If A Tree Falls In The Forest, Will A Regulator Hear It?
"If a tree falls in a forest and no one is around to hear it, does it make a sound?" …or put another way, if a client is ripped off by his/her advisor and a regulator does not know about it, was the client really harmed? After a career in the financial services business as an advisor, supervisor and senior executive, I can’t believe I’m about to stand up for the entity that has caused me so much frustration and consternation over the years; FINRA. You may have noticed quite a bit of industry media and opinion leaders piling on the study released last week titled "The Market for Adviser Misconduct" . The wide distribution of that study which concluded that 7% of “financial advisers” have records of misconduct and of that, 44% of those “advisers” are re-employed in the industry within a year, has prompted headlines like "beware of your financial advisor" and "It just got harder to trust financial advisers". As a former Pres/CEO of a 7,000 advisor B/D and more recently having launched an RIA and B/D from scratch through a start-up, I’ve seen the good, bad and ugly from regulation and a lack thereof. Yes, there are some bad actors in the B/D business and unfortunately they too often resurface only to continue their bad acting. Even 1% is a number too high. But to focus on the somewhat flawed study of 7% and 44% is very misleading. This not to mention the suspect timing of the release just weeks before the expected DoL proposal is to be made public. I won’t argue the numbers and methods they used to come to their conclusions. They may even be accurate. What is concerning though is the media spin on it.
After the study and resulting media coverage hit the streets, Elizabeth Warren came out in a Senate Banking subcommittee hearing criticizing FINRA for not doing its job. My initial impression was, Wow!...if she is all over FINRA who closely supervises their member firms, she must be clueless about how inept the SEC and state insurance departments are at policing their constituents. Here’s why I had that reaction:
Companies live in fear of FINRA: No matter what level of the business you’re in, if you’re registered, FINRA is ever-present. If a tree falls in their woods, they will definitely hear it. No one individual is more important than the broker-dealer firm and any supervisor turning his/her head on misconduct will likely lose their career for “failure to supervise”. Any deviation from “company policy” is typically met with some form of discipline and is made as part of the broker/advisors record. This at times leads to some fairly minor infractions to be reported as misconduct as most B/D’s now exercise a zero tolerance policy.
Routine activities for RIA’s are often cited as misconduct for brokers:I’ve had to discipline (and report to FINRA) for actions that fall into the category of “Failure to comply with company policy”. An advisor was once preparing for an annual review and since the B/D at the time did not have a means to show a snapshot of all the client holdings, the advisor created his own Excel spreadsheet and showed the values. While it was accurate and did not misstate the holdings, the spreadsheet was found in the client file during a routine compliance review and the advisor was then terminated for “Failure to comply with company policy”. Refer a client to an insurance agent who then sells your client a policy? In some circumstances that could get a registered rep fired for “selling away”. There are many routine activities in the SEC RIA world that would get one fired in the FINRA world.
Certain alleged misconduct, despite being inaccurate, is reported as misconduct anyway: An advisor in a smaller town had an arch rival at a competing firm who was targeting his clients. A tactic that the competing broker used was to write complaint letters for his prospects (the advisors clients) claiming misrepresentation so the firm would waive surrender charges and return the original investment even though there was no basis for it. Of course, each event was reported as a client complaint as required by FINRA. The weight of too many of these complaints forced the B/D to terminate the honest advisor since the risk of remaining affiliated was too great despite the false nature of the complaints.
The majority of FINRA regulated brokers are also investment advisors: I find it interesting that the financial media and several in the fee-only community continue to run with the narrative that it’s the commission hungry broker allowed to sell bad products versus the fee only RIA who always acts in their clients best interests. It’s been widely reported that 88% of B/D registered reps are also registered as investment advisor representatives (part of the corporate RIA). And the largest Indy B/D, LPL was reported to have 62% of their 2014 gross sales in advisory business and trending heavily towards going 100% to fees. This is happening at all B/D’s in the business. The narrative of RIA good guys versus broker bad guys is running thin and based on an era gone by.
Registered insurance agents and brokers drop FINRA to escape supervision: I know many brokers and agents who dropped their FINRA registration to simplify their lives. Many of them are now born again fee only’s. While there are some advisors who have been fee only from the inception of their practice, most started out as brokers and simply could not deal with FINRA all up in their stuff. Some did it in a sincere interest to change their business model to be on the same side of the table as their clients. But as many did it to get out from under FINRA’s thumb.
FINRA members are dramatically shrinking while RIA ranks are the fastest growing. Just a few years ago, the number of B/D’s was around 5,500. This year that number will dip below 4,000 and the expected reduction will likely quicken after the DoL rule crushes the small IBD model. One wonders, with FINRA being over-resourced inspecting brokers who are trending towards investment advisory and the SEC under-resourced…
The ease in opening an RIA versus a B/D is somewhat disconcerting:Starting any business from scratch is always a tough task, but launching a new B/D is flat out painful. Huge business plans, pro-formas, multiple interviews, background checks, names of potential brokers to submit and vet, setting up net capital requirements, clearing arrangements, etc. It was an agonizing year of to and fro with FINRA to get approved. For the RIA it was pulling together an ADV, some various forms and filing in each state. A done deal after 2 months. It’s almost scary how easy it was to set up the RIA compared to the B/D. It’s equally scary how absent the SEC is in overseeing RIA business compared to FINRA.
So, where’s the report on RIA’s? There is no way to do a study on non-FINRA registered RIA’s because the data does not exist. And even if there was a “BrokerCheck” database for RIA’s, it would be highly suspect since nobody is looking except on average an audit every 10 years. If a tree falls in the SEC forest, they most likely will not hear it! This Investment News article states, “According to the SEC's annual report, 80% of exams by the SEC or self-regulatory organizations identify deficiencies; 35% find “significant deficiencies,” which might damage investors. But only 13% of those are referred to enforcement for action.” 35% have significant deficiencies? And that’s of the 9% RIA population they take the time to examine. Where's the media narrative on that? It’s no wonder why RIA’s staunchly oppose FINRA taking over the job!
There is no question that there continues to be bad apples affiliated with B/D’s, RIA’s and state insurance departments just as there are bad doctors, lawyers and CPA’s. While the popular study alleges that 7% of B/D brokers are bad apples, there are indications that the number in the non-FINRA regulated constituencies could be far greater simply because nobody is looking. As a proponent for a harmonized fiduciary standard, I hope we are all required to act in our clients best interests. I also believe that the incentives for selling certain products in the form of excessive commissions, exotic trips, etc. need to be taken out of the system. But as I started this article, "If a tree falls in a forest and no one is around to hear it, does it make a sound?" I can’t see how you can argue that FINRA should not and cannot inspect RIA’s when the majority of FINRA brokers are essentially conducting much of their business in the same way. And after the DoL proposal gets implemented, the lines will blur even further. Of all the entities in our business that we have to be held accountable to whether it’s the SEC, DoL, state insurance departments and state securities departments, FINRA is the only one that is actually getting the job done (geez, I can’t believe I’m saying that!). It seems like a waste of time and resources to have so many duplicate regulatory entities each with their own set of rules and procedures overseeing what is essentially the same activity of giving personalized investment advice. Unfortunately, I don’t see that changing any time soon. But reading all the vitriol about FINRA is almost laughable. It’s masking the real problem in the lack of accountability and inspection by state insurance departments over their agents and the SEC over their RIA’s. And now we’ve got the DoL stepping in to make things even more complicated. Like in politics, the industry voices are loudest at the extremes while the more level headed are somewhere in the middle. Our business is harmonizing and it’s my belief that the regulators should do so as well. Stoking the narrative that brokers are uniformly ripping their clients off while RIA’s are pure is not helping solve the problem of overlapping regulations and regulators. We have too many regulatory forests and various definitions of what constitutes a tree falling much less hearing it fall. Will anyone write about that?