Truth and Consequence

In spite of a myriad of rule makers and enforcers in our daily lives, the Bush Administration in the person of Treasury Secretary Henry Paulson is now advocating for a super-regulatory structure for finance. These omnibus measures are intended to clarify management and build confidence that transgressions are monitored. But the law of unintended consequences often comes into play with such wide-ranging initiatives, including rising costs, restricted markets, and limitations on individual rights.

Alongside the proposal for a new financial services authority, the SEC is questioning whether RIAs should be subject to more rigorous examination. Many advisors say that one of the compelling reasons for moving out of a broker/dealer into the RIA business model is to avoid supervision under the Financial Industry Regulatory Authority (FINRA). Ironically, their expressed desire to evade the enforcers helped put RIAs on the SEC’s radar screen. Despite the merits of the argument on which they prevailed, the Financial Planning Association (FPA) lawsuit against the SEC over the broker/dealer exemption rule contributed to a heightened awareness of unequal supervision of the business models. While it used to be possible to argue that compensation for one was fee-based and the other was transaction-based, now that broker/dealers have created or facilitated the emergence of investment advisory practices under their domain (see this month’s cover story, p. 46), this position rings hollow.

Some believe that FINRA should act as a self-regulatory body for RIAs. An opposite view being promulgated by the FPA and NAPFA is to create state-by-state SROs much like those in the accounting profession. The latter opposes FINRA’s focus on transactions, while the SEC may believe FINRA should perform the oversight because most fraud, deceit, and manipulation actually occur during transactions, not in the planning process.

While RIAs are not normally compensated based on which securities they buy or sell, opportunities for bad faith, conflicts of interest, and diversion of capital exist for those intent on enriching themselves at the expense of others. As practices get bigger and the span of control gets stretched, the possibility of abuse rises that may not be caught in a three-year audit cycle.

The good news: both sides recognize the need for better monitoring. Unfortunately, greater oversight could potentially marginalize many smaller firms that already struggle under the weight of compliance and paperwork. Should the FPA prevail in the state-by-state approach to governance, the burden could become even more onerous as many advisors serve clients in multiple states, requiring multiple registrations and multiple examinations. But either way, all parties must ask the question: What problem are we trying to solve?

I submit the problem we are trying to solve is to ensure we have a discipline in place to help us anticipate major transgressions before they occur and to protect individual investors from unscrupulous or incompetent purveyors of financial solutions. This may help to focus the regulations on stopping bad acts as they are being committed, rather than focusing solely on punishing bad acts after the trail is littered with the financially and emotionally broken victims.

Simplify This

The overlapping and sometimes contradictory rules of competing regulatory bodies overwhelm financial professionals and baffle the investing public. As one of my fellow panelists at the CIFA conference put it, “you cannot fight complexity with complex mechanisms.”

All the arguments and splitting of hairs over who should regulate whom tends to overshadow the best interests of the client. Simplicity would be one solution, along with a coherent approach to industry regulation that eliminates duplication, fosters trust and confidence in the capital markets, and clearly outlines reasonable expectations of both consumer and advisor.

Whether regulated by FINRA, the SEC, or state authorities, advisors will need to recognize common ground and move for a logical regulatory plan that allows them to manage their businesses without a greater burden of compliance, but with a firm approach to verification and transparency that protects the consumer from acts of bad faith.

I am on the fence as to whether there should be a super-regulatory authority for all of financial services or whether RIAs should have an SRO. I am still processing the debate over which is best for the consumer and the industry. But I fear that in this crisis moment the government will enact policies and procedures as yet another (perhaps duplicative) remedy for the behavior of certain people who should have known better.

Leaders in the business of providing investment advice, including association boards, should steer away from emphasizing the differences in practice models in this debate and focus on the benefits to individuals desiring professional guidance. Highlighting business models may prove effective in a marketing context, but may be counterproductive for RIAs when the perception is that consumers are at risk. In the end, trust is the most valuable currency this industry has. Debates about issues that mean nothing to the public only serve to confuse and annoy people who want to know that the majority of practitioners have their client’s best interests in mind. Those who do not will incur the wrath of the regulatory bodies, and ultimately the courts.