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Regulation and Compliance > State Regulation

Truth and Consequence

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Amid the hubbub over the potential for more regulation of the financial services industry arises an important question: whose interests are being served? The libertarian in me eschews restrictive oversight that smacks of social control, but the protective side wants to save the innocent from the fools and the crooks.

This tug of priorities came to light when I recently participated in an international forum in Prague sponsored by the Convention of Independent Financial Advisors (CIFA). My panel debated the pros and cons of allowing individual investors to make their own investment decisions without consequence to the advisor. The panelists were asked whether this was an unlimited right, and if not, when, and with what justification, should it be restricted. The moderator was Daniel J. Mitchell, PhD, a senior fellow at The Cato Institute.

With frustration building over spurious lawsuits and expensive compliance hurdles for investment professionals, an attitude of caveat emptor was clearly palpable with the idea that clients should know enough about personal finance to smell a problem before it happens. This seems quite different than the prevailing U.S. view.

Individual Rights

The fundamental belief in each individual’s right to freedom resonates well with many Americans. Yet while social liberties have emerged in countries that used to be restrictive, legislators and some bureaucrats have become more involved in our personal and business lives with the blessing of both Democrats and Republicans.

While investors have the freedom to make unsound investment decisions, they may have to forfeit this right if they do not exercise appropriate restraint. When an investor’s actions and those of their advisors put others at risk or negatively impact confidence in the capital markets, we must act to protect the rest of us. We must also safeguard individual rights and try to avoid using the law as a substitute for individual responsibility.

Let’s look at the mortgage crisis. The scores of people who took out adjustable rate mortgages to buy homes they could not afford can be seen as victims of their own bad judgment. They were hurt when interest rates jumped, but many other people anticipated and avoided this risk. While we can blame the individual’s problems on his greed or ignorance, the truth is that all bad acts occurred with a financial professional watching and, in many cases, advising.

In our industry, we know of RIAs as well as registered representatives who, in order to get greater yield, placed clients into preferred shares of funds invested in auction rate securities that are now illiquid. We know advisors of all stripes who recommended mutual funds based solely on historical performance.

Headline Risk

The negative headlines about the liquidity crunch and subprime mortgages reveal that no matter how doltish individual investors are, the entire financial services industry gets slammed when problems arise. Somebody who knew something should have done something! Moreover, the general marketplace, the media, and legislators do not differentiate between the different flavors of those who provide financial advice. Securities brokers, banks, financial planners, investment advisors, and wealth managers are all splashed by the muddy puddles of out-of-control investment vehicles.

The financial services industry contains multiple regulators and regulations depending on your business model. FINRA, the SEC, the OCC, and insurance and securities regulators in every state all touch us as either consumers or practitioners. The cost of compliance is probably the fastest growing expense in broker/dealer and registered investment advisory firms, and eventually these costs get passed on to the public.

New rules arise after critical events. The Great Depression spawned the Securities Act of 1930 and the subsequent Act of 1934. The Sarbanes-Oxley Act of 2002 emerged out of major corporate and accounting scandals such as Enron. The USA PATRIOT Act was created to intercept terrorists after the horrific attacks of 9/11.

Unintended Consequences

In spite of a myriad of rule makers and enforcers in our daily lives, the Bush Administration in the person of Treasury Secretary Henry Paulson is now advocating for a super-regulatory structure for finance. These omnibus measures are intended to clarify management and build confidence that transgressions are monitored. But the law of unintended consequences often comes into play with such wide-ranging initiatives, including rising costs, restricted markets, and limitations on individual rights.

Alongside the proposal for a new financial services authority, the SEC is questioning whether RIAs should be subject to more rigorous examination. Many advisors say that one of the compelling reasons for moving out of a broker/dealer into the RIA business model is to avoid supervision under the Financial Industry Regulatory Authority (FINRA). Ironically, their expressed desire to evade the enforcers helped put RIAs on the SEC’s radar screen. Despite the merits of the argument on which they prevailed, the Financial Planning Association (FPA) lawsuit against the SEC over the broker/dealer exemption rule contributed to a heightened awareness of unequal supervision of the business models. While it used to be possible to argue that compensation for one was fee-based and the other was transaction-based, now that broker/dealers have created or facilitated the emergence of investment advisory practices under their domain (see this month’s cover story, p. 46), this position rings hollow.

Some believe that FINRA should act as a self-regulatory body for RIAs. An opposite view being promulgated by the FPA and NAPFA is to create state-by-state SROs much like those in the accounting profession. The latter opposes FINRA’s focus on transactions, while the SEC may believe FINRA should perform the oversight because most fraud, deceit, and manipulation actually occur during transactions, not in the planning process.

While RIAs are not normally compensated based on which securities they buy or sell, opportunities for bad faith, conflicts of interest, and diversion of capital exist for those intent on enriching themselves at the expense of others. As practices get bigger and the span of control gets stretched, the possibility of abuse rises that may not be caught in a three-year audit cycle.

The good news: both sides recognize the need for better monitoring. Unfortunately, greater oversight could potentially marginalize many smaller firms that already struggle under the weight of compliance and paperwork. Should the FPA prevail in the state-by-state approach to governance, the burden could become even more onerous as many advisors serve clients in multiple states, requiring multiple registrations and multiple examinations. But either way, all parties must ask the question: What problem are we trying to solve?

I submit the problem we are trying to solve is to ensure we have a discipline in place to help us anticipate major transgressions before they occur and to protect individual investors from unscrupulous or incompetent purveyors of financial solutions. This may help to focus the regulations on stopping bad acts as they are being committed, rather than focusing solely on punishing bad acts after the trail is littered with the financially and emotionally broken victims.

Simplify This

The overlapping and sometimes contradictory rules of competing regulatory bodies overwhelm financial professionals and baffle the investing public. As one of my fellow panelists at the CIFA conference put it, “you cannot fight complexity with complex mechanisms.”

All the arguments and splitting of hairs over who should regulate whom tends to overshadow the best interests of the client. Simplicity would be one solution, along with a coherent approach to industry regulation that eliminates duplication, fosters trust and confidence in the capital markets, and clearly outlines reasonable expectations of both consumer and advisor.

Whether regulated by FINRA, the SEC, or state authorities, advisors will need to recognize common ground and move for a logical regulatory plan that allows them to manage their businesses without a greater burden of compliance, but with a firm approach to verification and transparency that protects the consumer from acts of bad faith.

I am on the fence as to whether there should be a super-regulatory authority for all of financial services or whether RIAs should have an SRO. I am still processing the debate over which is best for the consumer and the industry. But I fear that in this crisis moment the government will enact policies and procedures as yet another (perhaps duplicative) remedy for the behavior of certain people who should have known better.

Leaders in the business of providing investment advice, including association boards, should steer away from emphasizing the differences in practice models in this debate and focus on the benefits to individuals desiring professional guidance. Highlighting business models may prove effective in a marketing context, but may be counterproductive for RIAs when the perception is that consumers are at risk. In the end, trust is the most valuable currency this industry has. Debates about issues that mean nothing to the public only serve to confuse and annoy people who want to know that the majority of practitioners have their client’s best interests in mind. Those who do not will incur the wrath of the regulatory bodies, and ultimately the courts.