Your Clients Are Watching You

The big question to have arisen from the financial meltdown is: Have financial market regulators been doing their jobs well? Okay, it’s not the only big question, but it is certainly one of them. And the other big question: What kind of hit to its reputation has the financial advisory business sustained? Will the Ponzi schemes and other meltdown headlines leave a permanent mark?

The big question to have arisen from the financial meltdown is: Have financial market regulators been doing their jobs well? Okay, it’s not the only big question, but it is certainly one of them. And the other big question: What kind of hit to its reputation has the financial advisory business sustained? Will the Ponzi schemes and other meltdown headlines leave a permanent mark?

Probably not, but in the short run, yup, clients are watching you.

Let’s face it: Regulatory actions do seem to be related to the health of the capital markets. In good times, when presumably everyone is making money, client complaints tend to fall and Financial Industry Regulatory Authority (FINRA) enforcement actions decline too. And in bad times, arbitrations against firms and registered reps increase.

This year, the SEC and FINRA are warming to their tasks—having slacked off in 2008, says one law firm (see below). The most popular complaints so far this year? Breach of fiduciary duty, misrepresentation and negligence, says FINRA. (It is interesting that it’s breach of fiduciary duty, and not breach of the suitability standard that is the big focus, since fiduciaries are so often thought to be the purest of the pure in the investment advisory profession.)

Since 2007 was a good year in the capital markets (and indeed, the four years before it), 2008 was a relatively slow year for regulators. According to a report by Sutherland Partners, a Washington, D.C. law firm, FINRA fined firms $35 million in 2008, a roughly 55 percent drop from $77.6 million in 2007. Furthermore, the number of disciplinary actions also declined, as FINRA resolved 1,007 formal disciplinary actions in 2008, a nine percent drop from 1,107 in 2007. Brian Rubin, an attorney with Sutherland and a co-author of the study, says one of the reasons for the decline in fines and disciplinary actions was that there were fewer “blockbuster issues” or industry-wide practices resulting in significant customer harm (according to FINRA), like the unsuitable sales of B shares of mutual funds and “late trading” of mutual funds that exploded a few years ago.

Another contributing factor: Rubin says FINRA may have been affected by what he calls the SEC’s “retrenchment” on the enforcement front. “I think on the regulatory front enforcement cases have probably lagged the past year or so, but we expect they will increase this year or next year,” Rubin says.

That’s not surprising. The prestige of financial advisors in particular—and Wall Street and banks in general—has taken a hit in the subprime meltdown and the Madoff and Stanford scandals. Arbitration claims have already risen sharply so far this year. According to FINRA, arbitration filings have almost doubled year-to-date through April compared to last year. New cases filed through April 2008 jumped 81 percent to 2,403 in 2009. While arbitrations rose, the actual number of cases closed have declined by 4 percent year-to-date through April compared to last year, FINRA says. (A typical arbitration takes about 13 months, and can cost tens-of-thousands of dollars; for more, see Registered Rep.’s January cover story, Fix Arbitration Now.) FINRA spokesperson Brendan Intindola says the decline in cases closed reflects the relatively low number of complaints from 2006 to 2008. Because of the recent spike in enforcement and client complaints, he says the number of closed cases will peak again 18 months from now.

Indeed, the securities industry might need to brace itself for a bull market in arbitrations—around levels of 2003—cases that reflected the tech wreck bear market of 2000 through 2002.

Again, client complaints and other malfeasance seem to arise during down markets. That said, 2008 was a year of bad firsts for Wall Street that will likely come to roost in arbitration filings. Over the last year, investors were burned by exposure to complex securities, such as “guaranteed” or principal protected securities that were anything but, and to auction-rate securities (ARS).

The principal protected securities and ARS will certainly bite, says David Robbins, an attorney at Kaufmann Gildin Robbins & Oppenheim. Robbins predicts that arbitration cases involving investments that were sold for the risk-averse client will indeed have the most traction because risk-adverse clients were not investing for capital gains. “Whereas the last market crisis was limited to a single industry, this is worldwide, a systemic meltdown,” says Robbins. “Those who, unlike me, opened their account statements, said, ‘Oh My God,’ and, after they picked up their pants, called their attorneys.”
Tim Pedregon, a financial services compliance consultant and former NASD compliance examiner, says the SEC and FINRA were in “crisis mode” last year, but “will start going out and auditing firms, so you will probably see an increase in fines next year.”

Pedregon also says the number of arbitrations will probably lead to some special examinations of firms—especially since the SEC recently approved amendments to Forms U4 and U5, as well as FINRA Rule 8312 (FINRA BrokerCheck Disclosure). The amendments, among other things, make significant changes to disclosure questions on the forms, including new questions that require firms to report allegations against registered reps in an arbitration or litigation in which the registered person is not a named party. This amendment will be effective November 14.

It seems FINRA is more focused on individual situations as opposed to pursuing any industry wide solutions, says Jacob Zamansky, a New York-based securities industry attorney. “They used to trail the SEC and New York Attorney General’s office and, if there was a big settlement or fine, they would jump in the picture. You don’t see much of that anymore,” Zamanksy says. That said, Zamansky says he has received calls this year from FINRA examiners wanting to investigate cases that he filed. Zamansky says, “I think as the number of arbitrations trends up, the number of investigations will go up also.”

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