One-Man Think Tank: Inside the legal issues of the Goldman Sachs hearings

Brooke’s note: This is an extraordinary column. I suggest that anyone in the financial industry who wants a deconstruction of the hoopla [legally] surrounding Goldman Sachs will want to read it all. This column is also longer than you might be able to read between client meetings. One alternative is to read Elizabeth MacBride’s accompanying article, The suitability standard, defined that tackles that issue and gives Ron Rhoades’s Cliff Notes version of the suitability standard.

David Bellaire, the general counsel and director of government affairs for the Financial Services Institute, published a response to Ron’s column that can be read by clicking here

Last week, Sen. Carl Levin recounted his frustrating experience trying to figure out what rules and regulations govern Wall Street firms’ dealings with investors.

“When my colleagues and I asked the leaders of Goldman Sachs how they could sell investments that the firm thought were bad deals, while at the same time betting against those investments, these executives said that was just how they do business,” he recounted in a press release issued April 30.

The Goldman Sachs hearings have propelled the possible imposition of the “fiduciary standard” for broker-dealers back into the limelight. With Senator Levin’s focus on why Wall Street firms could package and sell what a firm’s employee admitted at the time was a “sh***y product,” there now exists substantial doubt regarding the efficacy of the “suitability” doctrine under which broker-dealers operate with respect to their customers.

What are the differences between the suitability and fiduciary standards?

Answering this question is critical to the financial reform debate in the Senate. And achieving an understanding of the distinctions also requires knowledge of the two fundamental types of commercial relationships found under the general law today, and how the core rules and principles applicable to those relationships are often modified by specific statutes or rules.

This column presents a primer on the underlying legal concepts behind the issues playing out in the Senate – and represents an attempt to relieve Sen. Levin’s frustration.

Arms-length relationships with customers: Good faith is all that is required.

The first type of relationship under the law is the “arms-length relationship.” “Arms-length” relationships apply to the vast majority of service-provider/customer engagements. In arms-length relationships the doctrine of “caveat emptor” generally applies. In other words, parties in “pure” arms-length commercial relationships generally possess a duty to undertake diligent inquiry in order to ascertain facts; there is no duty of disclosure by either party absent a special relationship of some kind, except in certain extremes.

In arms-length relationships the parties are also generally free to contract with each other and are largely free to determine the terms of their contract. Neither the service provider in an arms-length relationship, nor the customer, possesses any duty to take care of the other party. Additionally, a party possessing of superior knowledge or astuteness (generally) may thereby benefit at the other party’s expense.

The standard of conduct expected of the actors in arms-length relationships has been described by the courts as the “morals of the marketplace.” [In re Auto Specialties Mfg. Co., 153 B.R. 457, 488 (Bankr. W.D. Mich., 1993).] As such, parties to arms-length relationships are always subject to the requirement of “mere good faith and fair dealing” in the performance of their obligations; this doctrine is fundamental to all commercial transactions. Good faith requires that each party perform their respective obligations and enforce their rights honestly and fairly. The doctrine of good faith is so fundamental to contract law that Aristotle once observed, “If good faith has been taken away, all intercourse among men ceases to exist.” [Aristotle, cited by Hugo Grotius in De Jure Belli ac Pacis, Libri Tres (1625), and cited by J.F. O’Connor in Good Faith in International Law (Brookfield USA: Dartmouth Publishing Company Limited, 1991) at p.56.]

At issue in the Goldman Sachs case: disclosure, not suitability

There are many laws, designed to protect consumers, which impose additional requirements upon product and service providers in arms-length relationships. At times certain contract terms are prohibited; for example, currently debated is whether to prohibit compulsory FINRA arbitration, made binding by the terms of most broker-customer contracts. At other times certain forms of a contract, or required language in the contract, is required (such as truth-in-lending disclosures found in many consumer finance documents). In other circumstances in arms-length relationships, disclosures may be required. For example, §551 of the Restatement (Second) Torts also imposes a duty to disclose “facts basic to the transaction” when custom or other circumstances would expect disclosure to correct a potential victim’s mistake.

Yet, under the common law, the precise boundaries of the disclosure obligation in arms-length relationships remain unknown. Indeed, “[t]he question of when an individual in possession of valuable information unknown to her contracting partner has the right to remain silent and profit from her secret knowledge has fascinated scholars in philosophy, law, and history since ancient times.” [Arthur B. Laby, “The Fiduciary Obligation as the Adoption of Ends,” Buffalo Law Review, Vol. 56, No. 1 (2008), available at SSRN: https://ssrn.com/abstract=1124722.]
Federal Securities Laws Impose Enhanced Disclosure Obligations Upon BDs in Arms-Length Relationships with their Customers

The 1933 Securities Act and the Securities and Exchange Act of 1934 both adopt a “full disclosure” regime for securities issuers and broker-dealers, respectively, as a protection for individual investors. Generally, under these Acts Congress sought “to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry.” [Affiliated Ute Citizens of Utah v. United States, 406 U. S. 128, 151 (1972) (quoting SEC v. Capital Gains Research Bureau, Inc., 375 U. S. 180, 186 (1963)).]

Where disclosures are undertaken by a party (whether or not mandated by law), whether required by the terms of the parties’ agreement, voluntarily undertaken, or compelled by law or regulation, the statements made must be truthful and complete. Otherwise actual fraud, also called “common law fraud,” will be found to exist. If statements of facts are not complete, “concealment” may have occurred, which is itself a form of actual fraud. “The law of fraud knows no difference between express representation on the one hand and implied misrepresentation or concealment on the other … The best element of business has long since decided that honesty should govern competitive enterprises, and that the rule of caveat emptor should not be relied upon to reward fraud and deception.” [Charles Hughes & Co. v. S.E.C., 139 F.2d 434 (C.C.A.2, 1943).]

Material role

The possible failure to undertake complete disclosures is one of the issues in the SEC’s recently filed enforcement action against Goldman Sachs. The SEC alleges that the marketing materials that the mortgages selected in forming a collateralized debt obligation (CDO) were chosen by a well-known and respected firm. Then the SEC alleges that another firm – one of the world’s largest hedge funds – played a material role in selecting the mortgages for the CDO (a fact the SEC asserts was not mentioned in the marketing materials). The SEC further alleges that the hedge fund had taken a short position against the CDO – in essence betting against its success – another fact which the SEC alleges was not disclosed to investors.

Hence, the issue in the Goldman Sachs proceeding is not whether the MBS was “suitable” for the investor; rather, the main issue is whether the disclosures of all material facts were undertaken, and if the disclosures that were made were – because of alleged omitted facts – misleading to the investor in the CDO. It could take years to sort out the actual facts of the SEC vs. Goldman Sachs dispute. However, settlement of the case is highly likely within the next several months, for, as every securities firm realizes, ongoing proceedings with the SEC involve tremendous risk to reputation – whether or not the SEC ultimately prevails. And, Goldman Sachs would rather put its human capital to the pursuit of new opportunities in the investment banking world, rather than devoting substantial time and energy to the defense of the lawsuit.

Further modification of arms-length relationships via the suitability doctrine.

Of course, federal securities laws applicable to broker-dealers (BDs) and registered investment advisers (RIAs) impose not just disclosure obligations (of varying forms and degrees), but other obligations. Some of the restrictions imposed, for all BDs and RIAs, arise from the doctrine called “suitability.”

The suitability doctrine did not arise directly out of Federal securities statutes, but rather is derived from several legal doctrines. It is now embodied in a specific rule adopted by the NASD (now FINRA). FINRA Rule 2310, Recommendations to Customers (Suitability), which states: “(a) In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs. (b) Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning: (1) the customer’s financial status; (2) the customer’s tax status; (3) the customer’s investment objectives; and (4) such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.”

But where did FINRA (formerly NASD) get its authority to impose the suitability standard upon broker-dealers, thereby further modifying the arms-length relationship with their customers (beyond certain disclosures)? After four years of discussion between the SEC and industry groups, and multiple amendments in Congress, in 1938 the Maloney Act was passed. This Act amended the 1934 Act to provide for the establishment of one or more national self-regulatory organizations for broker-dealers, the rules of which must be “designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to provide safeguards against unreasonable profits or unreasonable rates of commissions or other charges, and, in general, to protect investors and the public interest ….” Subsequently, in 1939 the “National Association of Securities Dealers” (NASD) was formed, which initially provided self-regulation of the over-the-counter market, and which since (through a merger with NYSE of certain regulatory functions) has become the “Financial Industry Regulatory Authority” (FINRA), with broader authority over the conduct of BDs. In 1983 Congress legislated that all BDs must become members of NASD (now FINRA).

It should be recognized that “suitability” is also, generally, one of the requirements imposed upon RIAs. “[S]uitability is also applied to investment advisers – it is part of (but does not supersede) the adviser’s fiduciary obligations. See Suitability of Investment Advice Provided by Investment Advisers, Investment Advisers Act Release No. 1406 (Mar. 16, 1994). In Release No. 1406, the SEC proposed a rule under the Act’s anti-fraud provisions requiring advisers give clients only suitable advice. Although the rule was never adopted, the SEC staff takes the position that the rule would have codified existing suitability obligations of advisers and, as a result, the proposed rule reflects the current obligation of advisers under the Act.” [Robert E. Plaze, Outline, The Regulation of Investment Advisers by The Securities and Exchange Commission, at p.39, fn. 82, available at https://www.sec.gov/about/offices/oia/oia_investman/rplaze-042006.pdf.]

Practical Aspects of Suitability: Risks vs. Fees vs. Tax Implications

I get asked about suitability a lot. I explain, to regulators, that it basically is a rule that prevents harm from being done to a customer in an otherwise arms-length relation with a broker. The suitability rule says (in simple terms) that “the investment must, from the standpoint of its riskiness, be OK for this particular customer, taking into consideration the circumstances of the customer and the customer’s portfolio as a whole.”

The suitability obligation consists of two inter-related dimensions. The first is “know-your-customer” suitability, which focuses on the circumstances of the particular customer. The second is “know-your-security” suitability (also called “reasonable-basis suitability”), which focuses on the characteristics of the recommended security.

Yet, a “suitable investment” is one that is “just OK” from the standpoint of the investment product’s risk characteristics, as pertaining to that customer. The BD is generally not required, as part of suitability, to consider the fees, costs, nor tax efficiency of an investment product.

Nor is the broker required to monitor the investment. A salient feature of a BD’s obligations under the suitability doctrine, generally, is that they flow from the recommendation of a securities transaction to the customer. After execution of the recommended transaction the BD generally possesses no ongoing duty with respect to the security purchased. However, there exists some authority that taking an unsolicited order for a security, which the BD knows or should know is so egregiously unsuitable for the client that it should not be permitted, or permitting an investor to pursue a course of conduct – such as margin trading on Internet stocks – can form a basis for BD liability. At the minimum, a “duty to warn” the customer of undue risks may exist. For this reason full-service and discount BDs often limit the products on their platform, or permit only certain pre-qualified clients to access certain types of products or trading strategies.

The Other Form of Commercial Relationship: Fiduciaries and Their Clients

The “fiduciary relationship” is distinct from the arms-length relationship, in that in which the law requires the fiduciary to carry on with the fiduciary’s dealings with the client at a level far above ordinary, or even “high” commercial standards of conduct. Those whom the law classifies as fiduciaries must carry on their dealings with beneficiaries at a level high above ordinary commercial standards.

The fiduciary standard of conduct has been developed based upon centuries of precedent, and in recognition of the fact that a fiduciary acts on behalf of the client, alone, save the provision of reasonable compensation which is agreed to in advance. There are many reasons for the imposition of fiduciary status; some of these were summarized in the decision of Von Noy v. State Farm Mutual Automobile Insurance Company, 2001 WA 80 (WA, 2001), in which Justice Philip Talmadge, in a concurring opinion, stated: “A fiduciary relationship is a relationship of trust, which necessarily involves vulnerability for the party reposing trust in another. One’s guard is down. One is trusting another to take actions on one’s behalf. Under such circumstances, to violate a trust is to violate grossly the expectations of the person reposing the trust. Because of this, the law creates a special status for fiduciaries, imposing duties of loyalty, care, and full disclosure upon them. One can call this the fiduciary principle.”

In essence, the fiduciary standard is a restraint upon conduct. At times it may require foregoing certain activities; at other times it requires enhanced disclosures followed by the informed consent of the client.

As stated long ago by an English court: “The temptation of self interest is too powerful and insinuating to be trusted. Man cannot serve two masters; he will foresake the one and cleave to the other. Between two conflicting interests, it is easy to foresee, and all experience has shown, whose interests will be neglected and sacrificed. The temptation to neglect the interest of those thus confided must be removed by taking away the right to hold, however fair the purchase, or full the consideration paid; for it would be impossible, in many cases, to ferret out the secret knowledge of facts and advantages of the purchaser, known to the trustee or others acting in the like character. The best and only safe antidote is in the extraction of the sting; by denying the right to hold, the temptation and power to do wrong is destroyed.” [Thorp v. McCullum, 1 Gilman (6 Ill.) 614, 626 (1844).]

The fiduciary standard, in essence, operates to restrain greed, and this necessity to restrain opportunism was reflected in a U.S. Supreme Court decision: “The dangers of fraud, deception, or overreaching … motivated the enactment of the [Advisers Act] ....” [Lowe v. SEC, 472 U.S. 181, 210, 105 S.Ct. 2557, 86 L.Ed.2d 130 (1985).]

It should be noted that a violation of a fiduciary duty – i.e., a breach of trust – results in “constructive fraud.” A finding of “actual fraud” is not required for a fiduciary to have engaged in misconduct. Nor is intent to deceive required. These distinctions have long been recognized by the law.

When Are “Financial Advisors” Fiduciaries?

A “financial advisor” may acquire fiduciary status as a result under several laws or legal doctrines. Sections 206(1) and 206(2) of the Investment Advisers Act of 1940 (“Advisers Act”) create a federal fiduciary standard of conduct for investment advisers. Additionally, and regardless of whether a financial advisor is regulated as a registered representative of a broker-dealer, insurance agent, bank employee, or investment adviser, the financial advisor will frequently be held to be a fiduciary through the application of state common law, which imposes fiduciary status upon financial advisors in relationships which, on their particular facts, are appropriately categorized as fiduciary in nature. Additionally, the acquisition of de jure or de facto discretion over a customer’s investments results in the application of fiduciary status to a financial advisor under the law of agency; since the exercise of discretion is often broad, the commensurate fiduciary duties are also deemed to be quite broad.

It should be noted that the Advisers Act has always adopted the “best interests” standard found in the Investment Advisers Act of 1940, which is a codification of state common law. In contrast, ERISA largely adopted a “sole interests” standard – which is a stricter form of fiduciary obligation. Hence, financial advisors providing clients advice on accounts subject to ERISA may possess additional duties under their status as an ERISA fiduciary.

What Are the Specific Fiduciary Duties?

In the United States we frequently refer to a triad of broad fiduciary duties – due care, loyalty, and utmost good faith. These three broad fiduciary duties are best viewed as overriding principles, not specific rules. Yet, from various judicial decisions and administrative rulings, it is possible to further define the boundaries of these broad principles.

First, an advisor shall act with due care. In connection therewith (and not by way of limitation), an advisor possesses a fiduciary duty to the client to exercise with good judgment, knowledge, and due diligence as to the investment strategies, the investment products, and the matching of those strategies to meet the needs and objectives of the client, and with that degree of care ordinarily possessed and exercised in similar situations by a competent professional properly practicing in his or her field. An advisor shall also maintain the confidentiality of client information in accordance with applicable law and the agreement with the client.

Second, an advisor shall abide by his, her or its fiduciary duty of loyalty to the client at all times during the course of the relationship with the client. In connection therewith (and not by way of limitation), the advisor shall at all times place and maintain his or her or its client’s best interests first and paramount to those of the advisor. The advisor shall not, through either false statement nor through omission, mislead his or her or its clients. The advisor shall affirmatively provide full and fair disclosure of all material facts to his or her or its client prior to a client’s decision on a recommended course of action, including but not limited to: (1) all fees and costs associated with any investment, securities and insurance products recommended to a client, expressed with specificity for the particular transaction contemplated; and (2) all of the material benefits, fees and any other material compensation paid to the advisor (and additionally those benefits, fees and other material compensation paid to the advisor representative) or to any firm or person with whom he or she or it may be affiliated, expressed with specificity for the particular transaction which is contemplated. Furthermore, the advisor is under an affirmative obligation to reasonably avoid conflicts of interest which would impair the independent and objective advice rendered to the client. As to any remaining conflicts of interest which are not reasonably avoided, the advisor shall undertake full and affirmative disclosure of such conflict of interest and shall ensure the intelligent, independent and informed consent of his or her or its client is obtained with regard thereto. In any event, the proposed arrangement remains should be prudently managed in order that the client’s best interests are preserved and that the proposed arrangement is substantively fair to the client.

Third, an advisor shall act with utmost good faith toward his, her or its client. Not by way of limitation thereof, an advisor shall not act recklessly or with conscious disregard of the client’s interests.

Contrasting “Suitability” with the “Fiduciary Standard.”

During last week’s Goldman Sachs hearings, it should come as no surprise that various Senators appeared confused as to the obligations Goldman Sachs possessed to its customers in the sale of mortgage-backed securities. As stated in a 2007 article by Greg Deaver, “Confusion over the concept of fiduciary and suitability among the investing public has been a major hurdle for most broker-dealers and their customers. Investors want a clear explanation of the difference, and financial professionals have turned to the regulators for definitive answers. Unfortunately, a clear, definitive explanation has not been rendered to date and, further confusing the situation, investment adviser and brokerage professionals have been debating their duties in public.” [Greg Deaver, Fiduciary vs. Suitability – the debate continues (2007), available at https://www.acacompliancegroup.com/documents/Fiduciary_vs_suitability.pdf.]

A claim for unsuitability typically arises when a representative of a broker-dealer recommends to a customer an investment that he knows, or should have known, is inappropriate for that customer based on the customer’s investment objectives. The customer then proceeds typically to FINRA arbitration, where FINRA’s suitability rule is set forth as the standard of care, and the customer then seeks to prove that this minimalist standard of care was breached and was the cause of the customer’s claimed damages.

In contrast to the minimalist approach of the suitability doctrine, a fiduciary is required to recommend only investments that are the best for the client, following extensive due diligence on both the needs and situation of the client, investment strategies, and investment products themselves.

More controversial is whether the fiduciary standard requires tax-efficient investment portfolio design and management – many state regulators (privately) say “yes,” while the SEC staff has not, apparently, gone that far. Under the general suitability obligation there is no requirement that tax-efficient investments be recommended.
In addition, under broker-dealer regulation conflicts of interest are permitted to exist, and at times only “casual disclosure” of the conflict of interest is required of the broker-dealer. In contrast, the fiduciary duty of disclosure is not satisfied merely by “casual disclosure,” such as “there may be facts which may be of interest to you” or “I may possess a conflict of interest.” As stated in an oft-cited decision by Justice Cardoza: “If dual interests are to be served, the disclosure to be effective must lay bare the truth, without ambiguity of reservation, in all its stark significance ….” [Wendt v. Fischer, 243 N.Y. 439, 154 N.E. 303 (1926).]

The fiduciary standard also requires reasonable avoidance of conflicts of interest, and when not avoided the client must be provided, affirmatively, with full and complete disclosure in a manner ensuring client understanding. The client must thereafter consent to suggested transaction. And, since courts rarely believe that a client would consent to a proposed action that is adverse to the client’s own interests, the nature of the client’s consent is likely to be heavily scrutinized.

But even this explanation over-simplifies the current legal landscape. In practice, regulators and arbitrators often apply the “suitability” standard more or less strictly, or the “fiduciary standard” more or less strictly, to suit the facts of the case or their own understanding of these standards.

How Well Has NASD/FINRA Done At Protecting Investors? The Failure of the Suitability Standard.

The suitability standard was one of the first rules enacted by NASD (now FINRA). Article III, section 2 of NASD’s original “Rules of Fair Practice” mandated that members recommend only suitable investments. One would think that, over time, the suitability standard would evolve, and that with the increased complexity of today’s modern financial world the standard of conduct applicable to brokers would likewise evolve. Sadly, this has not been the case.

In 1938, the Assistant General Counsel of the SEC stated that the “Commission has concluded that the next stage in the job – the job of raising the standards of those on the edge to the level of the standards of the best – can best be handled … by placing the primarily responsibility on the organized associations of securities dealers throughout the country.” [Chester T. Lane, Address Before The Seattle Bond Club (Mar. 14, 1938), available at https://www.sec.gov/news/speech/1938/031438lane.pdf.]

The theme of continually raising the standards of the industry was repeated in a speech by SEC Commissioner George C. Matthews, shortly after the Maloney Act was passed in Congress, in which he stated, “Ideally, the industry should eventually play the predominant role in its own regulation and development …. It should in the largest possible measure achieve that ideal under democratic institutions which Josiah Royce described as the forestalling of restraint by self-restraint … I wish to re-emphasize the evolutionary character of the program provided for in the [Maloney] Act … it is our hope … that the work of construction [of regulation] will continue through the years until there shall finally have been erected a professional edifice commensurate with the importance of the investment banking and over-the-counter securities businesses in our national economy.” [George C. Matthews, A Discussion of the Maloney Act Program, before the Investment Bankers Association of America, October 23, 1938, available at https://sec.gov/news/speech/1938/102338mathews.pdf.]

Senator Maloney himself noted that the Act had, as its purpose, “the promotion of truly professional standards of character and competence.” [Senator Francis T. Maloney, Regulation of the Over-the-Counter Security Markets, Address at the California Security Dealers Association, Investment Bankers Association, National Association of Securities Dealers 2 (Aug. 22, 1939) (transcript available in the SEC Library at 11 SEC Speeches, 1934-61).]

Has, as Senator Maloney believed, FINRA achieved for its members “truly professional standards of character”? As observed nearly 50 years ago by a commentator, it has long been recognized that it has not. “NASD ... [does] not, as do the professions, consider the public interest as one of [its] goals …. Let us consider the attitude of the professions toward the public interest. The goal of public service is embedded in the definition of a profession. Pound, The Lawyer from Antiquity to Modern Times 5 (1953). A profession performs a unique service; it requires a long period of academic training. Service to the community rather than economic gain is the dominant motive. We may measure the broker dealer’s activities against these criteria … Although at least part of his trade is to give service, profit is his goal. The public interest is stated in negative terms: he should refrain from wrongdoing because it does not pay. This attitude is the crux of the matter, the heart of the difference between a profession and the broker dealer’s activity … The industry emphasizes its merchandising aspect, and argues that the broker dealer is subject to the duties of a merchandiser even when he is also acting is his advisory capacity … the NASD [has] proved incapable of establishing accepted standards of behavior for the activities of the trade … Past experience has proved that it is unrealistic to expect the NASD to regulate in the public interest ….” [Tamar Hed-Hofmann, The Maloney Act Experiment, 6 B. C. Indus. & Com. L. Rev. 187 (1964-1965), available at https://sws1.bu.edu/tfrankel/Mahoney%20Act.pdf.]

Prompted senators

The full Senate will take up consideration of the financial services regulatory reform legislation this week. As widely reported, the Goldman Sachs proceedings and the fall-out from last week’s hearing may well prompt Senators to seek the imposition of some form of a fiduciary standard upon broker-dealers.

In essence, Congress may well impose restraints upon broker-dealers which the industry, through its self-regulatory organization, FINRA, has long opposed. For example, early in the 1940’s, shortly after its formation, NASD hailed its achievement in preventing the possible mandated split of “dealer” (including investment underwriting) functions from the functions of a broker (i.e., undertaking trades as an agent). Since then, NASD (now known as FINRA) has long undertaken actions against the public interest, including but not limited to: (1) FINRA’s failure to seek appropriate supervision of derivatives [Alliance for Economic Stablility, “Securities Regulatory Reform: Addressing FINRA’s Inherent Conflict and Moral Hazard,” Jan. 4, 2010]; (2) FINRA’s advocacy promoting fee-based brokerage accounts, without subjecting them to the fiduciary standard of conduct, leading to an SEC Final Rule which was overturned by the U.S. Court of Appeals in Financial Planning Association vs. SEC (2007); (3) FINRA’s refusal to share information with state securities regulators (see Testimony of Denise Voigt Crawford, Texas Securities Commissioner and President, North American Securities Administrators Association, Inc., Before the House Financial Services Committee, October 6, 2009); (4) NASD’s failure to prevent (and subsequent defense of) price-fixing activities in the mid-1990’s, as to the activities of market makers [SEC Chair Levitt said that the evidence showed FINRA “did not fulfill its most basic responsibilities” and concluded that by FINRA’s failure “American investors were hurt — large and small, sophisticated and inexperienced, institutional and individual — all were hurt by these practices.” Statement By SEC Chairman Arthur Levitt, Press Conference Regarding The NASD, Washington, DC, August 8, 1996. Available at https://www.sec.gov/news/speech/speecharchive/1996/spch113.txt and (6) NASD’s failure to prohibit stock analyst conflicts of interests (including very recent attempts to break down, to a degree, the Chinese Wall which was re-built after the scandals which occurred early in the last decade).

Given FINRA’s long history of opposition to the strengthening of the standards of conduct of its members, it should not be surprising that FINRA now seeks to limit the raising of standards, by opposing the bona fide best interests fiduciary standard of conduct found in the Advisers Act, as to the activities of broker-dealer firms.

Yet, the suitability standard of conduct is largely a failure, in terms of protection of consumers. As stated in a recent letter from consumer advocates: “Under a suitability standard, a broker is not required to ensure that his recommendations are what is best for his clients, but only what is generally suitable. The suitability standard allows brokers to recommend investments, for example, based on the amount of compensation the broker receives rather than what is in the best interest of the client. The suitability standard does not even require brokers to disclose their compensation so that their clients can evaluate conflict of interest payments for themselves.” [October 21, 2009 Letter to Senator Akaka from Fund Democracy, Consumer Federation of America, North American Securities Administrators Association, Inc., National Association of Personal Financial Advisors, Certified Financial Planner Board of Standards, Inc., and Financial Planning Association, available at https://www.nasaa.org/content/Files/MFTA_Fiduciary_Letter.pdf.]

The Challenge for the Senate: Courage

The challenge the Senate faces is in understanding the distinctions between arms-length and fiduciary relationships, and in fashioning the appropriate high standard of fiduciary conduct for the delivery of financial and investment advice. The Goldman Sachs hearing provides the impetus for Congressional action, but will the action taken by the Senate, if any, be consumer-favorable?

In the first year of his administration, faced with a financial crisis of epic proportions, Franklin Delano Roosevelt told the press that his principal objective was to restore the idea that dealers in securities, both new and old, are fiduciaries. Will the 2010 Congress, on the heels of this “Great Recession,” follow the lead of the Congresses which endured the “Great Depression” and enact a bona fide fiduciary standard of conduct for all who provide advice regarding securities, as F.D.R. desired? Or will it continue to turn to FINRA, whose only major action to enhance the standards of conduct of its members occurred over 70 years ago, and which since then has, in representing the economic interests of its members, opposed so many times further major restraints upon their conduct in the delivery of investment products and advice to Americans?

Do Senators possess the courage to stand up for Main Street, in the face of strong opposition to enhanced standards of conduct by Wall Street, insurance companies, and other powerful and influential lobbyists? Stay tuned.