Is FINRA Suitable?

A reluctant bridesmaid FINRA is not.  The painful minuet that we’ve seen over the years of Wall Street's regulator denying an appetite for advisor regulation is over and done. 

Ever since the financial crisis presented an opportunity to reshape regulation of investment advisers, the Financial Industry Regulatory Authority has been inching its way forward to seize the bridal bouquet, most recently in a Nov. 2^nd letter to the SEC. 

Despite recent publicity of FINRA’s one-sided courtship, the notion of having Wall Street’s primary self-regulatory organization oversee investment advisers goes back decades. 

In 1989, at the request of the SEC, FINRA’s predecessor organization, the NASD, conducted a pilot examination program of its dually registered broker-dealer/investment advisers.  Not surprisingly, the financially strapped federal agency readily concluded that the NASD would be a suitable regulator for the rapidly growing advisor industry.  Acting with aplomb, NASD volunteered to serve as the SRO for all investment advisers. 

For various reasons, this backdrop did not stir up much controversy, perhaps due in part to a less-organized advisor lobby.  SRO legislation was advanced by the SEC beginning in 1989, but the effort failed in Congress, due mostly to partisan gridlock.  Eventually, with the Republicans gaining control of both Houses in 1996, compromise legislation passed, divvying up advisers between the SEC and states. 

While the SRO debate did not stop, it was relatively muted for years, until the financial crisis in 2008 changed the political dynamics.  One of the provisions inserted in the final Dodd-Frank Act, presumably with the encouragement of FINRA, was a study on enhancing investment adviser exams.  When the SEC reports back to Congress later this month, we can expect to see a recommendation for "one or more SROs" to oversee investment advisers.  Don't bet on a proposal from the Chicago Stock Exchange.

In the meantime, it might be helpful to look at the NASD’s performance record of regulating advisors in practice.  Although we do not know what criteria the SEC relied on in 1989 to evaluate the success of NASD’s pilot program, we can nonetheless look at a convenient proxy today, which would be the NASD's oversight of fee-based advisory programs from 1999 to 2007. 

Touted by the SEC as a way to enhance investor protection, the fee-based programs were granted an exemption from the Advisers Act under the reasoning that charging fees instead of commissions would more closely align the financial interests of registered representatives with their customers.  As a result, proponents argued, brokers would be less inclined to generate commission revenue through unnecessary trades.  Moreover, by charging a flat fee, most programs offered customers additional flexibility through unlimited trading in these accounts.

As a Dec. 6, 2010, letter from FINRA to the Commission reveals, however, fee-based accounts were no panacea.  Asked by the SEC to provide details on an abusive practice in fee-based accounts known as ‘reverse churning’ – ironically doing nothing -- the FINRA letter detailed some surprising results. 

The NASD sweep was conducted in the mid-2000s and covered 25 brokerage firms sponsoring fee-based programs.  Ten of the firms were found to have compliance problems, which resulted in $7.4 million in fines and $9.5 million in restitution to thousands of clients.

Some of these problems were found much earlier, though, beginning with a sluggish response by the NASD to its new oversight responsibilities.  Content in the belief that its intensive rules-based regimen was superior to a principles-based fiduciary standard, or perhaps buying into industry rhetoric that the fee-based rule merely continued regulation of traditional full-service brokerage programs, it took NASD several years to discover, or at least report, the problems that it had uncovered.  In November 2003 it finally issued a warning to member firms detailing a host of problems, including reverse churning, unsuitable placement of unqualified customers in fee accounts, misleading advertising, and failure to supervise.  Customers with these accounts, the NASD said, would have individually saved thousands of dollars by holding these same assets in commission accounts. 

It is interesting to see how NASD translated the rhetoric underlying its suitability standard into practice.  Certainly, all of the violations cited by the NASD would have been fiduciary breaches, given the implied suitability requirements of a fiduciary.  However, during the belated sweeps of fee-based programs 3-6 years after the rule was put into effect, crude quantitative measures were employed by FINRA to determine suitability.  In essence, reverse churning violations were based on an absence of any trading activity in a fee-based account for at least eight consecutive quarters.  In case you’re not counting, that’s two years of being paid without giving advice – not exactly the kind of practice that would meet a fiduciary standard of due care.

Compliance problems were compounded by some brokers, according to the NASD, who ‘double dipped’ by placing Class A or B shares in fee-based accounts.  In its recent letter to the SEC, FINRA did not mention the other, potentially catastrophic losses that would have been experienced by investors sold technology stocks at the height of the bubble.  Since most of the fee-based programs utilized basic asset allocations, these unfortunate investors did not have the benefit of periodic rebalancing since discretionary accounts were prohibited under the rule. 

To make matters worse, in some instances asset allocation recommendations from the back office were completely ignored by brokers, according to fiduciary advisers who later worked with some of the victims.  Brokers intent on chasing performance in sector investing were often working other day jobs after the tech bubble burst.  Since a fiduciary duty to diversify assets is not a default standard under the NASD’s “high standards of commercial honor and just and equitable principles of trade,” no breach would have occurred.  Thus, trapped in its own arguments regarding the advantages of a suitability versus fiduciary standard, the NASD diluted investor protection under a rule designed to enhance it.

In political terms, as an energetic proponent of the fee-based rule, NASD had its own conflict of interest regarding the rule's problems.  If the NASD had energetically publicized the compliance problems – the SEC also did not mention the compliance issues in its many public releases on the rule – NASD might have lost jurisdiction over an important book of business.  Ironically, most of the 1 million customer accounts and $300 billion in assets were eventually transferred to direct SEC oversight after a court vacated the rule for other reasons.

Exacerbating the NASD’s own conflicts was its turning a blind eye to violations of the Adviser Act’s restrictions against special compensation, thereby undermining one of its own complaints about regulatory ‘gaps’ in the securities laws.  In one significant action taken by the NASD against Morgan Stanley for fee-based program violations, NASD disclosed that Morgan Stanley began offering its fee-based program in 1996, three years before the exemption was even proposed.  Other firms acknowledged, in affidavits provided to the SEC as the result of a legal challenge of the rule, that their fee-based programs also were started much earlier.  As a regulator that points with pride to its stringent, two-year examination of brokerage firms, how could the NASD have missed this one?

Today, it is unclear how a FINRA-run SRO would apply a fiduciary standard.  No pronouncements have come from FINRA leadership, other than a motherly embrace of a fiduciary standard and a pledge to involve consumers and investment advisers in its governance structure.  (FINRA fails to mention that 88 percent of all investment adviser representatives are affiliated with broker-dealers, another red flag to a potentially conflict-ridden process.) 

Some of the questions that should be considered by policymakers:

• Given its past regulatory actions involving fee-based programs, would FINRA assess an advisor’s duty of care and utmost good faith based solely on trading activity?
• How would the SRO determine reasonable compensation in light of other advisory services, such as charitable giving, risk management, budgeting and cash-flow analysis, that are offset by asset managment fees? 
• If the SEC imposes a fiduciary standard on brokers, which is limited to providing 'personalized investment advice' under Dodd-Frank, to what extent, if any, will the fiduciary standard apply if a broker subsequently churns the account?
• Would the SRO be willing or have the authority to adopt a default duty to diversify investment accounts, similar to the fiduciary duty under state trust laws?
• As other regulators begin to rely increasingly on Investment Policy Statements to assess fiduciary conduct, would the SRO be willing to do the same?

A regulator's perspective of practical day-to-day management of fiduciary conflicts, not banal statements of support for all things fiduciary, should be offered before Congress moves forward on this SRO proposal. 

Comments

[John Hawkes]

The fact that no trades did not occur does not mean that no advice was given. After a review the "advice" to remain the same is always valid. Having said that there are many accounts that have little activity in the RIA world.