Greetings from the world of 2011. I'm writing this column to help you address the issue on the minds of investors and consumers everywhere in your future day and age: How can we finally fix the regulatory system after the latest traumatic events shook the markets to their core?
How could the brokerage industry have done so much damage so quickly? Wasn't it barely a decade ago that the very same firms brought capitalism to its knees?
We, too, asked ourselves these questions in the aftermath of 2008. Go back in your history books to 2000, when the brokerage industry disgraced itself with the tech stock analyst scandals, with using IPO shares as bribes to favored customers, with front-running mutual fund returns to defraud investors and with hiding Enron's liabilities in tricky off-balance-sheet investment entities. The dust had hardly settled on convictions, regulatory sanctions and settlements before whole brokerage groups were packaging and selling toxic mortgage pools to their best customers.
I don't yet know the details of your debacle. But I can tell you the underlying root cause of it and the ones that preceded it.
If you're taking notes, write this down: Whenever we allow representatives of product manufacturers and brokerage houses to give self-serving investment advice to consumers-and especially when we let them pose as consumer-friendly professionals-their employers will find endlessly clever ways to distribute junk investments into consumer portfolios and siphon money from hard-working Americans into their bonus pools.
Congress and the regulators actually came to this conclusion as they were sifting through the ruined economy of the 1930s. They passed the Investment Advisers Act of 1940 as a way to help the public distinguish between (this is the wording in the legislative notes) "honest advisers" and "stock touts." They decided that honest advisors should be held to a principles-based standard that was unambiguous; in their dealings with their clients, they were required to watch out for the interests of their clients-period.
Brokers were held to a different standard, and the differences are not subtle. In our time period, perhaps also in yours, brokers often joke with one another about gussying up investments to look more attractive than they really are, putting lipstick on the pig. If the standards of the 1940 act had been applied to brokers, this behavior would violate the regulatory code instantly.
In my time, we've watched the brokerage community systematically obscure the distinction between those who must watch out for client interests and those who can get away with selling junk to customers. They stopped referring to their sales reps as "brokers," instead calling them "investment advisors," "financial advisors and planners," and "vice presidents of investments."
Meanwhile, under the rules-based system governing brokers, administered by FINRA, there was no impediment to creating and selling pools of junk mortgages. We can see it now so clearly: If brokerage firms had been required to live up to the principles-based fiduciary standard of the 1940 act, none of those highly profitable investments would have passed their own smell test.
We can't put all the blame on the brokerage community; what we're talking about is a manifestation of human motivation and behavior. If you give corporate executives a chance to reap huge profits by finding perfectly legal ways to have their representatives slyly pose as agents of the consumer, they're going to take that opportunity every time-particularly when the rewards are generously distributed into their bonus pools.
It happened to investors in the 1920s and 1930s, it happened many times thereafter, especially in 2000 and 2008. It happened to you, and it will happen again unless you get smart about finally fixing the problem.
In our age, we already knew the solution-extend the registration requirements of the 1940 act to brokers and anyone else who makes a living giving investment advice to consumers. You know that, too-and many honest brokers would welcome this change. Yet you also know that instead of doing so, we actually took several steps backward. The SEC began systematically replacing principles with rules and then misleadingly called this set of compromises a fiduciary standard.
How did this happen? Let's look at the SEC bosses and how effective they were at protecting citizens from predators coveting their retirement money. We don't know what, if any, backroom deals were made with whom, but it is not hard to see that, as we were picking up the pieces from the 2008 scandal, former FINRA CEO Mary Schapiro and former FINRA executive Elisse Walter ably served the core interests of the brokerage industry as SEC chair and commissioner.
Right before they accepted their new responsibilities, FINRA gave them hefty severance packages. Looking back, you'll see how deftly they transferred the oversight of today's "honest advisor" to the brokerage community's regulatory organization. Meanwhile, they replaced the unambiguous principles-based regulation with rules that could be finessed. Their primary goal was not to protect consumers, but to protect the brokerage business model, and in that they were a great success.
This set the stage for the market catastrophe that plagued you, my readers of the future. If you do nothing else, remember those names, remember their agenda and know to watch for this same trick again.
It will not be easy to undo the damage and build a principles-based standard of conduct for everybody who provides financial advice. In addition to the brokerage firms, you will also have to fight the best lobbying efforts of the independent broker-dealers, whose trade organization, in our age, strongly endorsed FINRA and its rules-based regulatory scheme.
WHAT TO DO
As you pursue a fiduciary agenda, you will hear shrill cries that there aren't enough resources to oversee advisors. My best advice is to ignore them.
Instead, begin to create real, meaningful oversight of advisors, replacing the manifestly unproductive busy work that the SEC engages in today. In my day and age, the SEC's average RIA compliance employee manages to inspect just 2.3 advisory firms a year. And yet the SEC chair is screaming for more resources and asking the states to take over the burden of inspecting the majority of advisors.
You can streamline this stupefying lack of productivity by having the regulators spend more time with advisors who have embraced more conflicts of interest. Have the inspectors start with a few simple questions.
Is client money directed to a custodian so that the advisor never has a chance to touch it? Do clients receive duplicate statements from those custodians? Are client portfolios simply allocations of mutual funds and individual securities? Those questions, plus a fact-check call to the custodian, should answer most of what you need to know about 95% of the RIA firms in your marketplace.
The inspector should check the compliance manual and the advertisements (to see if outrageous claims are being made). He or she should ask for a CRM dump of books, records and trade blotters to ensure that everything is being tracked according to the rules.
If the inspector spends more than a day in that office, a stern supervisor should be asking why. However, if the advisory firm self-custodies, if there are significant commissions involved in the recommendations, if there are esoteric investments in client portfolios, if marketing materials make outrageous claims, then the field examiner should call in a forensic accountant, who should be able to determine within the week if any consumers are being ripped off.
Most of all, understand that we, here in your past, have gone through the process you're facing now. Unfortunately, we failed to prevent human nature from taking its course all over again.
Learn from our mistakes, and remember in your history books those who followed the sly, sneaky agenda of replacing clear principles with rules. Recognize the lasting pain of your parents, friends and neighbors as their dollars vanished into the pockets of financial predators. Feel outrage that this could be done legally so soon after it happened before.
Above all, understand what we did not: This is far too important to get it wrong again.
Bob Veres is editor of Inside Information (www.bobveres.com), which helps advisors keep themselves and their practices on the cutting edge of the profession.
Register or login for access to this item and much more
All Financial Planning content is archived after seven days.
Community members receive:
- All recent and archived articles
- Conference offers and updates
- A full menu of enewsletter options
- Web seminars, white papers, ebooks
Already have an account? Log In
Don't have an account? Register for Free Unlimited Access