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Long Legislative Fight Kicks Off with House Hearing On SRO, Fiduciary Standard

It’s impossible to know what the sum of the day’s testimonies, questions and comments will lead to, especially considering that whatever bill emerges would need to also pass a Democrat-controlled Senate. Whatever the outcome, it’s likely to be drawn out, but some compromises may be getting made.

Congressman Scott Garrett (R-N.J.) opened Tuesday’s House Financial Services Committee hearing on an SRO for investment advisers and a fiduciary standard for broker/dealers with a threat, suggesting that the SEC might not want to spend a lot of time or money writing a rule that could just be overturned later by a lawsuit.

“The SEC has a history of having rulemakings overturned in the courts,” said Garrett, pointing to the 23,000 staff hours and approximately $2 million in cost spent on the proxy vote rules that were recently challenged in courts. With regards to a potential rule on the fiduciary standard, the Commission needs to “thoughtfully consider the most prudent course of action,” he said.

But otherwise, the hearing was surprisingly civil, aside from some incoherent rambling from Representative Ruben Hinojosa (D., Tex.) and a series of interruptions from Gene Greene (D., Tex.) who wouldn’t allow any of the witnesses he questioned to finish their answers.

Republican representatives often directed their questions to Barbara Roper of the Consumer Federation of America, and David Tittsworth, executive director of the Investment Adviser Association, who are not their allies on the issues under review. In fact, Roper often got the last word in the question session after the witness testimonies. FINRA Chairman and CEO Richard Ketchum was careful to say that in the Bernie Madoff case not only was the SEC to blame, but FINRA missed it as well. Tittsworth and House Financial Services Committee Chairman Spencer Bacchus, who take opposing views on the SRO issue, exchanged a joke about their bawdy last names.

Everybody is acutely aware that this is the opening salvo in what is going to be a very long legislative fight,” said Duane Thompson of consulting firm Potomac Strategies and policy analyst for Fi360, a fiduciary training firm. “If anything is surprising, it is that there was so much collegiality between the participants before, during and after. But I think everybody staked out their positions.”

Today’s hearing was planned several weeks ago, and then last Thursday, House Financial Services Committee Chairman Spencer Bacchus proposed legislation that would allow one or more SROs to oversee all investment advisers.

CFA, Wild Card

It’s impossible to know what the sum of the day’s testimonies, questions and comments will lead to, especially considering that whatever bill emerges would need to also pass a Democrat-controlled Senate. Whatever the outcome, it’s likely to be drawn out, but some compromises may be getting made.

In mid-July, in testimony before the Senate Banking Committee, Roper came around on the idea of one or more SROs replacing the SEC as the examiner for investment advisers, saying that absent greater will to increase funding for the SEC, having an SRO is better than the status quo, and she reiterated that stance today. In exchange, FINRA’s Ketchum seemed to offer a few olive branches to Roper and the SEC during the hearing.

“The wild card here is the CFA, and to what extent it will state that it supports FINRA,” said Thompson. “Even though CFA may continue to have issues on what an SRO should look like, that removes a major hurdle for FINRA and possibly for some democrats who were looking for a reason to oppose it.” In her written testimony, Roper supported the idea of multiple SROs as opposed to a single SRO, but she chose to focus her spoken testimony exclusively on the fiduciary standard and did not explicitly endorse FINRA.

“While having more than one SRO creates challenges in terms of SEC oversight, the potential for regulatory oversight, and consistency of rules and enforcement, we believe the benefits of this approach outweigh the risks,” she said. “While it seems certain that FINRA would serve this role for dual registrants, those advisers who are registered exclusively as advisers may prefer to establish an alternative SRO oriented toward their fee-only business model. It would be important to ensure that any such alternative SRO had adequate resources to regulate effectively.”

Cost-Benefit Analysis In the Works

Roper granted that the SEC had not done sufficient cost-benefit analysis of the fiduciary standard—one of the things that Republicans and the opponents of the fiduciary standard have been calling for—but said that such an analysis is possible, and that the regulator is already working on it. She also emphasized that the suitability standard can, in fact, be very costly to clients: under that standard, the broker does not have to choose the most cost-effective product for his client and cost is the single biggest predictor of performance over the long term, according to Morningstar and others.

“The simple truth is investors pay significant excess cost and lose out on long-term benefits due to conduct permissible under the suitability standard and not under the fiduciary standard,” said Roper. “This can amount to tens of thousands of dollars over a lifetime. That’s real money to middle income investors. They can’t afford to sacrifice just so the broker can enjoy a better payday.” She continued that while there would be greater cost associated with the disclosures that a broker would have to provide to a client under the fiduciary standard, there would be an offsetting savings to the investor if the broker has to take cost into account when making recommendations under the fiduciary standard. “The SEC has been very sensitive on the cost issue,” she said.

Ketchum supported Roper on these points. “I agree with much of what Ms. Roper said,” he said during the questions after testimony. “I think the SEC is focused on cost here. I do believe that a properly implemented fiduciary standard makes sense. I think an analysis of cost makes sense. There will be some cost associated with disclosures although FINRA already requires disclosures on product by product basis.”

Oversight, Not Rules; Annuities Fireworks

Chairman Bacchus and some of the other Republican lawmakers repeatedly emphasized that the problem is not in the rules or standards but in the oversight, trying to steer the conversation back to the subject of passing oversight authority to an SRO. “Regardless of standard of care bad actors will naturally flow toward part of industry where there is the least oversight,” said Bacchus. Bacchus said the fiduciary standard rulemaking should be considered optional, and that as the SEC has plenty of other priorities on its plate, the regulator should put those things first. He also said that any new standard must not disrupt the relationship between the client and his or her chosen investment professional.

Roper singled out variable annuities for particular abuse, saying it is one area where the Consumer Federation of America thinks a fiduciary standard for all financial advisors could have the greatest impact. She’s not the only one to feel this way, she said. “Award winning author Liz Pulliam Weston has called variable annuities ‘the worst retirement investment you can make,’ she said. They have been called the most overhyped oversold products out there, she added. “At least $25 billion in investor excess costs are siphoned from vulnerable investors to the insurance industry sales force through variable annuities a year.”

Ken Ehinger, President and Chief Executive Officer, M Holdings Securities, Inc., who spoke on behalf of the Association for Advanced Life Underwriting, countered that many of the sales practice issues related to variable annuities have been addressed by FINRA rulemaking. In his testimony he also reiterated previous industry and broker/dealer positions that a fiduciary rulemaking would limit customer choice in terms of products and services because the higher cost would drive providers out of the business. Similarly, NAIFA President Terry Headly said a survey of NAIFA members indicated that if costs went up 15 percent, 65 percent of members said they would need to take actions that would limit their client’s access to financial advice.

Roper and Ehinger clashed over how much disclosure could achieve. “Confusion is not something you solve by changing legal standards,” said Ehinger. Simple, direct, easy to understand and read disclosures are the solution, he said, and FINRA has already created a rule to address this. Roper countered that the SEC commissioned the Rand study about the different standards of conduct for the brokerage and investment adviser industries precisely because they had tried disclosure and it had failed. “You can’t solve through disclosure or investor education a policy that doesn’t make sense,” she said. “And it will never make sense to investors that their financial advisor is a salesperson and their investment adviser is actually an advisor.”

The Right Way, The Wrong Way

Broker/dealer industry executives and representatives reiterated that any new fiduciary rules would need additional clarification about how to “operationalize” that standard to bd/ activities. “There’s a chance to write them the right way, which is not disruptive to investor relationships with advisors,” said John Taft, Chief Executive Officer, RBC Wealth Management, who spoke on behalf of the Securities Industry and Financial Markets Association. “There’s a way to do it the wrong way, increases costs, reduces access.”

In his testimony, Bill Dwyer, Chairman of the Financial Services Institute and CEO of LPL, said that the fiduciary standard would require three essential things:
1. Clearly articulated rules of conduct, so independent advisors and b/ds know their specific obligations to their clients.
2. Clear SEC guidance on the form and content of client disclosures. “Therefore, we believe disclosures should be written in plain English, consolidated wherever possible, and appropriate to the level of investor involvement.” He said client disclosures should also be tested by investor focus groups.
3. Effective regulatory supervision—aka the SRO for investment advisers.

DOL Conflict

Roper also said that the DOL’s proposed fiduciary rulemaking should look more like the SEC’s by including language that allows for commission-based products or proprietary products. The DOL rule would extend to all IRA accounts an ERISA-like standard, which is a much stricter standard than the one in the SEC rule.

“We have concerns about the DOL proposal,” said Roper. “We think there is potential to resolve the difficulties. The DOL proposal should not stop the SEC proposal. The concerns about the DOL proposal are that it doesn’t more closely resemble the SEC proposal,” she added. “It has a huge sellers exemption in it. At the other end of the spectrum, the b/d firms are right that when you apply absolute ERISA standard with no exceptions the b/ds are going to exit that business. Not enough fee only planners are going to step in and provide those services. One of the key issues is how will they do the prohibitive transaction exemptions.”

Congressman Stephen Lynch (D., Mass.) who questioned her on that point replied, “That’s very reassuring and helpful.”


The hot button issues in the SRO debate were whether one or more SROs should oversee the investment adviser industry, how well FINRA would be able to oversee an industry with which, in some ways, it competes, whether the SEC can really expand its responsibilities when it is in need of reform, and how FINRA would overcome some of its own shortcomings.

Ketchum emphasized in his testimony that if FINRA were to be selected as the SRO it would be sure to tailor rulemaking to the investment adviser industry and that members of the investment adviser industry would gain seats on any governing body. “I want to be very clear—if FINRA becomes an SRO for investment advisers, we would implement regulatory oversight that is tailored to the particular characteristics of the investment adviser business,” he said. “FINRA would establish a separate entity with separate board and committee governance to oversee any adviser work, and would plan to hire additional staff with expertise and leadership in the adviser area.”

Tittsworth of the Investment Adviser Association emphasized that the SRO model is greatly flawed. “Other countries have completely discarded or are moving away from the private regulatory model.” FINRA suffers from a lack of accountability, transparency, excessive cost and a bias favoring the b/d model, he said. Its budget and governance are not overseen by SEC or Congress. It’s lacks expertise. It’s not subject to the freedom of information act. It’s not required to conduct cost-benefit analyses before creating rules, unlike the SEC, which is required to conduct cost-benefit analysis before writing rules.

Ketchum replied that the regulator always addresses cost-benefit when asked to in comments by industry participants or by the SEC, but Tittsworth emphasized that it is not legally bound to do this in the way that the SEC is.

Bacchus asked Ketchum if FINRA would you be willing to accept enhanced oversight by the SEC or other government regulators and Ketchum said, yes. He added that FINRA accepts the criticisms of the Boston Consulting Group, which recently wrote in a report that the SEC should step up its oversight of the regulator.Further, he said FINRA would never write rules that would conflict or pre-empt with state rules and regulations for investment advises.

When asked why the insurance industry wants FINRA to be the SRO for investment advisers, Terry Headley, President of the National Association of Insurance and Financial Advisors (NAIFA) said, “It’s quite simple. Two thirds of our NAIFA members are registered through a b/d and 40 percent are also registered as investment advisers under a corporate RIA. Since they are dually registered reps. it seems the most cost efficient method since we are already examined by FINRA on an annual basis.” Currently, NAIFA’s dually registered members pay registration fees to FINRA and to each of the states in which they are registered with securities regulators. He admitted that the majority of the organization’s reps are too small to have the kind of assets that would put them in SEC registration.

When asked why the FSI (Financial Service Institute) thinks FINRA would be best, Dwyer said, “As we look at what is reasonable, the supervisory needs we have, I turn to precedent. The SEC has 70 years of overseeing us as an SRO. That is a track record that makes FINRA the obvious choice. Today FINRA has elaborate structure to do audits of institutions and offices across the country. We have thousands of employees around the country. We are best positioned to take on this task.”

with additional reporting by Diana Britton.

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