April 21, 2010

Goldman Sachs, Suitability and the Fiduciary Standard

SEC's allegations of fraud

Setting the stage for the discussion, Knut A. Rostad, chairman, the Committee for the Fiduciary Standard, noted that the SEC's civil charges of fraud against Goldman Sachs may be the clearest demonstration yet of, "why the fiduciary standard is important," and the differences between the fiduciary standard under the Investment Advisers Act of 1940 and the suitability standard under which brokers operate.

"Goldman has been clear that it regards this relationship as a caveat emptor situation," Rostad says. He quoted Goldman Sachs CEO Lloyd Blankfein's testimony in January before the Financial Crisis Inquiry Commission: "we are not a fiduciary," Blankfein said, adding in the testimony that Goldman must "fully disclose what an instrument is and be honest in our dealings, but we are not managing somebody else's money."

In the same testimony though, Blankfein also expressed that "...we do support the extension of a fiduciary standard to broker/dealer registered representatives who provide advice to retail investors. The fiduciary standard puts the interests of the client first. The advice-giving functions of brokers who work with investors have become similar to that of investment advisers. But, investors may not understand that the person they are getting advice from may be regulated under different rules and regulations. Retail investors should be able expect the same duty of care when they are receiving investment advice."

At the heart of this case, according to Rostad, is, "What is permitted conduct under the suitability standard? The SEC in its complaint expresses one view that Goldman's conduct is not permitted. Goldman in its reply thus far expresses another view: that its conduct, based on the facts, is fully and completely within the boundaries permitted in law. Here we have a picture of what Wall Street's most esteemed banking firm seems to believe is a suitability standard."

Rostad also noted that commentators have observed that "a clear SEC win in this case will be very difficult,"--that more likely we will see "a draw or a Goldman win." If that is so, he says that we would view an "unvarnished picture of some of the principles and practices that would appear to be affirmed as meeting the suitability standard requirements."

The case highlights "the wide gap and opposing roles of a broker who is permitted in law to further his and his firm's interests at the expense of customers', and a fiduciary who is required in law to put his clients' interests first. This is at the core of why the fiduciary standard is important," Rostad continued.

Rostad moderated the call with three panelists: Tamar Frankel, Professor of Law at Boston University School of Law; James D. Cox, Duke University Brainerd Currie Professor of Law; and Terry Savage, author and personal finance columnist based in Chicago.

Frankel looks "at the relationship" between Goldman Sachs and its clients. "Current law requires disclosure about the securities that are offered to investors, but does not require the brokerage institutions that sell the securities to describe themselves. The disclosure is about what is being sold, and not who sells it. When the salesperson says 'trust me,' the investors, nonetheless, trust. That is why the time has come to change the law. The salesperson's temptation is too great when investors trust them."

She adds, "Investors need not ask whether their broker has conflicts of interest or whether they offer complex instruments that are doomed to fail, or whether they are risky or to what extent they are risky. Investors need ask only one question: Are you registered under The Investment Advisers Act of 1940? That's all. If the brokers say, 'No I'm not,' then investors may consider choosing someone else." In Frankel's view, "If the courts and regulators cannot impose fiduciary duties on brokers, then investors may be able to do that. After all, we believe in the markets, don't we?"

The Goldman Sachs case does raise, adds Cox, "questions about the perils of too big to fail," in context of "too big to manage--when you have decentralized management, huge structures, and the rewards are great, it really does pose huge challenges. I think it's very interesting that this morning we find that the Goldman approach is--where I think they should have started off--they are now identifying this as a rogue trader issue. We all know the rogue trader story--rogue traders usually get identified only when they lose money not when they make money."

"The great thing about having a fiduciary standard," says Cox, "is that it would roll back some of the mist that Goldman and others are trying to hide behind, in terms of what their obligation to the client is." However, he notes, "we know that the pushback on there being a fiduciary standard is that it may introduce issues that are inappropriate, in some settings, for broker/dealer behavior, and that's why I think that the appropriate legislative response is to enable the SEC with rulemaking authority to either define or take out of the fiduciary standard. That is, you could either have the fiduciary standard being the default rule or you could have the fiduciary standard being an enabling provision which then requires definition."

"Certainly the baseline of that would be," according to Cox, "dealing face-to-face with customer relationships on recommending and things like that, there is a duty to disclose all material facts related to the relationship."

As a journalist and one who regularly interacts with readers, Savage says, "It's time to redefine the responsibility of all the people who present investment products to the public." She adds that "it's astounding that those big banks in Germany" that bought the securities in the Goldman Sachs case, "didn't do their own due diligence, but of course they had Moody's and S&P rating those securities AAA."

Maybe Cox has the last word in this case so far. He asserts that "IKD asked a lot of questions and the important thing about adding a fiduciary duty is that...IKD made certain things known to Goldman [about] was important to IKD...it was important to IKD about who assembled these; it was important about the quality of the portfolio. There are lots of things that Goldman knew about this that it didn't disclose. It may well be that the SEC is going to be unsuccessful at proving, [the allegations] so exactly, why not have a fiduciary standard that says you've got to turn all the cards face up on the table when you're representing somebody in a transaction."

Comments? Please send them to kmcbride@wealthmanagerweb.com. Kate McBride is editor in chief of Wealth Manager and a member of The Committee for the Fiduciary Standard.

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