More On Legal & Compliancefrom The Advisor's Professional Library
- The Few and the Proud: Chief Compliance Officers CCOs make significant contributions to success of an RIA, designing and implementing compliance programs that prevent, detect and correct securities law violations. When major compliance problems occur at firms, CCOs will likely receive regulatory consequences.
- Whistleblowers A whistleblower is any individual providing the SEC with original information related to a possible violation of federal securities law. The Dodd-Frank Act established a whistleblower program that enables the SEC to reward individuals who voluntarily provide such information.
The very public goodbye letter from Mr. Greg Smith to his employer, Goldman Sachs, in March touched off a firestorm of comments, opinions, and reflections. These comments are divided into two groups. The first group takes the position that Goldman is emblematic of all that is wrong with Wall Street today and something needs to be done to restore trust. The second group, albeit much smaller, is dismissive of Mr. Smith and suggests that in the free market system a natural order will prevail.
In the court of public opinion, Mr. Smith has the upper hand with Goldman losing over $2 billion in market value on the day his diatribe was released to the The New York Times even though he clearly states that he knows of no "illegal activities" being conducted by the firm. After reading Mr. Smith's words, it is instinctual, if not with the appropriate dosage of moral certitude, for a casual observer to support Mr. Smith.
Being in the securities industry, I suggest looking at this issue with a different lens: this self-created news should serve as a poignant case study about the much wider debate of applying the fiduciary standard to all who offer professional investment advice. The Smith-Goldman affair demonstrates the immense and natural support for a "client's best interest" instead of a "zero-sum-gain" standard and the public confusion about the current applicable standards. It is important to state that I take Mr. Smith at his word that his observations, experiences and feelings are not exaggerated and that he has no ulterior motive other than using The New York Times opinion section to express his frustrations.
This latest episode punctuates the ongoing debate about the proposed rulemaking by the Securities and Exchange Commission to close any regulatory gaps and to unify standards of conduct between broker-dealers and investment advisors when providing personalized investment advice and recommendations about securities to retail customers. Contemporaneously, the Department of Labor has introduced, withdrawn, and re-proposed the introduction of a redefinition of fiduciary under ERISA. The DOL intends to tighten the definition and apply the ERISA fiduciary standard to IRA accounts so that more investment professionals must be held accountable for their advice as a fiduciary.
Goldman Sachs has four business segments, according to its own website: investment banking, investing and lending, institutional client services and investment management. These business segments can be divided into the broad universes of broker-dealer services or investment advisory services from a regulatory basis (to keep this discussion simple, banking, CFTC, and other regulators and regulations are not addressed). According to the January 2011 Study on Investment Advisers and Broker-Dealers by the SEC Staff, "[t]he regulatory schemes for investment advisers and broker-dealers are designed to protect investors through different approaches. Investment advisers are fiduciaries to their clients, and the regulation under the Advisers Act generally is principles-based. The regulation of broker-dealers governs how broker-dealers operate, for the most part, through the Commission’s antifraud authority in the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act), specific Exchange Act rules, and Self Regulatory Organization (SRO or FINRA) rules based on Exchange Act principles, including (among others) principles of fairness and transparency."
The Study went on to state that, for broker-dealers, "[u]nder the antifraud provisions of the federal securities laws and SRO rules ... relating to just and equitable principles of trade and high standards of commercial honor ... are required to deal fairly with their customers. [B]roker-dealers are subject to ... requirements that are designed to promote business conduct that protects customers from abusive practices, including practices that may be unethical but may not necessarily be fraudulent. An important aspect of a broker-dealer’s duty of fair dealing is the suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the interests of its customer.”
Broker-dealers also are required under certain circumstances, such as when making a recommendation, to disclose material conflicts of interest to their customers, in some cases at the time of the completion of the transaction."
On the other hand, "[a]n investment adviser is a fiduciary whose duty is to serve the best interests of its clients, including an obligation not to subordinate clients’ interests to its own. Included in the fiduciary standard are the duties of loyalty and care. An adviser that has a material conflict of interest must either eliminate that conflict or fully disclose to its clients all material facts relating to the conflict"
When the public reacted to Smith's words, they were not only disgusted by the alleged violation of trust and confidence, distorted priorities and a questionable business moral compass but by the fact that Goldman Sachs does not place clients' best interests first and treats clients as nothing more than naive fat wallets upon which to be preyed. This reaction may indeed be appropriate on a prima facie basis, but upon closer examination, the applicable regulatory standard for Goldman Sachs' conduct tells a very different story. And it is this story that either the public is willing to understand, accept and live with or insist on an alternative rule of conduct.
Mr. Smith was a mid-level executive in Goldman Sachs' London office selling derivative products to institutions and not delivering investment advice. In the U.S. his conduct must adhere to the FINRA suitability standard if he is dealing with retail clients. The suitability standard is a commercial transaction standard of fairness and transparency between willing buyers and willing sellers and is based on just and equitable principles of trade and high standards of commercial honor. Terms such as anti-fraud, fair-dealing and suitability obligation form the basis of this rule-based standard.
Under FINRA Manual Section 2111(a), the broker "must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile... and any other information the customer may disclose to the member or associated person in connection with such recommendation." According to FINRA, the suitability rule is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.
In its manual, FINRA further states three obligations that make up the suitability standard.
1) Reasonable-Basis Suitability. The broker should have an understanding of the potential risks and rewards associated with the recommended security or strategy before the broker can recommend the same security or strategy, so long as the broker has a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.
2) Customer-Specific Suitability. The broker should have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer's investment profile.
3) Quantitative Suitability. The broker should have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, is not excessive and unsuitable for the customer when taken together, in light of the customer's investment profile
The fiduciary standard applicable to investment advisors is significantly and materially different. It is a principle-based standard of always serving in the client's best interest with due care and good faith. In the event of an unavoidable conflict, the advisor must disclose fully and completely so that the client understands the material impact of the conflict.
If Mr. Smith is a broker dealing with a retail customer in the U.S., the FINRA basic standard of conduct under its suitability rule applies. He would not be expected to meet a duty of loyalty or to serve in the best interest of the client. After all, suitability is a basic fair dealing standard for commercial transactions. Although he may romanticize and long to restore the old Goldman Sachs corporate culture, real or imagined, from a regulatory framework he would be barking up the wrong tree.
In the retail investment world, broker-dealers are trying to sell a financial product or strategy for a profit. The end goal of the broker is to effect the desired transaction in order for the broker-dealer to receive the revenue and for the broker to be compensated. The broker has a duty of loyalty to his employer, the broker-dealer firm. As long as the three FINRA suitability obligations have been met, any information delivered in promoting the use or implementation of the investment product or strategy would often be thought of as investment advice.
In this case, the advice is the "means" or the path and the completion of a transaction is the "end" or the desired outcome. In contrast, an investment advisor delivers advice as an end and all investment transactions are means to fulfill that end. This does not suggest that a broker is not capable of or has the ability to offer investment advice, but the client must be cogently aware that the advice may be path dependent.
In the case of Smith-Goldman, institutional clients or counter-parties understand or should understand that Goldman is not a fiduciary advisor to them when Goldman is selling or promoting a financial instrument. If a client needs advice on a transaction with Goldman or any other seller of investment instruments, the client would engage the services of an investment expert to scrutinize Goldman's proposed commercial transaction for the best interest of the client.
I believe that the general approach of using commercial transactional standard of suitability remains sound under a sales transaction. However, applying the fiduciary standard should be the only approach when investment advice is given Retail clients are often ignorant of, or purposefully confused by, the differences between a counter-party (broker) whose mission is to complete a financial transaction and an adviser offering advice in the best interest of the client.
The duality of our regulations significantly contributes to this dangerous and often confusing state of affairs. The current regulation is far too accommodative to those offering conflicted advice. Can one truly believe in the advice of a physician who prescribes medications that he also sells? How about if the advice of a litigation attorney, as a condition of service, requires the plaintiff to purchase an annuity contract from him to fund the structured settlement? We expect the ‘best interest’ standard from our physicians and attorneys, and we should demand the same standard when we seek investment advice.
Many practitioners are frustrated and worried about the status quo and fear that we will have more regulations as a result. If history is a guide, regulations and laws tend to increase in response to a systematic erosion of trust in a system. Unless we restore trust, the system will rely on more regulations as a substitute.