The story of FINRA's implacable drift from its founding ideals to a pallid 'no-lying baseline'

Brooke’s Note: The plot thickens. In this second — absorbing — combination of history and fiduciary bible thumping, Ron Rhoades tells the life story to date of FINRA from its infancy in 1939, when it was called NASD, to its idealistic adolescence and then, well then it’s pretty much downhill, according to our fiercely partisan and erudite one-man think tank. Along the way, there’s a crusading New Deal senator, gripping courtroom drama and a whole lot more. Simply put, for anyone with a dog in this hunt, it’s a good read. For more, check Part 1: Why keeping FINRA from ruling RIAs is critical to these firms, the investor — and even the U.S. economy — and stay tuned for Part 3, which delves more deeply into FINRA’s misdeeds.

Why was the fiduciary standard not implemented in the early days of securities regulation, for brokers? The answer lies with FINRA, its inherent conflicts of interest, and its failure to protect the individual investor. Let’s examine FINRA’s early history, and the evidence of FINRA’s massive flop. To do so, we must first explore the relationship between brokers and their clients that existed prior to FINRA’s existence.

Brokers as fiduciaries: Before FINRA

At the beginning of the 20th century, “The business of buying and selling stocks and other securities [was] generally transacted by brokers for a commission agreed upon or regulated by the usages of a stock exchange,” wrote John Dos Passos in “A Treatise of the Law of Stock Brokers and Stock Exchanges, published in 1905. Indicative of the known distinctions between brokers and dealers, an early Indiana law provided for the licensing of brokers but not for “persons dealing in stocks, etc., on their own account.”

In those days, stockbrokers were known to possess duties akin to those of trustees, including the duty of utmost good faith and the avoidance of receipt of hidden forms of compensation.

To illustrate that point, Dos Passos, in his treatise, quoted from Banta v. Chicago :

“He is a broker because he has no interest in the transaction, except to the extent of his commissions; he is a pledgee, in that he holds the stock, etc., as security for the repayment of the money he advances in its purchase; so he is a trustee, for the law charges him with the utmost honesty and good faith in his transactions; and whatever benefit arises therefrom ensures to the cestui que trust.“

By the early 1930s, the fiduciary duties of brokers (as opposed to dealers) were widely known. As summarized by Cheryl Goss Weiss, in contrasting the duties of a broker vis-à-vis with a dealer:

“By the early 20th century, the body of common law governing brokers as agents was well developed. The broker, acting as an agent, was held to a fiduciary standard [emphasis added] and was prohibited from self-dealing, acting for conflicting interests, bucketing orders, trading against customer orders, obtaining secret profits and hypothecating customers’ securities in excessive amounts — all familiar concepts under modern securities law. See: Six tips for avoiding a disastrous broker-dealer decision.

“Under common law, however, a broker acting as principal for his own account, such as a dealer or other vendor, was by definition not an agent and owed no fiduciary duty to the customer. The parties, acting principal to principal as buyer and seller, were regarded as being in an adverse contractual relationship in which agency principles did not apply.”

The fact that stockbrokers were known to be fiduciaries at an early time in the history of the securities industry (when acting as brokers and not acting as dealers) should not come as a surprise. To a degree it is simply an extension of the laws of agency. One might then surmise that, if the broker provides personalized investment advice, then a logical extension of the principles of agency dictates that the fiduciary duties of the agent also extend to those advisory functions, as the scope of the agency has been thus expanded.

Secret profit

While agency law provides one basis for the imposition of broad fiduciary duties upon brokers, early court cases confirmed the existence of broad fiduciary duties upon brokers in situations where brokers possessed relationships of trust and confidence with their clients. For example, In the 1934 case of _Birch v. Arnold, which did not appear to involve the exercise of discretion by a broker, the relationship between a client and her stockbroker was found to be a fiduciary one, as it was a relationship based upon trust and confidence. See: Barney Frank puzzles crowd on his fiduciary stance at TD summit — as questions from Skip Schweiss and advisors expose his haziness on the RIA structure and soul.

As the court stated:

“She [the client] had great confidence in his honesty, business ability, skill and experience in investments, and his general business capacity; that she trusted him; that he had influence with her in advising her as to investments; that she was ignorant of the commercial value of the securities he talked to her about; and that she had come to believe that he was very friendly with her and interested in helping her. He expected and invited her to have absolute confidence in him, and gave her to understand that she might safely apply to him for advice and counsel as to investments … She unquestionably had it in her power to give orders to the defendants, which the defendants would have had to obey. In fact, however, every investment and every sale she made was made by her in reliance on the statements and advice of Arnold, and she really exercised no independent judgment whatever. She relied wholly on him.” (emphasis added). See: Why you won’t know your female clients are unhappy until they’re out the door.

In this case, the Massachusetts Supreme Court held that, in these circumstances, facts “conclusively show that the relationship was one of trust and confidence” and therefore the broker could not make a secret profit from the transactions for which the advice was provided.

In Norris v. Beyer, another pre-FINRA decision (1938), the broker’s customer, “untrained in business — she had been a domestic servant for years — was susceptible to the defendant’s influence, trusted him implicitly.” The court stated: “We are persuaded from the facts of the case that a trust relationship existed between the parties … The [broker] argues that he was not a trustee but a broker only. This argument finds little to support it in the testimony. He assumed the role of financial guide and the law imposed upon him the duty to deal fairly with the complainant even to the point of subordinating his own interest to hers” [emphasis added)]

“This he did not do. He risked the money she entrusted to him in making a market for hazardous securities. He failed to inform her of material facts affecting her interest regarding the securities purchased. He consciously violated his agreement to maintain her income, and all the while profited personally at the complainant’s expense. Even as agent, he could not gain advantage for himself to the detriment of his principal.”

Hence, while under the Securities Exchange Act of 1934 and FINRA rules, broker-dealers are not subject to an explicit fiduciary standard, in private litigation between customers and brokers and in some arbitrations, fiduciary standards are applied when a relationship of trust and confidence is found. As noted in a recent law review article, “Notwithstanding the absence of an explicit fiduciary standard, broker-dealers are subject to substantially similar requirements when they act as more than mere order takers for their customers’ transactions.”

This appears in accord with the original intent of Franklin D. Roosevelt and Congress. In a law review article titled “A Lesson from History, Roosevelt to Obama — The Evolution of Broker-Dealer Regulation,” Matthew P. Allen wrote: “Roosevelt and Congress used the 1934 Exchange Act to raise the standard of professional conduct in the securities industry from the standardless principle of caveat emptor to a 'clearer understanding of the ancient truth’ that brokers managing 'other people’s money’ should be subject to professional trustee duties.”

The fact that broker-dealers may, when providing more than trade execution services to individual investors, possess broad fiduciary duties was confirmed by the SEC Staff Study on Investment Advisers and Broker-Dealers (As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act) (Jan. 2011), which stated:

“Broker-dealers that do business with the public generally must become members of FINRA. Under the anti-fraud provisions of the federal securities laws and SRO rules, including SRO rules relating to just and equitable principles of trade and high standards of commercial honor, broker-dealers are required to deal fairly with their customers. While broker-dealers are generally not subject to a fiduciary duty under the federal securities laws, courts have found broker-dealers to have a fiduciary duty under certain circumstances … This duty may arise under state common law, which varies by state. Generally, broker-dealers that exercise discretion or control over customer assets, or have a relationship of trust and confidence with their customers, owe customers a fiduciary duty similar to that of investment advisers.”

What about the Investment Advisers Act of 1940? At the time of its enactment it was designed to apply to investment counsel, a relatively new type of professional paid directly by the customers for his or her advice. It required investment counsel (i.e., investment advisors) to register with the SEC. See: Why the New York Times fiduciary article won’t deter the special interests.

Moreover, Section 206 of the Advisers Act imposed a fiduciary duty upon investment advisers. Brokers were exempted from the registration requirements of the Advisers Act, provided that their investment advice remained “solely incidental” to the brokerage transactions and they received no “special compensation.”

But here’s the key — the Advisers Act never stated that brokers providing personalized investment advice (whether “solely incidental” or otherwise) were not fiduciaries. The law applicable to brokers remained the same.

The Securities Markets Study (1935)

An influential early study of the securities market was conducted following the 1929 stock market crash. Written in large part prior to the adoption of the Securities Exchange Act of 1934, the entire study was published by Twentieth Century Fund in 1935. Entitled “The Securities Market,” the study provided a long review of the functions of the securities markets and the activities of their various actors and participants (including brokers and “investment counsel”).

The authors of the study described the “brokerage-firm-customer relationship” as follows:

1. It acts as his broker in the purchase and sale of securities and in the borrowing and lending of stocks.

2. It acts as a pledgee, in which capacity it either advances its own capital to finance his margin transactions, or, much more commonly, advances capital borrowed from banks.

3. It is the custodian of his securities and cash.

4. It exercises, to some extent, the function of an investment counsel to him.

These relationships imply great responsibilities and obligations on the part of a brokerage firm. Under these circumstances the customer is entitled to expect the fullest possible protection … To the greatest extent possible, a condition should be created where the conflict of interest between broker and customer is reduced to the minimum (emphasis added).

The Securities Market study went further in suggesting protections for conflicts of interest for investment counsel — those individuals who were paid directly by their clients — stating:

“We believe that anyone who entrusts his investment problems to an investment counsel is entitled to protection … He should be assured that his financial advisor is possessed of at least certain minimum qualifications and, in addition, that he is free from all entanglements that might divide his loyalties … [emphasis added]

“No individual should be granted, or permitted to retain, a license to practice as investment counsel for pay who is in the business of underwriting, distributing, buying or selling securities either as a broker or principal; or who is in the employ of, or is in any way affiliated with, or is a stockholder or partner in, any organizations engaged in any manner whatever in such activities … No licensed investment counsel should be permitted to employ, or to retain in his employment, anyone in any way connected with any activity or implied [in the foregoing sentence]; or to associate himself as a partner, joint stockholder, or otherwise with any such disqualified person.”

In essence, the Securities Market study recommended that brokers be held to the “best interests” fiduciary standard of conduct, with conflicts of interest minimized. Also, the study recommended the separation of brokers and dealers (who deal in their own securities, or who sell offerings of securities firms in initial or subsequent public offerings). See: Borzi: Exemptions from conflict of interest will be part of new fiduciary proposal.

The Securities Market study also, in essence, recommended that investment counsel be held to the “sole interests” fiduciary standard in which avoidance of all conflicts of interest was required. Additionally, no “dual registration” (as exists today) as both a broker (or dealer) and investment adviser (“investment counsel” in 1935) would be permitted, given the insidious conflicts of interest under such affiliations. See: Should I dump my securities licenses?.

1938 Maloney Act: A noble attempt to raise standards

By the mid-1930s, broker-dealer firms were subject to registration requirements, but the attributes of a profession were sorely lacking. Partly to escape from direct government regulation, but also as a result of the aspirational desires of the Maloney Act’s primary author — Sen. Francis T. Maloney (D-Conn.) — to create a true profession, the Maloney Act of 1938 amended the Securities Exchange Act of 1934 and created the authority for the recognition of a self-regulatory organization.

Public-policymakers in 1938 clearly understood that the goal of the Maloney Act was to create a true profession, bound by fiduciary standards. In 1938, the assistant general counsel of the Securities and Exchange Commission stated that the “commission has concluded that the next stage in the job — the job of raising the standards of those on the edge to the level of the standards of the best — can best be handled … by placing the primarily responsibility on the organized associations of securities dealers throughout the country” [emphasis added].

The theme of continually raising the standards of the industry was repeated in a speech by then SEC Commissioner George C. Matthews, shortly after the Maloney Act was passed in Congress, in which he stated, “Ideally, the industry should eventually play the predominant role in its own regulation and development … It should in the largest possible measure achieve that ideal under democratic institutions which Josiah Royce described as the forestalling of restraint by self-restraint … I wish to re-emphasize the evolutionary character of the program provided for in the [Maloney] Act … it is our hope … that the work of construction [of regulation] will continue through the years until there shall finally have been erected a professional edifice commensurate with the importance of the investment banking and over-the-counter securities businesses in our national economy.”

Even Maloney stated that the Maloney Act had, as its purpose, “the promotion of truly professional standards of character and competence.”

SRO’s very early statements confirmed fiduciary duties of brokers

Early statements by NASD (now FINRA) confirmed the existence of high fiduciary standards of conduct for brokers in the very early days of the self-regulatory organization’s existence. In only the second newsletter it issued for its members, in 1940, NASD unequivocally pronounced that brokers were fiduciaries:

“Essentially, a broker or agent is a fiduciary and he thus stands in a position of trust and confidence with respect to his customer or principal. He must at all times, therefore, think and act as a fiduciary. He owes his customer or principal complete obedience, complete loyalty, and the exercise of his unbiased interest. The law will not permit a broker or agent to put himself in a position where he can be influenced by any considerations other than those to the best interests of his customer or principal … A broker may not in any way, nor in any amount, make a secret profit … his commission, if any, for services rendered … under the Rules of the Association must be a fair commission under all the relevant circumstances.”

A little more than a year later — in the October 1941 issue of N.A.S.D. News, in discussing the decisions of two cases, NASD wrote that it was “worth quoting” statements from the opinions:

“In relation to the question of the capacity in which a broker-dealer acts, the opinion quotes from the Restatement of the law of Agency: 'The understanding that one is to act primarily for the benefit of another is often the determinative feature in distinguishing the agency relationship from others…. The name which the parties give the relationship is not determinative.’ And again: 'An agency may, of course, arise out of correspondence and a course of conduct between the parties, despite a subsequent allegation that the parties acted as principals.’”

When chairman Benjamin Howell Griswold, Jr., called to order the first meeting of the NASD Board of Governors in 1939, he described the association as a “worthwhile experiment” that would succeed only through “coordinated effort, careful study, good will, and hard thinking.”

“If you do succeed,” he told the board, “then both the Securities and Exchange Commission and yourselves are entitled to the credit for the development of a plan that may tend more than anything else to restore confidence, remove the legal obstacles that now alarm you and re-establish the capital issues market of this country.”

The tide turns: SRO enacts low standards of conduct

By 1942, the committee appointed by NASD to enact rules of conduct for its members had finished its work, and the SRO’s rules of conduct (via a “Uniform Practice Code” and “Rules of Fair Practice”) were adopted. Yet, despite the clear pronouncements by early NASD writers in the SRO’s 1940 and 1941 newsletters, the aspirations of SEC commissioners and Sen. Maloney for adoption of the highest professional standards, and case law clearly setting forth that a broker was a fiduciary when in a relationship of trust and confidence with a customer, NASD’s rules of conduct omitted any reference to the fiduciary duties of brokers when providing personalized investment advice.

Yet, in 1942, and now, there exists little doubt that the relationship between most clients and their brokers, when personalized investment advice is provided, is a personal one. See: A conversation between a wirehouse advisor and a senior citizen who seeks trust.

Indeed, as recognized by the SEC staff as recently as 2005, “[f]ull-service broker-dealers have always sought to develop long-term relationships with their customers who often come to rely on them for expert investment advice,” according to a law review article by Ronald J. Colombo, “Trust and the Reform of Securities Regulation,” published in 2010.

In such relationships, he continues, a broker “does not simply execute orders at a client’s command, but rather renders investment advice to the client … “ Such brokers are not simply functionaries, but rather “are clearly fiduciaries in the broadest sense.”

Yet the SRO’s omission of any mention of fiduciary standards in its rules for its brokerage firms and their registered representatives continues to this day. By, in effect, ignoring the law and the statements of the Maloney Act’s principal author, FINRA continues to keep the standards for brokers at the very low level of suitability. See: The suitability standard, defined.

In fact, the true purpose of FINRA was revealed early on.

“In October 1943, the NASD board adopted a policy that set general guidelines for markups in customer transactions,” According to Colombo. “Members’ reactions to it ranged from endorsement to opposition, leading executive director Fulton to further explain the policy: 'The NASD did not and does not seek to regulate, let alone curtail, profits of its members. The NASD is devoted to the principle that its members are in business to make money [emphasis added].”

This devotion by NASD and its firms to protection of their profits was strongly felt in1943, when the SEC sought to impose a rule requiring disclosure by dealers of all of their profits from any transaction. The securities industry reacted most sharply, and by 1947 the SEC’s proposal was abandoned.

As will be seen, the SRO and its member firms have continued their fight, for more than seven decades, against heightened standards of conduct or other restrictions which might impede their outsized profits. See: FINRA’s regulatory white flag may be a pause before it plays white knight to SEC’s cash-starved damsel.

The disastrous suitability standard

There exists a broad range of consumer protections available to regulate the sale of securities and/or the delivery of investment advice, ranging from the arms-length standard — generally applicable to contracts between parties with relatively equal knowledge and bargaining power — to the strict “sole interests” fiduciary standard of conduct.

The arm’s-length standard

In most commercial transactions, the consumer and the merchant of securities operate at arm’s length. In these arm’s-length relationships of parties, such as exist for most sales and purchases of everyday products, the relationship can be characterized as follows: PRODUCT MANUFACTURERS ⇒ MANUFACTURERS’ (SALES) REPRESENTATIVES ⇒CUSTOMER.

Suitability

Sometimes the consumer is aided (or denied protections) by specific laws, which impose some additional duties on one party, other than just by those duties that the general common law might provide. For example, upon broker-dealers there is imposed the requirement that investment products sold to an investor be “suitable,” at least as to the risks associated with that investment.

In essence, suitability requires an effort on the part of the broker to “match” customers to particular products, by matching products to objectives. The duties relate mainly to the risk assumed by the customer; the broker must ascertain the risk-return characteristics of the security against the particular characteristics and objectives of the customer.

The “suitability doctrine” is explicitly set forth as a rule by FINRA, and recognized by the SEC as a “fundamental duty of brokers” enforceable by FINRA under the securities laws’ general anti-fraud rule (Rule 10b- 5). However, the suitability doctrine demands only that a broker/brokerage firm “will make specific recommendations of securities only if it has a reasonable basis for believing that they are suitable for the customer.”

Yet, suitability, while imposing upon brokers the responsibility to not permit investors to “self-destruct,” confines the duties of brokers to their customers, with respect to the broad common-law duty of due care. With the rise of the concept of the due care and actions for breach of one’s duty of due care (via the negligence doctrine that saw accelerated development in the early 20th century), brokers sought a way to ensure they would not be held liable under the standard of negligence.

After all, according to Onnig H. Dombalagian, in the law review article “Investment Recommendations and the Essence of Duty,”
“[T]o the extent that investment transactions are about shifting risk to the investor, whether from the intermediary, an issuer, or a third party, the mere risk that a customer may lose all or part of its investment cannot, in and of itself, be sufficient justification for imposing liability on a financial intermediary.”

This appears to be a valid view as to the duty that should be imposed upon brokers; provided, however, that the broker is providing only execution services to the customer.

Yet, the sales of mutual funds and other pooled investment vehicles exploded following the SEC’s abolition of all fixed commission rates, which was effective on May 1, 1975. In effect, no longer were brokers performing execution services, but they were, in fact, recommending investment managers.

Yet, NASD/FINRA permitted the suitability doctrine to be extended, over the decades, to incorporate recommendations of investment managers. In essence, brokers continue to operate with a free hand — unburdened by the duty of nearly every other person in the U.S. with respect to their activities — which, at a minimum, require adherence to the duty of due care of a reasonable person.

The limited disclosure obligations of brokers and their registered representatives

Federal and state securities laws also impose, at times, various disclosure obligations upon broker-dealers beyond the “no-lying baseline” which exists in arm’s-length transactions. Yet, there is no obligation of a broker, generally, to disclose to customers all of the compensation that it or its registered representatives receive.

According to a U.S. District Court decision in 2005, In re Morgan Stanley & Van Kampen Mutual Fund Securities Litigation, “Neither the SEC nor [NASD] have required registered representatives of broker-dealers to disclose their own compensation in a securities transaction, although both have been fully aware that registered representatives often received special incentives beyond the normal compensation to sell a particular product — such as differential compensation resulting from soft-dollar payments and payment for shelf space, management bonuses and sales contests.”

Moreover, according to Castillo v. Dean Witter Discover & Co. in 1998, brokers and their registered representatives don’t even possess a duty to disclose the receipt of additional compensation for selling proprietary mutual funds over other funds.

Briefly contrasting the fiduciary relationship

The fiduciary relationship arises in situations where the law has clearly recognized that fiduciary duties attach, such as principal and agent relationships, or where there exists the actual placing of trust and confidence by one party in another and a great disparity of position and influence between the parties.

Under the fiduciary standard of conduct the financial advisor possesses both a duty of due care (judged by comparison of the financial advisor’s acts to other professionals’, not consumers’), as well as a fiduciary duty of loyalty. Under the fiduciary duty of loyalty, there arises a duty to disclose all material facts. See: TD throws its first client-best-interest summit, a micro-event, by 'candlelight’ in Palm Beach and ideas rise from the RIA deeps.

Yet, even then the fiduciary standard requires more, as mere disclosure of material facts is thought to be inadequate as a means of consumer protection for clients in a relationship of trust and confidence with their advisor. Stated differently, even with full disclosure of conflicts of interest and specific compensation amounts, disclosure does not come close to being a substitute for the protections offered by a bona fide fiduciary standard of conduct.

The relationship of the parties in a fiduciary relationship is reversed from that of an arm’s-length relationship. The fiduciary relationship can be illustrated as follows:

In summary, the low standard of conduct possessed by brokers under the suitability standard continues despite the fact that the negligence standard today applies to govern the duties of care owed by most of us in our society. In contrast, the fiduciary standard for professional advisors requires adherence to a professional duty of care, as well as mandatory disclosure of all material facts (including compensation). Even then, the fiduciary standard requires much more of the advisor providing personalized investment advice.

The Maloney Act failure

Why has FINRA had so many documented failures? Because — at its core — FINRA acts as the protector of its member firms, rather than protecting the public interest. As Tamar Frankel, America’s leading scholar on fiduciary law as applied to the securities industry, wrote in 1965:

NASD … [does] not, as do the professions, consider the public interest as one of [its] goals … Let us consider the attitude of the professions toward the public interest. The goal of public service is embedded in the definition of a profession. (Pound, The Lawyer from antiquity to modern times 5 1963). A profession performs a unique service; it requires a long period of academic training. Service to the community rather than economic gain is the dominant motive. We may measure the broker-dealer’s activities against these criteria … Although at least part of his trade is to give service, profit is his goal. The public interest is stated in negative terms: he should refrain from wrongdoing because it does not pay. This attitude is the crux of the matter, the heart of the difference between a profession and the broker-dealer’s activity …

_The industry emphasizes its merchandising aspect, and argues that the broker-dealer is subject to the duties of a merchandiser even when he is also acting is his advisory capacity … the NASD [has] proved incapable of establishing accepted standards of behavior for the activities of the trade … Past experience has proved that it is unrealistic to expect the NASD to regulate in the public interest _ [emphasis added.”

Sadly, Frankel’s observations from nearly five decades ago continue to ring true.

FINRA: A sad excuse for a regulator

FINRA possesses an inherent conflict of interest because, at its core, it remains under the control of its large Wall Street broker-dealer firms, while also regulating those same broker-dealers. This means that FINRA will always be an ineffective protector of consumers, and that its rules and regulations will instead foster the excessive profits of its members.

The adoption of the failed suitability standard, and its extension to broker-dealer’s advisory activities, rather than an appropriate professional standard of due care, insulates FINRA’s broker-dealer firm members from much of the liability that might otherwise attach to their recommendations.

FINRA’s failure to recognize, or enforce, the fiduciary duties of brokers when providing personalized investment advice (rather than trade execution services) remains a dismal omission from the rules of conduct which govern its members. Even the failure to simply mandate specific disclosures of compensation by broker-dealers, in all circumstances, is another black eye on the SRO’s seven-plus decades of oversight of its member firms.

While FINRA prides itself on the robustness of its broker-dealer examination program, including the frequency of examinations, no amount of examinations will serve to protect the public interest adequately if the standards to which brokers are held remain inherently weak and flawed.

As FINRA itself has noted, it exists to preserve the profits of its members. Sadly, FINRA’s continued existence, and the weak conduct requirements it imposes upon its members, do not serve the public interest.

Coming up: Part 3 – Exploring FINRA’s litany of failures.

Ron Rhoades, JD, CFP® serves as chairman of the Steering Committee of The Committee for the Fiduciary Standard. He is an assistant professor of business law and financial planning at Alfred (N.Y.) State College.