Plus: a Washington outsider's view of reform; and FINRA's Ketchum on new fraud focus

May 28, 2010 — 4:37 AM UTC by Brian O'Connell


Brooke’s Note: One step forward two steps back. Goldman Sachs comes to Congress to be chastised for its fiduciary approach but leaves having convinced its members that conflicts are okay under a suitability standard. The fiduciary standard gains great lip service after the Goldman Sachs hearings and now it’s back on the ropes. Fiduciary advocates link arms in their conviction about accountability and then fiduciaries lock horns over who the standards should apply to. It’s a story line stumbling to some sort of conclusion with the consumer’s fate — and many advisors — hanging in the balance. Here’s the latest play-by-play.

The financial reform bill is making its way across Capital Hill and into the hands of Rep. Barney Frank, who will oversee the conference committee charged with reconciling the House and Senate versions of the bill. Hopes had dimmed that the final version would require brokers and insurance agents to be held to the same fiduciary standards as investment advisors, but some fiduciary stalwarts were keeping the flame alive.

Meanwhile, in the aftermath of the lobbying over the Senate bill, it’s possible to discern the differences in the positions and priorities of groups that have lobbied for the fiduciary standard, but represent different parts of the investment advisory industry and thus have slightly different priorities.

Knut A. Rostad, chairman of the Committee for the Fiduciary Standard, and a regulatory and compliance officer at a Falls Church, Va.-based investment advisory firm, was still sounding the clarion call. Said Rostad, over the U.S. Senate’s failure to include a fiduciary reform amendment before it sent the bill across the hall to the House of Representatives: “The absence of a requirement that brokers who give investment advice be regulated like investment advisers is stupefying, but not surprising. Investors’ (voters) historically low expectations of Congress have been met.”

Despite that shot across Congress’s bow, Rostad remains hopeful that the issue isn’t dead just yet.

“The fat lady has not sung,” he added. “Wall Street reform and the fiduciary issue move to the conference committee. The key question now is whether conference committee members agree with how the Senate has “picked winners and losers” as it essentially endorsed the “Goldman standard” for all clients of brokers who give investment advice.”

Senators bought the Goldman line

Rostad also feels that Senators were duped by powerful lobbyists from brokerage groups – and he cites Goldman Sach’s recent testimony on Capital Hill as influencing Senators’ judgments on the fiduciary issue. Said Rostad; “Twenty three days after Goldman Sachs explained to the entire world, in excruciating detail, that the suitability standard means it’s fine to conceal a huge conflict of interest from a client (because the client is very smart, and understands Goldman’s role as a market maker), the Senate effectively endorsed the “Goldman standard” for institutional clients for all retail clients of brokers. This is not the world’s greatest deliberative body’s proudest moment.”

NASAA, the North American Securities Administrators Association, also has lobbied hard for the standard. But it can take consolation in what will likely be a big win in its column – the shift in oversight of RIAs with up to $100 million in assets from SEC oversight to state regulation.

“We are disappointed the Senate did not include the Akaka-Menendez-Durbin amendment to extend the single most important investor protection – the fiduciary duty for brokers who provide investment advice,” said Denise Voigt Crawford, President of the North American Securities Administrators Association (NASAA). “Instead, the Senate subjected investors to unwarranted delay with a provision (the Johnson Amendment) to require the SEC to conduct a year-long study of the fiduciary issue.”

Like Rostad, Crawford believes it’s not too late for Congress to get fiduciary form right.

“The House bill directs the SEC to issue rules requiring brokers who provide personalized investment advice to retail customers to have the same fiduciary duty as investment advisers,” she said. “During the reconciliation process, the House provision will square off against the delay and dilution promised by the Senate study. The choice should be clear.”

The Washington, D.C.-based Investment Adviser Association has also lobbied for the fiduciary standard, though it had significant concerns that the House version gave too much power to the SEC to interpret the phrase “fiduciary standard.” Reflecting its constituency, which includes larger RIAs serving institutional clients, the IAA has been particularly harsh on any movement toward the Financial Industry Regulatory Authority (FINRA) – the brokerage industry’s self-regulatory organization – to extend its jurisdiction to investment advisers.

Says the letter, signed by executive director David Tittsworth; “We believe that the self-regulatory model has not demonstrated effectiveness or efficiency. At a minimum, we believe that an examination of FINRA’s transparency, accountability, track record, costs, and conflicts of interest is warranted before it is granted any additional authority.”

A Washington outsider’s view

Meanwhile, a Washington, D.C., outsider, Don Trone, took a much more sanguine view of the entire debate.

“I believe the financial services industry should permit the bifurcation of standards and practices, whereas the original language would have swept everyone into the fiduciary net,” said Trone, the CEO of Connecticut-based consulting firm Strategic Ethos. “The industry, as well as the public, would be better severed if we permitted a limited number of professionals in the industry to identify themselves as broker/ product experts (salesman) and be held to existing suitability standards.”

“To illustrate, think about the typical large wirehouse with 40 brokers in a branch. Chances are very good that among the 40 there is one broker who lives and breaths muni bonds – that’s all the broker wants to do – sell and research muni bonds. When the other brokers in the office need a laddered muni-bond portfolio for a client, who do they turn to? The muni-bond expert. Same could be said about sophisticated insurance products: Why not allow a broker to be designated as the insurance expert in the branch?

“Also, I don’t see the ultimate timing of the enactment of the fiduciary standard being impacted all that much by the Johnson amendment. Even if the bill had included fiduciary language, the designated regulator (probably the SEC) would have had to look at the impact of the legislation on the industry; propose new regulations; solicit public and industry feedback; and then, promulgate final regs. The Johnson amendment, in essence, formalizes some of the very steps the SEC would have had to have done anyway.

“Now before the fiduciary vigilante group begins to circle my house with burning torches and pitchforks, let me reiterate that I have been advocating a fiduciary standard for all investment and financial advisors for more than 23 years. The key difference: I believe the fiduciary standard should apply to anyone who holds themselves out in an advisory role, which is the overwhelming majority of professionals in our industry. The situation we have today is that most brokers are claiming that advice is incidental to the sale of a product, and therefore they shouldn’t be held to a fiduciary standard. In essence we’re allowing brokers to claim a suitability standard unless it can be proven that a fiduciary standard is warranted.

Hogwash. My recommendation is that we reverse the scenario – the broker will be held to a fiduciary standard unless it can be demonstrated that the broker has clearly stated that they are in a sales role, and has clearly identified himself/herself as a broker (see above illustration of muni bonds).”

NAIFA gives thumbs-up to Senate’s handling of fiduciary provision

Not everyone is critical of the Senate’s vote to turn back – by a 57-42 vote – the Menendez-Akaka amendment that would make broker-dealers and insurance agents who provide investment advice act in the best interests of their customers.

On May 21, the National Association of Insurance and Financial Advisors went on record strongly endorsing the Senate rejection of the Menendez-Akaka amendment. Said NAIFA President Thomas D. Curry, “NAIFA supports efforts to ensure that consumers are fully protected in the financial services marketplace, and applauds the Senate for its objective approach to address the issue of a harmonized fiduciary standard in its version of H.R. 4173. The Senate language requires the SEC to write rules to address gaps in investor protections following the completion of a thorough analysis of how the regulations now governing broker-dealers and investment advisers are applied and enforced.”

Curry adds that the amendment’s uniform approach wouldn’t have worked, and that real fiduciary form should be handled inside fiduciary standards should be handled inside private investment firms – a tough pill for reform advocates to swallow given the loose regulations that helped fuel the banking crisis of 2007-2008.

“The assessment called for in the Senate bill has never been done and it would result in a fact-based approach to address real problems rather than by adopting a ‘one-size fits all’ amorphous fiduciary standard—the need for which is unsupported by any factual findings,” adds Curry. “NAIFA believes the best way to protect consumers from bad actors is through strong and effective supervision within financial services firms, and regular, periodic inspections by the SEC and other regulatory bodies.”

FINRA chief targets new fraud focus; shifts focus on broker-dealer exams

FINRA CEO and chairman Rick Ketchum has a lot on his plate these days, and he didn’t mind sharing it all with a securities industry audience at the securities regulator’s annual conference in Baltimore this week.

In a keynote address, Ketchum said that FINRA is beefing up its fraud protection powers, specifically in the training of fraud protection specialists at FINRA who can thwart investment scams before they occur. Ketchum says that FINRA has also strengthened its broker-dealer examination program, including a harder look at any investment advisory business conducted through the firm or by an affiliate.

It will shift that effort into higher gear throughout 2010.

“We now gather more information before each examination about a firm’s ownership and affiliate relationships,” he said. “This includes understanding the nature of any investment advisory business conducted through the firm or any affiliate, or by associated persons. Our exam teams use expanded internal and external information about firms to identify potential conflicts of interest or other evidence of problems before the examination. And, when apparent conflicts of interest are identified, examiners are looking for appropriate internal controls and segregation of duties.”

Similar to the stance taken by the SEC, FINRA will be spending more time on higher-risk activities. “We now gather more information before each examination about a firm’s ownership and affiliate relationships,” he said. “This includes understanding the nature of any investment advisory business conducted through the firm or any affiliate, or by associated persons. And, when apparent conflicts of interest are identified, examiners are looking for appropriate internal controls and segregation of duties.”

Ketchum may feel the need to get in front of the fraud issue. FINRA has come under fire for its lax oversight of several high profile investment fraud schemes, including the $50 billion theft of investors’ money by Bernie Madoff.

Customized FINRA examinations

Ketchum also told his Baltimore audience that FINRA will edge away from its “one-size-fits-all” examinations of broker-dealers.

“The financial crisis provided a potent reminder of the need for FINRA, and all other regulators, to re-examine how we can more effectively protect investors,” says Ketchum.
“At FINRA, we have focused intently on strengthening how we go about looking for fraud at firms, and how we process tips and allegations of fraud when they come our way. We have also worked hard to arm our examiners with new training and education on fraud detection.”

Ketchum points to FINRA’s Office of Fraud Detection and Market Intelligence, created in October, 2009, as a good example of the fresh approaches its taking with fraud protection. “This unit provides a heightened review of allegations of serious frauds, a centralized point of contact internally and externally on fraud issues, and consolidates recognized expertise in expedited fraud detection and investigation,” he adds. “The office combines several departments, including departments investigating insider trading and manipulation and the Central Review group, which is responsible for preliminary review of filings from firms. It also includes the Office of the Whistleblower, which we established in March 2009. “

Some other points on FINRA’s recent broker-dealer exam efforts include:

Tougher stances on advisory-broker separation: “When a firm acts as both adviser and broker to customers, and these functions are not segregated, firms have a higher level of control over customer assets. FINRA has enhanced custody and customer protection procedures to review for such activity,” Ketchum said.

A fresh look at “feeder funds” : “We are also examining the relationship between broker-dealers and/or their affiliates with feeder funds, or master funds that utilize feeder funds,” added Ketchum.

Eyes on the off-balance sheet stuff

Putting potential “red flags” in sharper focus: “We are looking more closely for material misstatements in financial reports, unusual money movement, and any apparent red flags involving a firm’s auditor or exceptional off-balance sheet items,” he said.

Taking a closer look at self-reporting practices: Says Ketchum; “Since much of the information used for examination is self-reported, to mitigate the risk that inaccurate information provided by firms may affect the focus of examinations and conceal violations, FINRA is independently verifying information, including custody information with DTCC or other outside custodians. We are also verifying customer account activity and balances directly with customers.”

Getting proactive versus reactive: “To ensure that serious matters get escalated quickly, FINRA has focused on the speed and efficiency with which we bring enforcement actions,” explained Ketchum. “Quicker action means more investors escape harm. We need to be out of the business of sweeping up bodies, and into the business of getting in there before too many investors are hurt. And we are doing everything we can to ensure that we have a more laser-like focus on fraud detection. This includes working with states and with other regulators to pursue and prosecute allegations of fraud.”

That could signal the end of FINRA’s “one-size-fits all” broker-dealer regulation stance, and a more intense focus on risk-based analysis. For the entire Ketchum speech, visit:

Mentioned in this article:

Investment Adviser Association
Top Executive: David G. Tittsworth

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