 2,473 311
Misrepresentation 1,187 739 2,005 3,408 463
Online Trading 8 1 3 0 0

*Each case can be coded to contain up to four controversy types. Therefore the columns in this table cannot be totaled to determine the number of cases served in a year.

Breach of fiduciary duty was cited in 4,206 arbitration cases. Of the 11 types of complaints compiled by FINRA, the next highest categories were 3,408 for misrepresentation and 3,405 for negligence.

About 65,000 arbitration cases were filed with FINRA in 2009, the highest number of arbitration claims since 2004.

The finding is an argument for imposing fiduciary standards, said Marc Minor, chief of the Bureau of Securities in the New Jersey Department of Law & Public Safety, which is the state’s attorney general’s office.

State securities regulators are calling on Congress to end mandatory arbitration clauses that are included in most brokerage contracts. Both House and Senate bills include provisions that encourage the SEC to do so, but the North American Securities Administrators Associations wants Congress to expressly prohibit the practice.

Stephen Winks

Stephen Winks

April 23, 2010 — 2:34 PM

The FINRA Arbitration Proceeding Table establishing the nature of arbitration proceedings tells the story.

Over 70% (16,336) of the 22,141 arbitration cases related to breach of fiduciary duty, unsuitability of investments, breach of contract, omission of facts and misrepresentation are resolved by a fiduciary construct in support of fiduciary standing. Accountability, transparency, disclosure and the advisor’s descretion over client affairs in the best interests of the consumer cures a lot of ills.

If you add in negligence, lack of supervision, churning, margin calls and unauthorized trading which are effectively delt with through either an outsourced expert CIO function through which small advisors leverage their poerfolio construction capabilities or through large advisors housing their own CIO function in their practice. This is faster, better and cheaper than selling retail products as a series of disjointed unrelated transactions.

Most of the industries compliance issues can be eliminated by an audited prudent investment process utilizing advances in (a) prudent process tied to statutory documentation assuring fiduciary standing, (b) new technology that affords accountability, disclosure and transparency that supports continuous comprehensive counsel required for fiduciary standing, (c) a functional division of labor (Advisor, CIO, CAO)which simplifies the routine execution of an extremely high level of counsel,(d)conflict of interest management, and (e) advisory services support for each of the ten major market segments advisors are active. Approximately 12% of industry revenues are attributable to compliance and can be redirected to more productive endeavors.

None of this innovation is possible unless the idustry acknowledges and supports fiduciary standing of its brokers. The majority of SEC Commissioners support “the” fiduciary standard of care for brokers, it is up to Congress to provide the SEC with the necessary legislative authority to require fiduciary standing for brokers.

It is time for the brokerage industry to embrace Modernity after 70 years of maintaining brokers do not render advice (subject of the Goldman suit), thus requiring the consumer to determine investment merit on their own regardless of how limited their investment knowledge and experience may be. This is untenable from both the perspective of the consumer and the advisor.

The enabling resources must be provided to the terribly under resources brokerand advisor so they can unambiguously act in thre consumer’s best interest. This is the public policy Congress should be supporting and as a by product the “too big to fail” issue will resolve itself in the best interest of the consumer.


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