Registered investment advisors may end up getting to know a new regulator, but the tougher fiduciary standard they live under will be extended to cover their broker-dealer rivals. That's the likeliest scenario after the SEC released a pair of long-awaited reports in January.
While RIAs are happy about the uniform standard of conduct, they are less pleased by the prospect of oversight by FINRA. "I fear regulation by FINRA because the regulatory burden would be unbearable," says Bob Christenson, CFP, an investment advisor at Net Worth Advisory Group, a fee-only planner in Sandy, Utah. The Investment Adviser Association (IAA), representing RIAs, issued a statement decrying a "lack of transparency and accountability of non-government regulators" from a self-regulatory organization (SRO), like FINRA. RIAs with $25 million or more in assets are currently regulated by the SEC, while their smaller cousins fall under state jurisdictions.
The first SEC study, on examining RIAs, complains that the agency doesn't have the firepower to do the job right. While it doesn't call for FINRA to take over outright, it says an SRO would be a good substitute. The study, mandated under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, also suggested another option-that the SEC hire extra examiners and retain jurisdiction over RIAs, paid for by charging them user fees. Many advisors would no doubt be in favor of this approach.
The SRO option seems easiest to implement, however, and some suspect the SEC favors a FINRA solution. The action now shifts to Congress, which has the power to transfer advisor regulation from the SEC to FINRA. Expect a fierce lobbying battle to ensue.
But advisors got some good news from the second Dodd-Frank-required SEC report, issued two days later, proposing that broker-dealers be subject to the fiduciary standard. RIAs currently operate under the more stringent fiduciary precept. It's up to the SEC whether to subject brokers, many of whom like to call themselves "financial planners," to the fiduciary standard. Placing both under that common code likely would benefit investors, forcing brokers who are pushing merchandise to change their ways. It also could be a competitive advantage for RIAs, who have been working under the fiduciary standard all along.
To some, it would not be such a bad tradeoff to have RIAs regulated by FINRA and brokers falling under a fiduciary regime, the outcome that the odds at this moment suggest. "It's really a compromise," says Don Trone, founder of Strategic Ethos, a consulting firm in Mystic, Conn. "Advisors win the battle on fiduciary and lose on who will regulate them." Numerous RIAs, however, believe the tradeoff would hurt them, with the fiduciary-provided marketing edge overshadowed by living under broker-dominated FINRA's oversight.
FINRA openly favors expanding its purview to cover advisors. Richard Ketchum, the authority's chairman, argues that since the SEC lacks the resources to regulate advisors, only a group with the heft of FINRA can get things done. FINRA says it has 1,000 examiners-more than double the SEC examiner force-and possesses the experience in enforcement and licensing to assume the SEC's oversight duties for advisors.
In a letter to the commission, using SEC numbers, Ketchum notes that 55% of broker-dealers are examined yearly and, due to thin SEC staffing, only 9% of RIAs. Plus, he points out, the Dodd-Frank Act, passed last summer to tighten the reins on financial services firms, has loaded new responsibilities onto the SEC, such as regulating hedge funds and municipal advisors, which will strain the agency's resources even further.
FINRA's intentions strike many advisors as being akin to a lion's graciously worded dinner party invitation to a gazelle. "We'd hate to see FINRA get this job," says fee-only advisor Christenson. He and other advisors object to what they see as FINRA's stultifying devotion to endless rules and paperwork requirements. Christenson, a onetime broker-dealer, recalls that back then he needed to file reports every time he received an investor check-and expects that will be the case if FINRA governs advisors. "I'd rather not have my client time eaten up," he says.
Broker-dealers chafe under the burden of FINRA rules, as well. Edward M. Lynch, managing director at Deitz & Lynch Capital in Newburyport, Mass., has both brokers and RIAs under his roof. "Sometimes the rules make no sense," he says. His firm has started a 401(k) program for a small company and has had to deliver a dozen prospectuses, for each of the fund alternatives, to all the employees.
FINRA will not comment on complaints that it overburdens financial professionals with rules. But an official with the Financial Services Institute (FSI) says that although it fights to end needless and repetitive regulations for its broker-dealer members, FINRA's rules-based approach is needed to protect investors.
"Since FINRA's examiners see brokers every year, they see trends and attempt to address them with new rules," says David Bellaire, general counsel for the FSI. Since the SEC examines RIAs less often, it is not as aware of problems, he adds-and tighter regulation of advisors is needed to fix these shortcomings.
Operating under FINRA would put advisors at a competitive disadvantage, some of them fear. "The FINRA board would love to control the regulatory structure of broker-dealers' biggest competitors, the independent RIA firms," says planning industry expert Bob Veres, who believes that FINRA is too close to the brokers it regulates. The board "would create a regulatory landscape that would make it much more difficult for that competition to thrive."
FINRA dismisses all the advisor hand-wringing, however. Ketchum, in his letter to the SEC, points out that the agency still will review FINRA decisions, and that advisors will sit on the organization's board. FINRA would set up a separate affiliate to handle RIAs, he says.
Showing how deep RIA antipathy toward FINRA runs, some in the advisor community perceive an SEC plot to hand them over to the SRO's ministrations. "FINRA has friends at the SEC," says David Tittsworth, executive director of the IAA. "That's no secret."
Indeed, two of the five SEC commissioners have ties to FINRA. Chair Mary Schapiro previously served as head of FINRA, and received a $9 million pay package upon departing. And Elisse Walter was a FINRA official before becoming a commissioner. The SEC won't comment on these suspicions: A spokesman responds that all it will say about the RIA regulation issue is already in its study.
Meanwhile, the newly Republican-controlled House also could prove a friend to FINRA. During deliberations over Dodd-Frank last year, Rep. Spencer Bachus (R-Ala.), now chairman of the House Financial Services Committee, offered an amendment allowing an SRO to regulate the 22% of investment advisors also registered as broker-dealers. Democrats, then in command of the House, stripped out this provision before passage. A Bachus spokesperson did not respond to questions about what the new chairman has in mind next.
Few expect any RIA transfer to FINRA, if that happens, to begin soon. It would take a while for the legislation to wend through Congress, for the SEC to hammer out the accompanying rules and for FINRA to apply and gear up for the new responsibilities. "We are probably looking at a several-year process," Bellaire says.
What about the user-fee alternative? As the first SEC study notes, imposing user fees on RIAs would give the agency the money to bulk up its RIA regulatory force-and avoid shunting advisors over to FINRA. At present, the commission is mainly funded through congressional appropriations, meaning its budget must traverse a political gauntlet. User fees would give the SEC a perpetual fountain of funding not subject to lawmakers' whims.
Many planners, however reluctantly, would rather pay fees than be subject to FINRA. "It's the better option," Tittsworth says.
An expanded SEC examiner force is preferable because the agency knows how to oversee RIAs and won't have to start from scratch, advisor advocates argue. "They've been doing this for 70 years," says Dan Barry, managing director for government relations at the FPA. "It's more efficient to use the existing infrastructure."
Trouble is, winning congressional approval for user fees may be an uphill battle that the SEC is hesitant to wage. The agency's clout in Washington is limited, given its record of policing a wayward pre-crisis Wall Street.
And the reception of Capitol Hill Republicans, thinking user fees are a disguised tax, is chilly, says Brian Hamburger, managing director at MarketCounsel, an Englewood, N.J., consulting firm. The Wall Street Journal's editorial page, highly influential in Republican circles, slammed user fees as "a never-ending source of SEC funding, regardless of performance."
It looks like advisors may get stuck with a regulator they dislike. But that second SEC study, calling on the commission to impose a fiduciary standard on broker-dealers, seems like a clear win. This standard compels advisors to act in their customers' best interest. Brokers are now held to the less-strict precept of suitability, which permits them to push their firm's inventory even if better alternatives exist.
This is a controversy that has swirled for a long time. Many RIAs take umbrage that some brokers call themselves "financial advisors," even though they actually function as salespeople. Advisors who concentrate on enlarging clients' pies instead of selling them the individual ingredients, believe they serve their clients better. "No man can serve two masters," says Gregg Fisher, CFA, CFP, president of fee-based planning firm Gerstein Fisher & Associates in New York, referring to brokers and their clients.
Generally, RIAs, who draw up financial plans for clients, are paid by charging a fee, often an annual percentage of client assets. Brokers make money through commissions on selling individual securities and mutual funds, so flying the seemingly impartial banner of financial planner helps their business. Often the public doesn't know that brokers "are not operating at a fiduciary level of care," says Marilyn Mohrman-Gillis, managing director of public policy at the CFP Board of Standards.
The advisor community greeted the SEC fiduciary study with glee. "This is a welcome surprise," says Nancy Hradsky, special projects manager at the National Association of Personal Financial Advisors (NAPFA). "It gives an additional level of protection for clients, especially the elderly." (NAPFA, the CFP Board and the FPA have banded together to form a group, called the Financial Planning Coalition, to represent advisors' point of view in Washington and elsewhere.)
The reaction from brokers is more muted, and their organizations give it wary support. Outright opposition to the proposal is hard to find, perhaps because after recent scandals, a higher level of care for investors is hard to criticize. Broker-dealers warn that complying with fiduciary rules might be more expensive for them and thus hurt competition with advisors. The FSI says the SEC must put out clear guidance to keep costs down and "retain access to services" for investors.
Sales-oriented financial pros focus on the possible practical problems of lumping two different business models under a common principle. "There is no standardized definition of fiduciary," says Terry Headley, president of the National Association of Insurance and Financial Advisors, which represents insurance agents. A position paper from the Securities Industry and Financial Markets Association (SIFMA), another brokers' organization, says that the fiduciary standard should apply solely when a client is receiving "personalized financial advice." The SIFMA-proposed exception would allow for one-shot transactions, presumably such as letting brokers sell a client enormously risky Greek sovereign debt if he or she insisted on it, without raising regulatory alarms.
Dual registrants, who are both brokers and RIAs, are more enthusiastic about the fiduciary standard, as they already follow it. At LPL Financial, the largest broker-dealer, the vast majority of its reps are dual registrants. Chairman Mark Cassady released a statement supporting a uniform fiduciary standard, saying "we welcome the clarity that the January SEC staff report brings" to the industry.
For RIAs, the potential marketing advantage of imposing a fiduciary standard on brokers is potent. Brokers "will still be selling financial products, and under fiduciary standards, will have to disclose conflicts of interest," says fee-only planner Jerry Verseput, CFP and president of Veripax Financial Management in El Dorado Hills, Calif. To the public, the differences among RIAs, brokers, insurance agents and others are murky. Once they all are working under a common code, the reasoning goes, the distinction will be sharper and RIAs will look purer.
But imposing this code on everyone might take a long time too. On the surface, momentum would seem to be with the universal fiduciary standard. The SEC has put the study's conclusions on its calendar for the spring. Nevertheless, the long-festering controversy surrounding the standard could delay a change. "The SEC will punt," Tittsworth predicts. "If this had been easy, it would have been done by now."
The two Republican-appointed SEC commissioners, Kathleen Casey and Troy Paredes, filed a dissent to the agency staff's fiduciary report, saying it is incomplete and that more data is needed to make an informed decision. While carefully adding that they are not necessarily opposed to a fiduciary standard, they call for fresh research into matters like the difference between brokers' and advisors' investment returns.
SEC Chairwoman Schapiro could shove through a vote on the question without GOP support, on a 3-2 vote, with her and the two Democratic commissioners in favor. Yet that would risk angering the revitalized Republican Party on Capitol Hill. "Why throw dirt in their faces?" Tittsworth asks.
Eventually, though, putting advisors and brokers under the same regulator and a universal standard of care, even if tailored for separate business models, has a commonsense appeal that should make it a reality. "Convergence of RIAs and broker-dealers, in regulatory terms, is inevitable," Lynch says. But in the meantime, fasten your seat belts.
Larry Light, a former Wall Street Journal finance editor, is author of Taming the Beast, a book on the evolution of investing strategies, due out in June.
One Week, Three Studies
Three studies released in January kicked the regulatory discussion and fiduciary topics into a higher gear. Let's take a look at them:
* GAO Report. Drafted by Congressâ€™ investigative arm, this study, released on Jan. 18, describes consumer confusion over the difference between fiduciary and suitability. It cites, for instance, a 2010 survey showing that 60% of investors believe insurance agents operate under the fiduciary standard. (They donâ€™t.) So the Government Accountability Office (GAO) calls for better consumer education.
The SEC has no notion about the extent of customer complaints concerning advisors as it does not track them, according to the GAO. The study identifies some gaps in regulation, but it concludes that no extra layer of regulation is needed, citing conversations with financial professionals and others. The report gives impetus to policy makers who want to improve existing oversight of financial professionals so that the public has a clearer understanding of the investment advice it receives.
* SEC Regulation Study. Known as the Section 914 report, after the Dodd-Frank section calling for it, this SEC staff study charts how the number of RIAs has grown almost 40% over the past six years, to 11,888, while the number of SEC examiners has dropped slightly, to 460. Released on Jan. 20, the study lays out three alternatives: impose user fees to bolster the SECâ€™s Office of Compliance Inspections and Examinations (OCIE); place advisors under one or more SROs; or go the less-comprehensive route and have FINRA examine the dual registrants.
The SECâ€™s staff makes clear that the OCIE lacks the manpower to cover all RIAs adequately, even though Dodd-Frank mandates that some 4,000 advisors, those managing $100 million or less, will be regulated by the states, rather than the SEC. The impetus of this studyâ€”interpretation by interested parties asideâ€”is that the system doesnâ€™t work and something must be done.
* SEC Fiduciary Study. The Section 913 report, issued Jan. 22, echoes the GAO finding that consumers are confused about the differences between advisors and brokers, and between fiduciary and suitability standards. As such, the SEC staff reasons, the best solution is to move everyone to a fiduciary standard, since that offers the best protection for the public.
It does acknowledge that a one-size-fits-all approach wonâ€™t work for a universal standard. The precise implementation of a fiduciary regimen is left for later. The upshot is that the SEC gets to stand on the side of the angels and be seen as a consumer champion. And the broker-dealer community does not dare oppose them on this prickly matter.
â€œThis industry has a weak regulator,â€ says Brian Hamburger, managing director at MarketCounsel, an Englewood, N.J., consulting firm. â€œNow itâ€™s post time, with a lot on the line.â€