Why the ‘‘Restoring American Financial Stability Act of 2010’’ will be REALLY AWESOME[!] for The Street and why government will always be The Street's BFF:
1.) Fiduciary duty for brokers, which is under debate today, would bestow on brokers that provide investment advice to retail investors a "fiduciary duty" - a mandate to act in those client's (investors') best interests. This includes disclosing conflicts of interest a broker may have in advising a retail investor about a certain security available for purchase. Brokers are not, nor have they ever, been required by regulation to act in the their clients' best interests, or disclose such conflicts, when giving investment advice. True! The Investment Advisers Act of 1940 made that exemption explicit.
Gist: The broker fiduciary proposal sounds more revolutionary than it is.
[Update: The Street - no surprise - is set to win this battle and thus, just as we predicted in the previous post, prevail in the consensus exercise posing as war over financial reform; Congress chose June 23 to proceed with a modified iteration of the weaker Senate version of the broker fiduciary proposal. The compromise would call for a year-long study by the Securities and Exchange Commission to determine whether requiring a fiduciary duty for brokers when giving investing advice to retail investors is appropriate. The SEC would be empowered to promulgate rules if moved by the study to do so, but proponents for establishing such a requirement complain the study will lead to naught. Compromise language, according to a fiduciary promoter quoted by InvestmentNews,
may force the SEC to sue to prove that other undefined methods, such as some sort of "disclosure," could not more easily mitigate the problems and conflicts posed by keeping in place the current uneven rules covering standards of customer care, in which brokers giving retail investing advice do not have to look out for their clients' best interests, whereas registered investment advisers do. Brokers say the lesser standard is necessary or more appropriate to their core roles as market-makers and liquidity providers. The final bill also preemptively weakens the SEC's ability to apply fiduciary duty in its full legal strength on brokers, as it precludes them from having any ongoing duties of "loyalty" to their customers in putting said customers' interests ahead of their own after giving said customers investment advice. It's a once-in, once-out, conversation-by-conversation (or transaction-by-transaction) deal if the SEC ever decides post-study to mandate it. Whereas the fiduciary duty registered investment advisers are held to mandates an ongoing "loyalty" to their customers, to essentially always act in their best interests. Also, the receipt of sales commissions by brokers, the bill says, would not alone be considered to violate any fiduciary duty applied. And perhaps most importantly, the bill appears to open the doors for the SEC (and those that lobby them) to gut or weaken the fiduciary standard for everyone, essentially by being told to reexamine the whole notion, or definition, of the standard of customer care that's been applied under the Investment Advisers Act of 1940. While the bill asks the commission to examine the opposite of the following question, it also asks the SEC to study whether "the regulation and oversight of brokers and dealers provide greater protection to retail customers than the
regulation and oversight of investment advisers" (and vice versa). Therefore, look for the industry to be all over the SEC to convince them to weaken the applied standard of customer care.]
Again, even if it comes to pass somehow, extending fiduciary duty to brokers sounds good, but the proposal does not cover all broker interactions with firms that manage retail investors' investments; it would only apply to brokers (and insurers) when they give investment advice directly to retail clients. It would, however, if passed, enable brokers to say they are looking after retail investors' best interests when giving them investing advice directly, because the regulations make them. Though one wagers the penalties will have to be sufficient to make it so.
Why it's important that the proposal would cover only retail clients is because said retail methods are not how we the people - the retail plebs - invest all our money, meaning via direct interactions with brokers or registered investment advisers (RIAs). A lot, perhaps the bulk, of money we invest, ends up with the big buy-side funds considered sophisticated institutional investors, who manage our money by interacting on a level deemed "sophisticated" by regulation, such as interactions between pension funds and brokers, or mutual funds and brokers, for instance. The fiduciary proposals in the House and Senate bills being debated by Congress would not bestow fiduciary duty on brokers in these interactions. The House bill would allow the SEC to determine whether to extend broker fiduciary responsibility to clients other than retail customers, such as those "sophisticated" institutional investors, while the Senate bill would not. The latter calls only for the SEC to study the impacts of making brokers act in their retail clients' best interests when giving them investment advice.
Even what exactly constitutes "investment advice" remains unclear. But it's important to know that such advice would not include trade execution, underwriting securities or general market-making, areas in which some so-called sophisticated institutional investors who manage our money claim they've variously been sold loads of shit, sometimes.
This means, for instance, that Goldman Sachs could still potentially structure and sell a bond similar to the one described by one former senior Goldman executive days after its sale as "one shitty deal," as long as the securities are considered "suitable" to the investor involved. Goldman is alleged by the SEC to have fraudulently sold Abacus, a collateralized debt obligation (CDO), or pool of mortgages, to IKB bank and ABN Amro, which combined lost near $1 billion on the deal. The SEC claims Goldman failed to sufficiently disclose that Paulson & Co., a hedge fund, had helped pick some of the mortgages that would go into the CDO that the Paulson fund ultimately shorted, meaning bet would fail, by purchasing credit default swaps on it. Letting the clients know more about Paulson's role in Abacus, the SEC contends, would or should have made the two banks at least think twice about buying portions of the deal. Background: IKB is a German lender to small and mid-sized businesses that required multiple German government-aided bailouts in 2007 and 2008 for getting snared in the credit meltdown by essentially going long on subprime, which means the bank bet that pools of mortgages lent to those with shaky credit profiles were a good investment that would rise in value and so IKB is understood to have bought a sizable chunk of them, a bet that proved disasterous. ABN Amro is a mainline European bank with a large retail client base that also acts as a broker-dealer. Each are deemed "sophisticated" in such interactions with brokers. The legislative proposals would change none of that: It's still "caveat emptor" or buyer beware for these big buy-side firms who manage a big chunk of our money, when they deal with brokers. Conflicts of brokers are need-to-know, as determined by the brokers who have the conflicts. (Goldman officials have said the "one shitty deal" remark referred to the Abacus trade's "execution," not what it contained nor its ability or inability to fuck over the client, which Goldman strongly contends it did not, nor intended to, do.)
Currently and since nearly forever, brokers with retail advisory accounts that give investment advice, like Morgan Stanley and Bank of America/Merill Lynch, have not been made by regulation to act in their clients' best interests when providing investment advice, or when selling customers financial products. Whereas registered investment advisers (RIAs) are made by regulation to act in their customers' best interests. Regulation bestows on RIAs fiduciary duty. RIAs can be registered individuals with a simple shingle hung, or they can be big pension funds like Calpers, or giant mutual funds like Fidelity or Pimco. They are also known as the "buy-side," because they need "sell-side" brokers, meaning big banks like Goldman Sachs and Morgan Stanley or so-called "discount" execution providers like Interactive Brokers, to "buy" securities or execute trades for them, but only under "suitability" not fiduciary standards, whether these RIAs are buying or selling: In nearly every single case worth noting, only broker-dealers can be direct members (or "liquidity providers") of trading centers like exchanges, and therefore only broker-dealers can directly execute trades on such trading platforms. They execute trades for or on behalf of buy-side firms. A big bank also creates or "structures" securities to sell to institutions bi-laterally (between the bank and institution only) in the so-called over-the-counter market, meaning the bank sells the institution a derivative or piece of structured debt it made up or put together - as was the case with Goldman's Abacus -where there's no exchange or third-party involved, the sale occurs directly and only between the bank and the institution (see the endnote at the bottom of this post). Because of this "club" structure in trading, as independent as your adviser claims to be, it is virtually impossible for him or her NOT to be beholden to the services of broker-dealers, who hold exclusive rights to offering clients' said execution services, but do not have to act in the best interests of those clients - the firms managing your money - regardless of whether trading occurs over an exchange or over-the-counter. Roads lead to brokers, and their lower standard of regulated customer care, almost always.
Other differences: Brokers are almost always paid based on sales commissions (i.e., trading commissions), though they also may collect fees for managing one's money as well: The industry calls this a "fee-based" model, even though it involves collecting commissions AND fees. RIAs can also, and some do, collect both management fees AND trading commissions. Only "fee-only" RIAs do NOT collect commissions, just management fees. Therefore, many investor advocates consider "fee-only" RIAs the most unconflicted or customer-centric, because of their non-reliance on trading or sales commissions for renumeration. Regardless, be particularly careful of monikers and wording when trying to understand advisers, and any financial regulation for that matter!
Addendum: One really cool thing The Street will gain if this fiduciary proposal (and the overall financial reform bill) passes? A primary differentiating claim and/or marketing argument of the buy-side - that registered investment advisers are better places to invest your money rather than with brokers because RIAs are bound by regulation to look after your best interests, whereas brokers are not - will seem to vanish: That fiduciary marketing edge that presumably favors RIAs in the minds of retail customers - presuming any knew enough to realize the difference (and various studies over the years say
many do not) - will be zapped because brokers would, if the proposal and bill passes, be made to compete on the same level as RIAs regarding retail customer responsibility standards when giving investment advice. At least on regulatory paper. Brokers could say: 'Not that we acted any differently before, but now regulation says there is
no difference between standards of treatment between brokers and RIAs when providing investment advice to retail customers, so come on over and invest with us: We've arguably got more money, technical firepower and neat tricks. Plus, we sell stuff too, just like our nickname.
Why the buy-side or any RIAs should be excited about this snatching away of what has been, at least on parchment, their competitive edge in mandated customer care, may seem unclear. However, it's important to know that brokers are salesman, essentially. They are able under long-standing regulations to market products to investors under a lower customer care standard than RIAs. Thus it could be argued that brokers have a sales edge in moving their products, because they can engage in more "salesmanship" - meaning they can push their products harder, without fiduciary duty, meaning with less concern or less care for their customers' best interests - under the rules, than RIAs, which is at least in part why the RIAs have found the different regulatory requirements for standards of customer care unfair. While RIAs can claim they take the higher road, meaning apply the higher standard of taking clients' best interests into account, selling products is more difficult under such an onus, because sales under such a fiduciary filter is harder than requiring mere suitability, in which the brokers need only prove the products they're recommending to clients are appropriate for the type of customer with which they're dealing.
David Tittsworth, executive director at the Investment Adviser Association (IAA), a lobby group for registered investment advisers that is strongly in favor of bestowing fiduciary duty on brokers, said it's difficult to know "the competitive ramifications" of the fiduciary proposal prior to knowing what form it may take or whether it's included in the financial reform legislation, an overall bill which ultimately faces full votes by the House and Senate. Congressional committee conferees missioned with merging the two different financial reform bills the House and Senate have passed were at press time still debating each body's versions of the broker fiduciary proposal, any portion of which could be bargained away or stripped completely out of the reform bill at any time.
Regardless, Tittsworth wrote (The) Street Controls (You) in an email, that:
"[RIAs] have consistently argued that persons who do the same thing, specifically, providing investment advice, should be treated the same way under the law. This seems to be fundamentally fair and appropriate. Further, I think investors/clients deserve the higher standard of conduct that fiduciary duty imposes, given the relationship of trust that exists between clients and those who provide investment advice."
Tittsworth also claims that because trade execution would presumably not be covered by a broker fiduciary standard, an investor could receive two levels of care or performance in what seems a single or package service. Investing advice, he said, could be done in the customer's best interest, while trade execution need only be priced "reasonably" and to a degree considered "suitable" for, or appropriate to the level of sophistication of that same investor. Therefore, Tittsworth argues, a broker's advice to buy a bond could presumably be in said investor's best interest, whereas execution of that trade, and therefore possibly the trading price the investor receives, may not be.
"If I'm a broker and you are the customer, I don't think you would want me to give you investment advice (I recommend that you buy XYZ stock) under a fiduciary standard and then turn around and sell you XYZ from my employer's inventory (for which they could earn substantial profits) and for which I get a big commission (as long as XYZ is "suitable" for you, I don't have to disclose these conflicts of interest that would place the interests of me and my firm ahead of your interests). That's 'hat-switching.' First, a broker is wearing his fiduciary hat (when providing investment advice), but then the broker switches to his suitability hat when it's time to sell the security or product recommended.
"We think that 'hat-switching' is detrimental to the best interests of clients," he said. "You should not be able to have a fiduciary standard when you're giving investment advice to a client and then turn around and sell a product under a lower standard to that same client."
How or whether a final fiduciary proposal might address the aforementioned nuances is unclear.
The Financial Industry Regulatory Authority (FINRA), a private, industry-funded, self-regulatory organization (SRO), has rules that aim to hold brokers to a "reasonable" standard of best execution, which requires brokers to show they've done reasonable due diligence in finding the best markets and most favorable pricing for the type of investor involved. FINRA monitors trades, in corporate bonds for instance, for prices that lie outside (5 percent has been given as a benchmark, though some critics consider that too wide a range) of those prices provided by other brokers in the same or similar securities.
Regardless, it's a safe bet most investors are confused. "Average investors typically don’t understand the differences between an RIA, a broker, a dealer, or an insurance agent," says Carrie Annand, spokeswoman for the Financial Planning Coalition, a group of financial planning trade organizations who combined in December 2008 to promote the interests of financial planners in the debate on financial reform. The fiduciary retail proposal would also cover insurance firms selling variable annuities and other investment products.
“People really don’t know the difference, and don’t know who it is they should turn to for which financial decision,” Annand says. “The idea behind supporting this measure is greater transparency, greater trust in the financial industry as a whole, and greater consumer protection."
Annand adds that "there are a lot of brokers out there who do adhere to the fiduciary standard, through their involvement in a certain association; perhaps they are a certified financial planner (CFP)."
True, but it is important to know that there is still no fiduciary requirement in such instances.
Also, know that the Certified Financial Planner Board of Standards bestows the certified financial planner (CFP) certification, and that this standards board is part of the Financial Planning Coalition.
While the CFP is considered one of the top certifications for independent money advisers, there is no requirement for a certified financial planner (CFP) to necessarily be a registered investment adviser (RIA). This means a certified financial planner, or CFP, will not necessarily have a fiduciary duty when advising customers, unless he or she is a registered investment adviser, or RIA, also. To review: If a CFP is an RIA, the investing advice he or she gives you must be in your best interest, according to regulation. If the CFP is NOT an RIA there is no such fiduciary duty, at least not by regulator mandate, for him or her to give investing advice considered to be in your best interest. Thus, it's recommended you ask your financial planner if he or she is a registered investment adviser (RIA) to ensure he or she is required to give you advice in your best interest. Also, it pays to make sure your RIA is using more than one broker for his or her trading or brokerage needs. This way, you can better ensure he or she is at least able to shop around - but make sure he or she actually does this - to find the cheapest execution fees and other brokerage service costs for you. Ask also your RIA to spell out exactly what he or she is passing on in making you pay for these brokerage costs, meaning itemize what these other, non-trade execution brokerage costs are, as brokers often offer advisers "package" services - especially if the adviser "exclusively" goes with one broker offering these "execution-plus" deals. These fees are in addition to simple execution fees and they add to your brokerage costs. They may include "research" or other services, which you or your adviser may deem less valuable than the price you're being made to pay might suggest they're worth, once you're able to look at them and cost-benefit what you're getting with what you'd pay and get without them. Make your RIA force his or her (and essentially your) brokers to compete on price for your business, if at all possible. As exclusive deals involving one broker are the norm, this may prove difficult. But at least have your adviser prove that the "deal" you're allegedly getting by going with one broker is one that truly gets you the lowest-cost service possible, versus simply an agreement by your adviser to trade a lot with the broker.
The Securities Industry and Financial Markets Association, the main trade and lobby group of Wall Street brokers, did not immediately respond to our request to give the brokers' positions on extending the fiduciary standard to those providing investment advice to retail clients. We will update this section when we hear back from our friends at SIFMA.
We'll also ask those responding to reply to claims made by IAA's Tittsworth regarding the differences in customer care standards between brokers' retail investing advice and retail trade execution that could emerge if fiduciary duty is extended to brokers. Also, remember that difference exists already in dealings including trading between institutional investors and brokers. That fiduciary requirement our mutual and pension funds adhere to when dealing with us can fail miserably once they start dealing with brokers, because then the chain of protection via fiduciary duty is broken, because brokers aren't made to adhere to it, and hence we're only as good as our RIA is in discerning whether he's getting treated well or sold down the river. But it's still our money. Caveat emptor indeed. Because within such gaps of standard care: shit happens.
That said, brokers would argue that they naturally adhere to high standards of customer care because they couldn't stay in business if they were found to continually, habitually or even occasionally stiff their customers. Yet and still, they've tended to strongly oppose coming under fiduciary requirements when it's been brought up in the past, though the reasons behind that opposition are rarely stated plainly. But it's plain to see that the rulebook enables brokers a less onerous standard when it comes to advice and hence sales efforts. It's right there in the rules. There's really no arguing that. But we'll wait to hear what they say.
Recent statements would posit that SIFMA opposes extending fiduciary duty to brokers, at least when they're dealing with institutional investors. On May 20, in response to the Senate passing its version of reform legislation including a provision focused on derivatives, Sifma President and CEO Tim Ryan said the trade group believes "that requiring financial institutions entering into swap contracts with state governments, pension funds or endowments to act as fiduciaries for their clients is legally unworkable and would limit these clients’ ability to access vital risk management tools.”
More on that later.
Endnote: Sell-side broker-dealers execute trades for or on behalf of buy-side firms. These big banks also create or "structure" securities to sell to institutions bi-laterally (between the bank and institution only) in the so-called over-the-counter market, meaning the bank sells the institution a derivative it created or piece of structured debt it put together - as was the case with Goldman's Abacus -where there's no exchange involved, or no "liquidity center" at all involved, which otherwise would aggregate or centralize multiple securities based on price offers from multiple dealers and make them available for trading. Instead, the bank is the sole liquidity provider in these situations as the sale occurs only between the bank and an institution. Or, actually, in practice, there are usually multiple legs involving different trades to institutions as whole deals are rarely able to be distributed whole hog to one institutional investor. Plus, the bank may need to offset its risk from selling a product to a fund. To do so the bank will buy credit protection from some firm going long (betting the value of the deal just sold will rise). Whether the bank's credit protection is deemed a pure hedge or a bet diametrically opposed to the deal the bank just structured can almost always be debated. Also, typically another fund, like a hedge fund, may want to short (bet against) whatever wager the institutions essentially made in their purchase of securities - whichever way the institution may have "gone long." So the bank might set up a multi-legged trade, or trades, involving these shorts and longs, aimed at satisfying the needs of all, or most, involved. The ability to see and act on all the capital needs, requirements and financial desires of the whole range of customers a big bank deals with: Therein lies the big banks' power.
No comments:
Post a Comment