February 1, 2008
By Helen Kearney
This year promises to be filled with changes that will shake up the usually staid world of compliance and spark heated debates about the future of financial regulation in the United States.
After years of increasing regulation, there’s a growing backlash with Wall Street heavyweights lamenting the loss of business to more lightly regulated markets overseas. The cries to take action about burdensome regulation are being taken seriously by government agencies and self-regulatory organizations.
The newly created Financial Industry Regulatory Authority (FINRA), formed by the merger of the National Association of Securities Dealers (NASD) and the New York Stock Exchange’s regulatory unit, has been especially responsive to calls to move away from the oppressive box-ticking compliance requirements of recent years.
In addition, the Treasury Department’s initiative to make U.S. capital markets more competitive is garnering support in the overall movement toward streamlined regulation.
But just as the push for change gains momentum, the subprime mortgage meltdown and subsequent credit crunch have served as sobering reminders of the need for investor protection. As a result, consumer advocates are arguing more vociferously that now is not the time to water down regulatory safeguards.
Along with these issues, regulators will be busy this year protecting the growing investments of baby boomer retirees and contemplating a renewed focus on the mandatory arbitration system.
A New Rulebook
Perhaps the most anticipated regulatory event of 2008 is the unveiling of the new FINRA rulebook. There’s been much buzz about FINRA’s pledge to reassess the heavily prescriptive rules brokers face, and move toward a more principles-based approach. Some in the industry hope this equates to an easing of the regulatory burden. Others, especially smaller firms, are concerned that it will create more uncertainty in the process.
Generally, a principles-based regulatory model sets out a number of high-level tenets that firms must follow rather than policing endless rules and requirements.
The United Kingdom’s Financial Services Authority (FSA) has led the way in adopting a largely principles-based model. While many of London’s larger brokerage firms have been pleased with the FSA’s approach, the idea has been criticized by smaller firms for failing to provide sufficient guidance in complying with its principles.
Mark Menschel, general counsel at FINRA, is confident of achieving a balance between rules and principles. “It’s true that people use principles-based regulation as a buzzword for less enforcement,” he says. “That’s not our intention. We intend to move to a more rational based system.”
FINRA’s chief executive, Mary Schapiro, agrees that a combination of rules and principles will make for the best approach. “Our markets are quite different from the European markets, for example, we have much broader retail participation,” Schapiro says. “We are looking into more opportunities to take a principles based approach but there are some areas where it wouldn’t be appropriate.”
FINRA points to the current business entertainment rule as a working example of principles-based regulation. The rule instituted basic principles and allowed firms to develop their own procedures to suit their business model.
Similarly, FINRA’s guidance on the supervision of electronic communications, published last June, did not impose strict rules on how many of a firm’s emails must be reviewed by the branch manager. Instead it left it to the firms to consider which areas posed the most risk when monitoring electronic communications.
Others in the industry hope the adoption of principles will lead to a more collaborative relationship between regulators and firms. Shane Hansen, a securities lawyer and partner at Grand Rapids, MI-based law firm, Warner Norcross & Judd LLP, believes this relationship has deteriorated in recent years due to overzealous enforcement. “In the last several years, there’s been more of a sense that there is no notion of forgiveness,” says Hansen, whose firm represents both investors and brokers. “A legitimate claim that it was an honest mistake of oversight does not get you anywhere. You’re going to get fined, it’s just a matter of how much.”
Travis Larson, spokesman for the Securities Industry and Financial Markets Association (SIFMA), points to the UK as a success story for collaborative regulation. The FSA “is less concerned with gotcha’ examinations than guiding regulations at firms,” Larson says.
Not everyone is in favor of such a change. Jed Bandes, president of the Mutual Trust Company of America Securities in Clearwater, FL, is no fan of the current regulatory regime but still does not think moving toward general principles will help. “If there’s no set rules, it just leaves it up to the examiner. They can just come in and say, we think you’re breaking a rule.’ ”
Others are just hoping for more basic improvements. “It would be wonderful, if nothing else, if the rulebook was written in plain English,” says Michigan attorney Hansen. “Some rules are so convoluted and scattered, you really have to know it all to know anything. It’s not one-stop shopping.”
Just as FINRA was establishing itself as the new regulatory powerhouse on the block, the Treasury Department announced that it was considering its own overhaul of financial services regulation. Kicking off its “U.S. Capital Markets Competitiveness” initiative in March last year with a conference attended by luminaries from the business and political worlds, the department ended the year by collecting submissions from industry groups detailing their wish lists for regulatory changes. The Department is expected to release its blueprint for reform early this year.
Since his appointment in July 2006, Treasury Secretary Henry Paulson has repeatedly expressed concerns that U.S. markets are losing their competitive edge to their more lightly regulated counterparts in Europe. His fears are echoed throughout the industry. A study released by the independent Committee on Capital Markets Regulation in December found that a record 56 foreign companies delisted from the New York Stock Exchange in the first ten months of 2007. That compares to 30 companies in all of 2006 and just 12 in 1997. Research from the Financial Services Forum, a group of 20 major Wall Street banks, found that 30% of foreign-listed companies cited excessive regulation as the primary reason they chose to list outside the U.S.
In October, Robert Steel, the Under Secretary for Domestic Finance, acknowledged major flaws in the current regulatory framework, saying the multiple levels of regulation were difficult to navigate and still exposed consumers to gaps in protections. “If we were starting fresh and had a blank page, no one would choose to draw a regulatory structure that resembles our current picture,” he added.
As with the new FINRA rulebook, the trendy phrase of many of the industry submissions to the Department is “principles based regulation.”
SIFMA’s Larson says: “This is the direction that the global market is moving and the U.S. would be shortsighted if it did not move in this direction.”
As the industry’s biggest lobby group, SIFMA had plenty of suggestions for reform. First and foremost, it is pushing for even greater consolidation among regulators. The industry trade organization suggested combining the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). SIFMA also took aim at state regulators. It said in its submission that it recognized their important investor protection role, but it recommended looking at “how best to eliminate redundancies and inefficiencies related to state regulation.”
Another trade group, The Financial Planning Association (FPA), has raised the issue of advisors being required to hold multiple licenses, particularly when consulting on retirement issues. It has recommended instituting a single license for a financial planner that would cut across regulatory lines. “With the existing regulators, each has their own spheres of expertise and influence,” says Dan Barry, the FPA’s director of government relations. “There are some blurry lines on who is regulating what and that leads to redundancies and inconsistencies.”
However, not everyone is lining up to support the push for reform. The North American Securities Administrators Association (NASAA), which represents state and local securities regulators, does not support changes to the current system. “It’s counterintuitive to be attempting to dismantle a tried and tested structure at a time when more Main Street investors are turning to the capital markets for their retirement needs,” says NASAA president and North Dakota securities commissioner Karen Tyler.
Jacob Zamansky, partner at New York law firm Zamansky & Associates LLC, which represents plaintiffs against brokers and firms in securities arbitration cases, agrees. “Our rules give investors the confidence to invest in the markets,” he says. “Having the integrity and confidence of investors doesn’t make us less competitive.”
But despite these concerns and the recent troubles in the market, the overall momentum for change remains strong. And, once again the UK’s Financial Services Authority is providing the model for reform. In December David Nason, the U.S. Treasury Department’s assistant secretary for financial institutions, told a gathering of business leaders in London that he believed “…in this new globalized marketplace we are engaged in a race to the top to achieve the optimal regulatory structure for the financial services industry.”
Dispute resolution between brokers and their clients is also likely to remain a hot topic this year with mandatory arbitration agreements increasingly under the spotlight. Consider this. Last July, the “Arbitration Fairness Act of 2007″ was introduced into the House of Representatives. If passed, it would make the pre-dispute mandatory arbitration agreements used by most brokerage firms unenforceable.
The controversial Solin study on securities arbitration released last June found that the percentage of investors’ victories were declining. And when they did win, they were recovering less money. The findings were particularly stark when it came to large claims (more than $250,000) against big brokerage firms, with investors recovering just 10% to 12% of the damages they sought.
Advocates argue that by making arbitration a condition for opening an account with the majority of brokerage firms, investors are essentially stripped of their right to access the court system. With the merger of the NASD and NYSE’s regulatory arm, both of which had their own arbitration systems, there is now only one choice for investors-FINRA.
Another major concern raised by investor groups is the presence of an industry representative on the three-person arbitration panel. Representatives can include employees of brokerage firms such as branch office managers, compliance officials or attorneys. In a recent white paper, The Public Investors Arbitration Bar Association (PIABA) considered the effects of consolidation in the industry on the arbitration process. “How severely can (the industry arbitrator) be expected to sanction a firm that may be considering him for employment in the not-too-distant future?” the PIABA wrote.
To be sure, industry officials defended arbitration.
Ron Kruszewski, chief executive of St. Louis, MO-based Stifel Financial Corp., doesn’t think this puts investors at a disadvantage. “The arbitration process has served investors well,” he says. “People often don’t understand that there are many cases in arbitration that would never see the light of day in court.”
And industry lobby group SIFMA insists that evidence of bias simply does not exist.
“Study after study by the industry and government agencies could not find bias by panels including an industry representative,” says SIFMA’s Larson. “Claimants actually receive better responses to their claims when there is an industry arbitrator on the panel.”
Investors also complain that firms, particularly the major wirehouses, don’t play fair when it comes to handing over documents that may damage their defense. Lawrence Klayman, a Boca Raton, FL-based securities lawyer who represents investors in arbitrations against their brokers, says: “The abuse that goes on as far as discovery is concerned is widespread and coordinated.” Unlike in court where a refusal to provide documents can result in a contempt ruling, there are few repercussions for uncooperative firms in the arbitration process, according to Klayman.
Indeed, FINRA has made some attempt to punish firms for withholding documents.
Last September, FINRA fined Morgan Stanley $12.5 million for falsely claiming that emails requested during arbitrations brought against them had been destroyed in the 9/11 terrorist attacks. Advocates argue it isn’t enough. “Given the effect of court sanctions and contempt power, one would expect Morgan Stanley would never have tried to get away with such an audacious scheme,” wrote PIABA in its white paper.
But, SIFMA argues that the less burdensome discovery procedures actually work in the investor’s favor. “Any move to make arbitration more like a court is going to benefit the party with the larger pockets, and that is the firm,” says Larson for the industry group.
It’s unclear whether the proposed legislation has much of a chance of passing. A similar bill introduced ten years ago failed to pass and so far this proposal hasn’t won significant backing.
But, the ensuing debate may lead to some modifications to the arbitration forum.
Kip Carevic, chief compliance officer at Raymond James & Associates in St. Petersburg, FL, says his firm is not in favor of abolishing arbitration because of the costs associated with litigation but is willing to contemplate some reforms. “We would like to see a closer look at industry representation on the panel, rather than doing away with arbitration,” he says.
With baby boomers holding an estimated $8.5 trillion in investable assets, and on target to inherit an additional $7 trillion, according to Cerulli Associates, it came as little surprise when FINRA took aim at inappropriate sales tactics targeting that investor group last September.
One of FINRA’s biggest concerns was the proliferation of senior designations, some of which require little or no training to achieve. A study conducted by the regulator found that a quarter of senior investors had been told by an investment professional that he or she was specially trained to advise on senior issues, and half of those investors said the accreditation made it more likely they would listen to the professional’s advice. Furthermore, it found that one in five seniors who lost money on an investment attribute that loss to being mislead or defrauded.
As a result, FINRA initiated two regulatory sweeps: one, focusing on bogus senior designations and the other on so-called “free-lunch seminars” some of which were designed to entice older workers to invest their retirement funds in inappropriate products.
Mutual Trust Co.’s Bandes says the move has hurt smaller firms by unnecessarily frightening older investors. “Merrill Lynch can do name-recognition ads but we can’t afford it,” he says. “We can only get in front of [potential clients] and that’s nearly impossible now. [FINRA has] made small firms look like pariahs.”
There’s also been some confusion as to which designations are acceptable. Nancy Lininger, founder of The Consortium consulting group, says firms are wary about being inadvertently caught up in the sweep. “Some broker-dealers have had a knee jerk reaction and told reps not to use any senior designation until we have rules to follow,” she says.
Meanwhile, NASAA has attempted to address these concerns by proposing a model rule that it hopes will be adopted nationwide.
The model rule establishes minimum standards for senior-specific certifications and the institutions that issue them, including meaningful standards for assuring the competency and continuing education of its students. A nationally recognized body should also accredit the institution, NASAA proposes.
The FPA supports NASAA’s model rule. “We are not opposed to the use of designations so long as it’s done responsibly and they’re not misleading,” says FPA’s Barry. “They must have underpinning education and continuing education and not merely be a certificate without expertise backing it up.”
In addition, Barry says that NASAA’s general approach is more efficient than having the states examine every certification and deciding whether it’s legitimate.
While FINRA looks likely to tighten rules in this area it appears committed to its pledge to review the overall regulatory burden. “We’re listening,” says FINRA general counsel Menschel. “Management is spending time getting out there and talking to firms. There’s a certain level of tension that’s inevitable between the regulator and regulated, but we don’t want any unnecessary tension.”