The financial services industry has spent most of this year anticipating regulatory changes in response to the recent global economic crisis.
The financial services industry has spent most of this year anticipating regulatory changes in response to the recent global economic crisis.
The overarching question that faces us is how the regulatory framework will change as the government tries to bolster public confidence in financial institutions besieged by one crisis after another, from the mortgage meltdown to the credit crisis to large Ponzi schemes. This response will affect the role and operations of the Financial Industry Regulatory Authority Inc. and how it interacts with investment professionals.
Two broad options appear as the government considers revising its approach to regulating financial service markets: Creating more government regulation or expanding non-governmental oversight.
The first option is less than ideal in certain instances; the Securities and Exchange Commission has already noted that it lacks resources to investigate the more than 11,000 existing registered investment advisers. And relying on increased SEC enforcement efforts leaves investors subject to the vagaries of annual budgetary battles in Washington.
A more sustainable course would be to have the SEC increase its oversight of self-regulatory authorities such as Finra, while expanding the overseer role of these organizations.
Finra's congressional mandate charges it with overseeing about 4,800 broker-dealer firms and ensuring compliance with the Securities Exchange Act of 1934, the rules of the Municipal Securities Rulemaking Board and its own rules. This authority, however, doesn't extend to investment advisers, who are subject to SEC and state regulatory oversight.
With about 4,500 firms offering both brokerage and investment advisory services and having functions that overlap, consolidated regulatory oversight of the two areas seems just around the corner.
Finra has been pursuing an expanded role in this very area, perhaps, in part, spurred by its lack of authority and inability to investigate the investment advisory firm central to the criminal scheme run by Bernard L. Madoff.
Indeed, in an attempt to broaden its jurisdiction, Finra is trying to extend its reach to the financial planning activities of dually registered broker-dealers.
Limiting Finra oversight to investment advisers who are also broker-dealers, however, would leave the thousands of investment advisory firms that do not act as broker-dealers in a regulatory oversight gap. Although some groups, such as the Financial Planning Coalition and the Financial Services Institute, have suggested a separate SRO for investment advisers, consolidating oversight of all investment advisers and broker-dealers may foster more efficient investigations and audits.
Moreover, the government may be more willing to give additional oversight authority to Finra — a known entity — rather than add another overseer to the mix. Finally, increased cooperation between the SEC and Finra likely would tip the scales toward Finra.
However, constructing more effective enforcement efforts alone won't resolve all the industry's problems. Creating and adopting one fiduciary standard for all financial service providers is equally important.
Right now, broker-dealers are subject to the overall anti-fraud provisions of the securities acts and Finra rules, meaning that they owe their clients a duty of fair dealing and must make suitable recommendations for which they have an adequate and reasonable basis. Investment advisers, on the other hand, owe their clients fiduciary duties (a higher standard that means they must be more than fair); they must put their customers' interests before their own.
This disparity in standards leaves retail investors exposed, as many investors don't appreciate the differences in duties owed by broker-dealers versus investment advisers. As Michael Chamberlain noted recently in InvestmentNews, investors are particularly vulnerable when broker-dealers use titles such as “financial consultant” or “financial counselors.”
If allowed to stand, the dual standards will complicate compliance enforcement efforts for any agency that seeks to police activities of these providers. As regulatory agencies (governmental and non-governmental alike) work closer together in response to the crisis, increased pressure for a uniform standard for all “financial services providers” should erase the distinctions that now exist and implicitly expand Finra's reach.
Any expansion of Finra's authority will also require it to make changes structurally to meet its new mandate.
Finra showed its commitment to change this year when it created a whistleblower office that allows staff members to work with anonymous tipsters and obtain as much information as possible even if the person remains anonymous. The traditional reporting mechanisms prevented most investigative follow-up when anonymous tipsters left incomplete information.
Last month, Finra also proposed creating an Office of Fraud Detection and Market Intelligence to meld the whistleblower office with its central review group. This would combine enforcement resources and other industry experience, allowing increased scrutiny of allegations of fraud and establishing a central point of contact.
Creating these offices alone, however, are not enough. Finra will have to respond more aggressively to reported problems to persuade the public and the government that self-regulation can work.
If Finra assumes an expanded role as an overseer, it will need to revise its internal operating procedures substantively. For example, it will need to adopt greater transparency in decision-making and financial management processes to avoid potential conflicts of interest.
Sustaining a larger mission will require Finra to evaluate its revenue structure, perhaps increasing fines and its caseload to add deterrence and pay a larger work force to conduct investigations and compliance efforts.
Accomplishing these goals and assuming new responsibilities also will require more training of existing and new Finra personnel.
Finra will have to do more than implement operational procedures. Given the economic crisis, lawmakers and individual regulatory agencies alike recognize a greater need to address systemic flaws, whether arising from fraud or negligence.
Accordingly, any SRO will have to focus more on systemic risks than individual institutions. Finra's newly proposed Office of Fraud Detection and Market Intelligence should assume this role.
Organizations such as Finra also will need to assess their priorities and work more closely with other regulatory authorities, which will get easier as government agencies like such as the Commodity Futures Trading Commission, the Federal Reserve and the SEC begin cooperating more themselves.
As part of its response to the crisis in investor confidence, the government may be forced at a minimum to adopt two changes: consolidate oversight functions of broker-dealers and RIAs, and subject broker-dealers and RIAs to the same fiduciary obligations. Although Finra may provide a natural home to oversee these functions, it will have to change the way it operates and interacts with the industry.
The direct and collateral consequences of Finra's expanded role will in turn directly alter how financial services professionals conduct their work.
Pravin B. Rao is a partner in the securities and litigation practice groups at the law firm Perkins Coie LLP. Howard J. Rosenburg is general counsel and chief regulatory officer at Chicago Investment Group LLC, a broker-dealer and investment adviser.
