For years, stockbrokers have routinely stepped over the regulatory boundary that divides traditional brokerage activities from investment advisory activities. By taking advantage of regulatory loopholes, brokers have been able to offer investment advisory services while avoiding being held to the regulations and standards that govern investment advisers. Provisions of the Dodd-Frank Act are effectively forcing brokerage firms to convert their retail operations to the investment advisory model. But brokers need not worry, it looks like “the fix is in.”
There has been a lot of focus on how brokers will make this transition – will they be forced to separate their trading activities from their advisory business and how will brokers deal with the fiduciary standard that investment advisers are held to? These issues are nothing more than a sideshow. Trading functions can be walled off and the brokerage firms know that they can get around the fiduciary standard through disclosures. The real problem for brokerage firms is that they won’t be able to self-regulate when they formally step into the investment advisory world.
FINRA
Currently, brokerage firms are regulated by the Financial Industry Regulatory Authority, or FINRA. FINRA is a Self-Regulatory Organization (SRO) that is run by its members (brokerage firms) for the benefit of its members. FINRA, under the supervision of the SEC, writes, interprets and enforces the rules that govern the brokerage industry – it’s the classic case of the fox guarding the hen house. It can’t be ignored that for years Bernard Madoff was one of the head honchos at FINRA’s predecessor, the NASD, serving on its Board of Directors and later as Chairman of the NASD’s stock trading system, NASDAQ.
For brokerage firms, the holy grail of FINRA is that it’s a non-government private entity and not subject to the Freedom of Information Act – it can operate in secret. This lack of transparency is underscored by the way investor disputes are handled. FINRA runs one of the nation’s largest arbitration forums, handling upwards of 7,000 new disputes a year. Anyone who opens a brokerage account, knowingly or not, agrees to submit any disputes with their broker to FINRA’s binding arbitration system. You rarely hear about these disputes because they’re handled behind closed doors, out of the public view.Contrary to popular belief, the FINRA arbitration process is painstakingly slow and very expensive, and the arbitrators are industry participants or industry friendly. My dad, upon retiring from running our family’s brokerage firm, was an arbitrator. His first case involved a dispute between Bear Stearns and one of their clients. My dad ruled in favor of the client – he was never called to hear another arbitration.
Unlike brokerage firms, the oversight of investment advisers has always been handled directly by the SEC (or state securities regulators). For more then 70 years, this transparent system of oversight has worked well. In contrast to the brokerage industry, disputes between investment advisers and clients are generally resolved in the courts, in open view of the public.
“The Fix”
Enter the Investment Adviser Oversight Act of 2011 (the Act), a draft of which was introduced last week by Spencer Bachus, Chairman of the House Committee on Financial Services. If it passes, the Act will create a “national investment adviser association,” in other words it will create an SRO for investment advisers. Not surprisingly, many in the brokerage community are calling for FINRA to step in and run this newly created SRO which will regulate investment advisers.
Brokerage firms will gladly transition to the investment advisory model just as soon as they get their investment adviser SRO up and running. Brokers want to keep guarding the hen house. They want to make and enforce the rules, and above all they want to keep their dirty laundry out of the public view. As far as we can see, the current system of overseeing investment advisers isn’t broken. We’re at a loss as to how adding this layer of self-regulation to the process will increase investor protection. It’s well established that FINRA looks out for the interests of its members (the brokerage community) and not necessarily the interests of investors. This Act is more about both the brokerage industry and FINRA’s self preservation, at the expense of investors who will be harmed by FINRA’s good ol’ boy way of protecting its own.
Andrew J. Haigney is managing director at EL Cap Investment Consultants.
