by Bill Singer
Wall Street Regulator FINRA Sings Kumbayah In Regulatory Fight Against Conflicts And Unsuitability
May 22, 2012
On May 21, 2012, the Financial Industry Regulatory Authority ("FINRA") posted Remarks by Richard Ketchum at the FINRA Annual Conference. Towards the end of FINRA CEO Ketchum's speech, he tells his audience that:
[I] want to leave you with three thoughts on how firms and regulators can work to do just that.
First, I call on you to do a better job of assessing-and disclosing-your conflicts. We've heard a lot in the last couple months about the culture at large firms through various media reports and the conflicts that are part of the day-to-day operations. However, I don't think the conversation should just be about the culture at one firm or another. We understand that conflicts exist in the financial services industry. We need to take a step back, acknowledge that there are risks and look at how we handle those conflicts.
Nine years ago Stephen Cutler, who was then director of the SEC's Division of Enforcement, asked firms to undertake a top-to-bottom review of their business operations with the goal of addressing conflicts of interest of every kind. I would like to see such a concept review become a standard part of operating procedure. You should be assessing whether your business practices place your firm's-or your employees'-interests ahead of your customers. What I can promise you is that, particularly with respect to the large integrated firms, we will look to have a focused conversation with you about the conflicts you have identified and the steps you have taken to eliminate, mitigate or disclose each of them.
Second, I call on you to ensure that the products you sell are appropriate for each investor. We have often reminded firms of their obligation to assess the potential risks associated with products that raise specific investor protection concerns. One of our concerns is the sale of complex products, and in January we published guidance in the form of a Regulatory Notice.
We've brought a number of enforcement actions involving complex products where we found firms didn't adequately supervise the sale of the products, the recommended products were unsuitable for the investors, or the sales material were misleading. We recognize the challenge you face when managing compliance oversight at a time when more customers are searching for yield and financial advisors are looking for products to meet these requests. Nevertheless, the suitability rule remains in effect, and it is the obligation of every firm to take steps reasonably designed to ensure that the suitability issues related to complex and other products are adequately addressed.
Before recommending a complex product to a retail customer, your financial advisers should be discussing the features of the product, how it is expected to perform under different market conditions, and the product's risks, potential benefits and costs. This means describing the circumstances under which the customer could lose money, not just those under which the customer would earn money. It also means explaining carefully the direct and imputed costs your client will incur and, where applicable, the fact that your firm or an affiliate is on the other side of the transaction. For this disclosure to work effectively, it will be equally important that you increase the training provided to your financial advisers to ensure that they fully understand the assumptions underlying the product and what can go wrong as well as right.
Finally, before any complex product is offered to a retail client, your financial adviser should be able to write down on a single page why this investment is in the best interests of your client. This does not have to wait until you find out the details of any fiduciary rulemaking the SEC may make. Being able to articulate why an investment is in the best interests of your client is fundamental to what the securities industry must be about if it is to deserve the trust of investors. The time to do it is now. . .
Bill Singer
Oh for godsakes - really? The head honcho of Wall Street's largest self-regulatory organization has so few arrows left in his quiver that he's reduced to spouting those three ideas as the bases for effective regulation in 2012?
Recycled Top To Bottom Review
According to FINRA's Ketchum, the securities industry needs "to do a better job of assessing-and disclosing-your conflicts."
My, now there's an idea with teeth and bite. It's the same hollow rhetoric that advocates cops do a better job policing, prosecutors do a better job prosecuting, and the military do a better job fighting. Help us, help you, help us, help you . . . ad infinitum, ad nauseum. How convenient it must be to just skip to the conclusion without bothering with the pesky details on just how to get there.
Wow, Wall Street's cops "understand that conflicts exist in the financial services industry." Not that you'd know it from recent events but, hey, even Sleeping Beauty eventually woke up. On the other hand, I'm not exactly jumping for joy when I learn that the industry's self-regulatory organization is yet again advocating that "we need to take a step back, acknowledge that there are risks and look at how we handle those conflicts." Yeah, great idea, take a step back, acknowledge risk. Just how much farther back can we step?
Do you folks at FINRA now have a better view of Goldman Sachs and that Abacus business? Do you have a wider perspective of JP Morgan's recent losing trades? Are you in a better position to see how lead underwriter Morgan Stanley handled the Facebook offering? Has the big picture with the Flash Crash or MF Global come into better focus? You got any more optics on the old Madoff and Stanford messes? If not, have you tried holding your thumb up between your eyes and the image that you're gazing at?
Ironically, in his speech, FINRA's CEO reminds us that "nine years ago Stephen Cutler, who was then director of the SEC's Division of Enforcement, asked firms to undertake a top-to-bottom review of their business operations with the goal of addressing conflicts of interest of every kind. I would like to see such a concept review become a standard part of operating procedure . . ."
So, lemme see if I got this. Today, those charged with regulating the securities industry think it helpful to regurgitate the same failed policies of the past, particularly those advocating endless rounds of "top-to-bottom review." And the point of once again doing all this industry soul searching is what - to lay the groundwork so that in 2022 some other CEO of FINRA can remind us that in 2012 Ketchum admonished us to follow Cutler's 2003 top-to-bottom review policy? In the end, all this introspection and turning over of the mattress gets us nowhere.
Ketchum concluded his comments by urging his audience to begin assessing "whether your business practices place your firm's-or your employees'-interests ahead of your customers. What I can promise you is that, particularly with respect to the large integrated firms, we will look to have a focused conversation with you about the conflicts you have identified and the steps you have taken to eliminate, mitigate or disclose each of them."
To sum it up, after Wall Street steps back, way back, and ponders the imagery and investigates the inherent conflicts in its business, FINRA is warning that we're all gonna sit down and have a "focused conversation." Whoa, and I thought this was all leading nowhere.
Suitability
Going from the sublime to the ridiculous, Ketchum then offers this guidance to his audience:
[B]efore recommending a complex product to a retail customer, your financial advisers should be discussing the features of the product, how it is expected to perform under different market conditions, and the product's risks, potential benefits and costs. This means describing the circumstances under which the customer could lose money, not just those under which the customer would earn money.
How many more times, for how many more years, are Wall Street's regulators going to talk the talk of suitability but refuse to walk the walk? At some point, the warnings are merely comical. And why the hell is Ketchum talking aboutcomplex products and suitability? Let's talk about something more basic, like the recent Facebook offering.Does FINRA believe that its larger member firms who were blessed with a Facebook IPO allocation were even-handedly "describing the circumstances under which the customer could lose money, not just those under which the customer would earn money?" Should we expect some regulatory sweep from FINRA on this very issue?
How does Wall Street's self-regulatory organization justify the $38 green-shoed offering of a social media company IPO that launched amid prognostications of a first-day close at multiples of that price? Last I looked, Facebook was below its public offering price and not looking all that pretty. At what picture was FINRA looking when it was in that crowd of gawkers who had stepped back and did the top-to-bottom review before selling Facebook?
Anyone see anything on FINRA's website about how this wunderkind social media company might not skyrocket in the first day's aftermarket but could - omigod - close below its public offering price within two trading days - as much as a double digit percentage retreat?
Where was FINRA's published warnings about Facebook, whose Q1 revenues were lower than its 2011 Q4, or whose shares were trading at 23 times sales revenue?
Did FINRA publish anything last week warning the public about all the different market conditions that could negatively impact the Facebook IPO - you know, like snafus at NASDAQ?
Yeah, I know. Don't do as I do. Do as I say.
One Page
Finally, we find ourselves in Absurdistan. I had to re-read Ketchum's speech to confirm that he actually concluded his remarks by urging his audience that "before any complex product is offered to a retail client, your financial adviser should be able to write down on a single page why this investment is in the best interests of your client."
Hellooooooo - don't you regulators know that the fast-talkin' con artists in the biz love to distil their pitch down to one page? In case you forgot, you folks file charges against pennystock hucksters for using such crib notes - you call them improper scripts.
Since when is the goal of determining suitability for each and every unique client accomplished by a one-size-fits-all script? Moreover, do those of you in regulation truly believe that this is an effective regulatory approach? How nice that Wall Street should dumb down complex products or gloss over the shortcomings in a basic stock offering - because that's all this one-page nonsense is going to achieve. This silliness comes off as little more than having some kid write "I will not engage in unsuitable conduct," one hundred times on a classroom blackboard during detention. If you want someone to produce a one-page synopsis of a securities offering, I would suggest that an independent consumer organization would be far more likely to produce meaningful workproduct.
Regulator Heal Thyself
Let's not forget that we're still waiting, nearly a month later, to learn just how severe FINRA's 2011 losses were. See," FINRA to propose fee hike due to "significant loss" (Reuters, April 25, 2012). In an industry that still suffers from reduced trading volume and continues to consolidate, FINRA must now make up whatever millions were likely lost in bad investments and/or operational costs via higher member fees, which will likely perpetuate the death spiral of less member firms generating lower net profits. It will be fascinating to see how suitable FINRA's 2011 investments were for a regulator charged with such an important role of policing the market - as it will also be intriguing to see how costly it was to service the regulator's salaries, costs, and expenses. Talk about an organization in dire need of a top-to-bottom overhaul!
For those of you who might view this column as unfairly singling out FINRA, I would refer you to my February 2, 2012, " Street Sweeper" column: "Beware of Alternative Higher Rates of Return For Your Fixed Income Portfolio," which commented upon a North American Securities Administrators Association (‘NASAA") press release: "NASAA Cautions Investors Not to Stumble When Interest Rates Fall Flat" (February 1, 2012). In that "Street Sweeper" column, I lamented:
I'm not saying those explanations are all wrong or even misplaced. What I am suggesting is that having raised bona fide warnings about investors seeking higher rates of return, NASAA's advice is largely useless. Here is what this securities regulatory association offers to those seeking alternative investments - here is what passes for the governmental version of providing direct, meaningful answers to truly important questions about how to best allocate one's life savings:
- Use common sense.
- Go find a trustworthy professional.
- Read incomprehensible disclosure documents.
- Telephone numbers that are rarely answered in person, if at all.
In the end, I find myself returning to the same uncomfortable position. There is a terrible moral hazard when regulators pretend that the markets are ultimately honest and that investors just need to make more of an effort to get to the truth - and you can achieve that by using common sense, calling industry professionals, and reading disclosure documents. Perhaps one of my recent "Street Sweeper" headlines best sums up my fears: Wall Street Regulators Perpetuate the Big Lie of Market Integrity (January 23, 2012).
Conclusion
This diatribe against failed regulation and ineffective regulators is built upon my thirty years in the business - as a regulator, as an industry lawyer, and as a public customer's advocate. The same discredited regulatory approach at FINRA persists at the states and at the Securities and Exchange Commission - and in Congress.
FINRA's Ketchum burnishes a tarnished solution. He suggests that Wall Street can best address the dual challenges of conflicts and suitability by having each brokerage firm look into its own heart and soul and do the right thing. It hasn't worked. It will never work. Kumbayah is not an effective regulatory regime. Nor is the occupation of Wall Street by hostile regulators or misguided social engineers. The answers are not found at either end of the spectrum, and the solution is not a simplistic one-page synopsis.
Unfortunately, we're never going to come up with new solutions from the same gene pool that has served as the source for the last several generations of Wall Street regulators. We need new blood and new ideas. You can't get that from a revolving door.