What the 8 pillars of a FINRA-replacing entity for RIA oversight look like and how personal accountability is key

First and foremost, the PRO would have as it members individuals (not firms) who are qualified to become members of the profession

Sunday 7.28.13 by Guest Columnist Ron Rhoades

Dina’s note: In this final installment of this four-part series, Ron Rhoades outlines a vision for a true profession of investment and financial advisors, through the creation of a professional regulatory organization that will protect the investor, not Wall Street interests. For those of you new to this series and those who want a recap, check out “Part 1:The story of FINRA’s implacable drift from its founding ideals to a pallid 'no-lying baseline’, “Part 2:Why keeping FINRA from ruling RIAs is critical to these firms, the investor — and even the U.S. economy and “Part 3:FINRA’s scandalous litany of failures and its efforts to redefine the true fiduciary standard out of existenceof Ron’s Fiduciary quartet. The last refuge of the criticized is to say: Well, then what would you do? With this article, Ron has preemptively struck down that line of counterattack.

The next financial crisis will come.

The reforms instituted, and that remain to be instituted, during the legislative and regulatory processes following the 2008-'09 financial crisis have been severely watered down. As a result, Congress and regulatory agencies have laid the foundation for yet another resurgence of excessive greed, with its ultimate dire consequences for the capital markets and our economy. See: The 10 most likely contributors to the next market panic.

The U.S. Congress rarely acts until a crisis has occurred. So, sitting here in mid-2013, we must ask whether we can outline the reforms that can voluntarily be adopted, in preparation for such an event. Why? So we can, as a profession, be prepared when the next crisis triggers congressional action.

A world too complex for FINRA rules

Given the complexity and global nature of the modern financial market, attempts to regulate the provision of personalized investment advice by specific rules as utilized by FINRA under its current regulatory regime will fail. Such an approach will inevitably encounter the fundamental problem of regulatory arbitrage. Such specific rules should just permit “financial institutions [to] find new ways to get around government rules, thus creating a never-ending spiral of rule making and rule evading,” according to Saule T. Omarova, in her 2011 law review article “Wall Street as Community of Fate: Toward Financial Industry Self-Regulation.”

Instead, we must embrace principles-based regulation, and in particular, the fiduciary principle. While there have been many judicial elicitations of the fiduciary standard, including Justice Benjamin Cardozo’s lofty elaboration, a relatively recent and concise recitation of the fiduciary principle can be found in a case in which Lord Millet undertook what has been described as a “masterful survey”:

“A fiduciary is someone who has undertaken to act for and on behalf of another in a particular matter in circumstances which give rise to a relationship of trust and confidence. The distinguishing obligation of a fiduciary is the obligation of loyalty. The principal is entitled to the single-minded loyalty of his fiduciary. This core liability has several facets. A fiduciary must act in good faith; he must not place himself in a position where his duty and his interest may conflict; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal. This is not intended to be an exhaustive list, but it is sufficient to indicate the nature of the fiduciary obligations. They are the defining characteristics of a fiduciary.” See: How 10 top groups define 'fiduciary’.

70 years of low standards

As previously explored in Parts 1 to 3 of this series, FINRA, under the control of its major members — Wall Street’s large broker-dealer firms — has kept the standards of conduct for brokers at extremely low levels for over seven decades. In so doing, it has utterly failed to protect the public interest. In a February 2010 letter to Congress calling for increased oversight of financial self-regulators, the Project for Government Oversight noted:

“[A] cursory examination of FINRA’s current leadership paints a clear picture of a regulator that is still captured by the [broker-dealer] industry it is tasked with regulating … Effective, independent and efficient government regulation is the only proper way to safely oversee our markets. Our economy is too important to be left in the hands of the very financial industry that brought us to the brink of collapse … [FINRA chief executive Richard] Ketchum argued that FINRA has a 'strong track record in our examination and enforcement oversight.’ However, POGO believes that FINRA’s track record tells a very different story. In fact, financial sector self-regulators, despite the power vested in them by the federal government, have failed to prevent virtually all of the major securities scandals since the 1980s.”

Even in 1941, the organization, then the National Association of Securities Dealers, commented upon the necessity of raising the standards of conduct, when its chairman opined: “[T]he time may come when we can arrive at a more professional status and we can give more of our attention as to who should be in the investment business …The principal byproduct [of formation of the SRO], which I don’t believe the founding fathers of this association ever thought of, is that for the first time in history the securities dealer begins to see what he looks like and it hasn’t been altogether a pleasing sight.”

Of course, as discussed in earlier installments of this series, FINRA has failed miserably to attain “professional status” for the “securities profession,” primarily because it has never raised its standards of conduct for its members and has never put the interests of the consumer first. See: Why advisors see FINRA as the devil.

The Maloney Act is a failed experiment (See: The story of FINRA’s implacable drift from its founding ideals to a pallid 'no-lying baseline’). Congress should disband FINRA and return broker-dealers to direct oversight by the Securities and Exchange Commission. Certainly, FINRA’s failures should not be rewarded.

A new organization borrowing from an old, trusted template

To replace FINRA, with regard to the market conduct regulation of those brokers and advisors providing financial planning and/or personalized investment advice, I propose the formation of a professional regulatory organization similar to the organizations that exist today for lawyers and certified public accountants.

How would a PRO be different from FINRA? Through these eight key attributes:

1. First and foremost, the PRO would have as it members individuals (not firms) who are qualified to become members of the profession.

History has shown that individuals, when guiding professional organizations (assisted by consumer representatives), seek to preserve and enhance professional standards of conduct. In contrast, firms as members of an SRO seek to consistently lower standards of conduct. This is, perhaps, the primary reason for FINRA/NASD’s abject failure to raise standards over the past seven decades. See: Non-partisan watchdog group writes a scathing letter about FINRA.

2. The PRO would possess a clear and unambiguous adherence to a bona fide fiduciary standard for its members.

The principles of the fiduciary standard would be clearly stated. As part of same, it would be recognized that, under the fiduciary duty of loyalty, disclosure of the conflict of interest is only a minor part of the fiduciary’s obligation. Such disclosure must be affirmatively and comprehensively made in a manner in which the financial advisor ensures client understanding of the conflict of interest and its possible ramifications. Thereafter, the client’s informed consent (not mere consent) must be secured. Even then the transaction must remain substantively fair to the client. In other words, it would be recognized that no client would voluntarily provide consent to be harmed; clients are not that gratuitous toward their financial advisors. See: Why only 14% of RIAs volunteer complete pricing information to clients and why selective fee disclosure is not a winning strategy.

Additionally, removal of the fiduciary “hat,” while not impossible, would be restricted to those situations in which is was likely that no further personalized investment advice would be provided to the client. Moreover, the fiduciary obligations would extend to the entire relationship with the client; the fallacy that a dual registrant can wear two hats at once will be forever buried.

3. The PRO would possess as its primary purpose the protection of the public interest.

4. A four-year college degree from an accredited institution would be required, plus an advanced course of study in financial planning and investments.

Passage of comprehensive entrance exam would also be required for licensure to provide “personalized investment advice” to “consumers.” Consumers reasonably expect that their financial and investment advisors are experts; we should educate and test to ensure a baseline level of expertise exists, rather than permitting nearly anyone to become licensed to provide financial advice following a couple of weeks of study of an exam manual. Continuing education would also be required. (Grandfathering might occur for prior entrants into the profession possessing substantial work experience and knowledge accumulated over years, provided a competency test would be passed by same.)

5. Peer review of alleged violations would be initiated.

One of the problems of securities regulation today is its focus on disclosure; in part, this is because securities examiners can test adherence to disclosure obligations fairly easily. Yet, evaluation of adherence to the full extent of the fiduciary’s duty of loyalty, and adherence to the fiduciary’s duty of due care, will usually require the judgment of professionals with substantial experience in the field. Hence, mandatory peer review of disciplinary matters should occur. See: Lockshin: All advisors must deal with the threat of low industry standards — before investors do it for them.

6. All fines imposed would be paid to U.S. Treasury and/or to the states, as appropriate.

This to avoid the inevitable conflict of interest arising from using fines imposed upon members to pay any expenses of the professional organization. Only the costs actually incurred by the professional organization in undertaking an investigation and any enforcement action could be recovered against a firm found to have committed a breach of duty. See: FINRA comes up with cost projections for its SRO and the CFP Board blasts them.

7. Either mandatory pro bono hours each year, or a mandatory annual contribution to a not-for-profit providing such services, would be required of all members.

Because, in the end, the profession must serve the public, including those who may be unable to afford (even on an hourly basis) the services of professional advisors.

8. Through legislative fiat (at the national and/or state levels), only professionals duly licensed as financial and investment advisors would be permitted to hold themselves out as such.

This includes a prohibition on the use of similar titles, or designations, by non-licensed individuals. Only those persons duly qualified would be permitted to practice and be allowed to utilize titles denoting professional status.

The Journal of Financial Planning initially published Dick Wagner’s seminal article, “To Think…Like a CFP” more than 30 years ago, in 1980. Wagner called for financial planning to become a true profession. He observed: “A true profession and its standards are important enough that its principles generally will prevail — often at the expense of apparent self-interest. Certain types of employment will be refused, certain procedures will be unacceptable under any circumstances. Financial sacrifices will be made in the course of these decisions. However, the ultimate financial impact will be positive because consumers will know what to expect and will have made the informed decision to pay for it!”

In other words, should consumers finally be able to trust all financial and investment advisors, as would exist if a true profession existed founded upon the fiduciary principle, demand for financial and investment advice in today’s complex financial world would soar. Additionally, the profession would attract more and better new entrants, to assist in serving the burgeoning demand for advice.

Can’t FINRA change?

This is doubtful, even if legislative action and SEC rule making occurs which enables FINRA to achieve all of the foregoing attributes of a true professional regulatory organization.

At its core, FINRA does not understand a true fiduciary standard of conduct, nor does it embrace a true fiduciary standard. It would take years, if not decades, to effect the culture change within FINRA necessary to effectuate the adoption, promulgation and enforcement of a true fiduciary standard of conduct.

Many a time I have seen a non-fiduciary broker hired by a registered investment adviser (not dual registrant) firm. And many a time I have seen the non-fiduciary broker unable to adjust, even after a year or more, to the strict ethical code to which true fiduciary advisors adhere. FINRA would encounter even more difficulties in this regard.

Of course, the SEC could compel FINRA to adopt rules of conduct that embrace all of the attributes of a true fiduciary standard of conduct. If FINRA refused to do so, the SEC could proceed administratively against FINRA as a substandard SRO, applying Securities Exchange Act § 19(9)-(h). Yet, realistically, given the close relationship between the SEC and FINRA, and the movement of personnel back and forth between the SEC, FINRA, the law firms serving Wall Street and the and large Wall Street firms themselves, this does not appear to be an option. It would take tremendous courage for three members of the SEC to force through such changes, as well as a Congress that understood the importance of the fiduciary standard of conduct for all Americans.
Hence, the far better approach is to “start over” and form a true professional regulatory organization.

Can a PRO be formed now?

Not right away. It would likely require action by Congress (although enactment one state at a time is an alternative). And, as we know, Congress does not usually act until a major financial crisis comes along.

But we can’t wait until the next financial crisis to begin the process of forming a professional regulatory organization. It must begin soon, if not now.

What can we do to prepare?

We must, as professionals, define and embrace bona fide fiduciary standards of conduct.

Currently, financial and investment advisors have several voluntary organizations. Some of them award certifications and designations; some do not. Many of them have ethical codes of conduct, but I would argue that most of these ethical codes fail to set forth the parameters of fiduciary obligations correctly, or in sufficient detail. See: Little-known understudy steps into NAPFA star role as Ron Rhoades bows out.

If we are to achieve a true profession, at the time of the next financial crisis, we must prepare, and voluntarily unite around, robust rules of professional conduct in which a true fiduciary standard is embraced by all of the members of such an organization and enforced through appropriate peer review. Then, armed with experience over the years in applying such a standard, the organization and its professionals would be well-equipped to petition and inform Congress of the merits of a true PRO at the time of the next major financial crisis.

What about the Dodd-Frank Act?

It is possible that a bona fide fiduciary standard can be imposed by the SEC on all those who provide personalized investment advice under Section 913 of the Dodd-Frank Act. I (and many others) will continue to advocate for this, through comment letters, other writings and visits to the SEC. I will also continue my advocacy in support of the Labor Department’s reproposal of its “Definition of Fiduciary” — in which the strict “sole interests” standard would be applied to nearly all providers of investment advice to defined-contribution plans and individual retirement accounts. See: Barney Frank puzzles crowd on his fiduciary stance at TD summit — as questions from Skip Schweiss and advisors expose his haziness on the RIA structure and soul.

Yet, as seen in the SEC’s March 2013 request for Information, major economic interests (Wall Street firms and insurance companies) have influenced the SEC to “assume” various parameters for a “fiduciary standard” that is not really a fiduciary standard at all — at least in the context of the world of professional advisors.

Rather, the SEC’s RFI posits a standard that is more akin to the very weak fiduciary standard seen in the world of employer-employee relationships, applying only basic principles of agency law. The SEC’s RFI ignores the stricter fiduciary-law requirements found in professional advisor-client relationships and reflects an inadequate understanding of the substantial public-policy rationale leading to the imposition of fiduciary status upon the professional advisor. See: Top RIA lawyer explains to the SEC why 'harmony’ is a harsh misnomer and why the price of its false spin is paid by investors.

The chance exists to turn the tide of rule making at the SEC, and hence we should work diligently for the SEC’s enactment of an appropriate and bona fide fiduciary standard. However, we must be prepared for the more likely outcome that the SEC will fail to act appropriately.

Take the next step

Hence, in the event (as appears likely at present) that the “fiduciary standard” is either not imposed upon brokers providing personalized investment advice by the SEC, or some weaker standard is imposed, as professionals we must be prepared to take the next step. See: TD throws its first client-best-interest summit, a micro-event, by 'candlelight’ in Palm Beach and ideas rise from the RIA deeps.

We must be prepared to embrace, voluntarily, through an existing organization (which possesses the courage to step up to the table) or a new organization, bona fide fiduciary obligations similar to those seen for other professional advisors (such as attorneys). We must be prepared to hold that, while reasonable restrictions can be imposed upon the scope of an engagement, that such professional, core fiduciary obligations cannot be waived.

We must be prepared to approach Congress when the next financial crisis occurs. Only we, as professionals, if armed with a history of its practical application, will be able to call upon Congress to implement a true fiduciary standard and the formation of a professional regulatory organization. It may take years, if not decades, for the opportunity to arise … but it will. See: Bernie Clark and Skip Schweiss head to Washington next week to fight on behalf of RIAs in Bachus bill showdown.

Hopefully the opportunity to spur Congress to act will occur soon (although I don’t wish for another financial crisis and its dreadful effects on our society), in order that our fellow citizens no longer suffer the harm they currently endure, far too often, at the hands of those not currently bound by a fiduciary standard.

Hopefully the opportunity will appear soon, in order that trust can be restored to our system of capital markets, greater capital formation occur, and we enter into a new era of American economic prosperity as a result.

Hopefully a true fiduciary standard and a professional regulatory organization will come to fruition soon, for the benefit of all providers of investment and financial advice, in order that we may then walk the streets proudly as the members of true profession.
Hopefully this vision will achieve reality, and soon. For the benefit of all consumers of financial and investment advice. For the sake of the financial futures of our fellow Americans. For the economic stability and vitality of America itself.

Ron Rhoades, JD, CFP® serves as chairman of the Steering Committee of The Committee for the Fiduciary Standard. He is an assistant professor of business law and financial planning at Alfred (N.Y.) State College.

Ron Rhoades