Regulatory Wire: Advisor groups long have pushed for the fiduciary standard; because of the Goldman Sachs case, they may get what they asked for, and more

The fiduciary issue began to come to a head this past week as Sens. Arlen Specter, D-Penn., and Ted Kaufman, D-Del., filed an amendment to the Senate’s Wall Street reform bill that would impose criminal penalties for willful breaches of fiduciary duty when giving investment advice.

Brokers who give advice would have fiduciary obligations under the amendment the two senators filed May 4 to the Restoring American Financial Stability Act.

The financial reform bill contains some expansions of the fiduciary duty, to swap dealers, and several other amendments would expand the fiduciary duty in other ways. Though it’s not clear that the Specter-Kaufman amendment will be voted in, it goes the furthest in imposing fiduciary liability and penalties for breaches.

An amendment that Sens. Robert Menendez, D-N.J., and Daniel Akaka, D-Hawaii, planned to introduce Thursday evening would replace the current provision in the Senate bill requiring a study of broker-adviser harmonization with language from the Wall Street Reform and Consumer Protection Act approved in December by the House. The House provision requires the Securities and Exchange Commission to establish fiduciary standards for advisers and brokers who provide personal advice to retail investors.

The financial reform bill being debated in the Senate, the result of an agreement between Senate Banking Committee Chairman Christopher Dodd, D-Conn., and Sen. Blanche Lincoln, D-Ark., would require fiduciary duties for dealers who act as counterparties in swap transactions with government entities, pension plans, endowments and retirement plans.

Boxer amendment covers institutional investors

Sen. Barbara Boxer, D-Calif., filed an amendment May 4 that would expand fiduciary responsibilities to cover advice given to government entities, pension funds, endowments and retirement plans about securities, commodities and derivatives.

But neither of those provisions covers fiduciary obligations for brokers dealing with retail investors.

Specter, whose amendment would cover dealings with retail investors, submitted his criminal liability amendment after holding a May 4 hearing in the Senate Judiciary Committee’s Subcommittee on Crime and Drugs that he chairs titled, “Wall Street Fraud and Fiduciary Duties: Can Jail Time Serve as an Adequate Deterrent for Willful Violations?”

The fiduciary issue has come into sharper focus since the Securities and Exchange Commission filed securities fraud charges last month against The Goldman Sachs Group Inc. for allegedly selling subprime mortgage securities that were picked by hedge fund Paulson & Co., which bet against them through short sales. The Justice Department has reportedly opened a criminal investigation of the case.

“The question arises as to what duty, if any, is owed by participants in this kind of arrangement,” Specter said at his hearing. Even for the sophisticated, institutional investors which were Goldman Sachs’ clients in the complicated collateralized debt obligation deal, Congress needs to decide what duties brokers, dealers and investment advisers should come under, he said.

Insufficient to have fines

Moreover, Specter added at the hearing, “I have long believed that it is insufficient to have fines for fraud. For corporate fraud, you have a fine and it is calculated as part of doing business.” Even when companies face large fines, they are typically a relatively small part of its profits, he said.

Most of the witnesses Specter invited to testify supported the idea of imposing criminal sanctions for willfully violating the obligation to act in the best interest of their customers.

“Wall Street firms no longer exist primarily to serve the needs of their customer,” said Barbara Roper, director of investor protection for the Consumer Federation of America. “In their world it appears that everyone takes it for granted that customers who can’t look out for their own interests are simply sheep waiting to be shorn.”

Fines may not be enough of a deterrent to stop predatory behavior, even for institutional investors, Roper said. “Holding out the possibility of jail time for violations has the potential to provide that deterrent,” she said. “Expanding the fiduciary duty and imposing criminal sanctions for willful violations could serve as a truly effective deterrent to the kinds of abuses that brought the global economy to the brink of collapse.”

Imposing fiduciary duties on Wall Street firms would make it more difficult for them to sell products primarily designed to remove risks from their balance sheets, and brokers would have to provide more complete disclosures about the products they sell and conflicts of interest they face, Roper said.

“Many Americans seek financial advice from their stock brokers, yet the reality is the legal obligations of a broker are simply limited to recommending securities that are suitable and reasonable to their clients, not putting their clients’ interests first,” and there is no legal obligation for brokers to avoid or disclose conflicts of interest, said Damon Silvers, policy director and special counsel to the AFL-CIO.

Congress should adopt fiduciary standards for brokers and investment advisers giving advice to retail and institutional investors such as pension funds and municipalities, and the criminal code should address willful breaches of fiduciary duty by brokers similar to criminal sanctions now on the books for breaches of fiduciary duties under the Employee Retirement Income Security Act, Silvers said.

Is jail time truly necessary?

Not everyone agreed that imposing criminal sanctions is appropriate. “Even if jail time for certain Wall Street misconduct is the best prescription for the current crisis, that goal does not require additional federal crimes,” testified Andrew Weissman, a partner with law firm Jenner & Block LLP, a former assistant U.S. Attorney in New York who was director of the Justice Department’s Enron Task Force.

Mail and wire fraud statutes already provide criminal sanctions that would likely cover Wall Street fraud, Weissman said. “Even if you were to define new fiduciary duties it is difficult to imagine what kind of material breach would not involve a misstatement or omission and thus be covered by at least one or probably several of the existing federal criminal statutes,” he said.

The administration has not taken a position on whether criminal sanctions should be applied to breaches of fiduciary obligations, according to Justice Department spokeswoman Laura Sweeney.

Schapiro says new ADV part 2, “plain English” rule will be proposed

Could the long decade-long wait for a new ADV Part 2 form be drawing a close? In a May 6 speech at the Compliance and Legal Society of the Securities Industry and Financial Markets Association 2010 annual seminar in Harbor Place, Md., SEC Chairman Mary Schapiro said SEC staff is preparing to present to the commission a recommendation on changes to the document, which is the primary disclosure form required of advisers.

Proposed requirements for a new ADV Part 2 narrative disclosure form were first made in 2000, and again in 2008, but the SEC has never finalized a new rule.

Schapiro said that her staff is preparing to present to the full commission a revised disclosure document. She said the new document would require a plain English narrative discussion of an adviser’s conflicts, compensation, business activities and disciplinary history.

Schapiro did not give a time frame. But she talked about the new form in the context of fiduciary duties for both brokers and advisers, an issue that she has addressed in the past.

“Right now investment advisers, as fiduciaries, have an obligation to provide advice that is in an investor’s best interest, and to avoid or disclose conflicts of interest,” Schapiro said. “Broker-dealers, who earn transaction fees and sometimes incentives for guiding decisions towards one strategy or another, do not currently have to meet this standard, although they are subject to a more comprehensive regulatory regime,” she said.

“Broker-dealers and investment advisers providing the same services, especially to retail investors, should meet that same high fiduciary standard,” she said, adding that she hopes the issue will be addressed in regulatory reform legislation.

While David Tittsworth, executive director of the Investment Adviser Association, said he is “encouraged” to hear Schapiro talking about completing Part 2, he added, “I don’t think this speech answers the question of, if the SEC indeed updates Part 2, would that have any impact on brokers or not within the adviser regulatory regime.”

Capping 12b-1 fees

In addition, Schapiro said she has asked SEC staff to present a recommendation on changing 12b-1 fees, which accounted for $12 billion collected by mutual funds in 2008 to cover distribution expenses. “Many investors have little idea that they are being deducted from their mutual fund, or what they are paying for,” Schapiro said. “We need to critically rethink how 12b-1 fees are used and whether they remain appropriate.”

Most brokerage firms that collect the fees use them to cover the cost of providing advisory services to clients, and they have opposed eliminating them. SEC staff has publicly discussed the idea of capping the currently unlimited fees for C shares of mutual funds when the fees reach the level of front-end A share fees.