Will Investors Be Better Off Post-Madoff?

Today the House Financial Services Committee will hear testimony from the SEC inspector general on the Madoff scandal. It promises to be the beginning of what Rep. Paul Kanjorski (chairman of the House Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises) is calling “the most substantial rewrite of laws governing U.S. financial markets since the Great Depression.” Wall Street could not have escaped congressional scrutiny after the year that we’ve had even if Madoff had never happened, but the failure of regulators to protect the public from his massive fraud has drawn fresh attention to the shortcomings of existing regulatory protections. Expect a cacophony of voices offering opinions as to what should or should not be changed in order to prevent future market crises and protect investors from unscrupulous con artists.

For most of my lifetime, financial regulators have mostly trusted the markets to police themselves.  That approach is sorely complicated by the fact that Treasury secretaries, SEC heads, and other top regulators tend to be folks who were previously investment bankers and Wall Street bigwigs.  Moreover, when they leave the regulatory world, they usually return to working for the people they formerly oversaw.  They tend to have a bias for keeping things the way they are, and sometimes they’re reluctant to accept criticism.  For example, former SEC head Arthur Levitt, who ran the SEC from 1993 to 2001, recently told the New York Post that he hasn’t seen anything to indicate that the SEC dropped the ball in its oversight of Bernie Madoff, whose Ponzi scheme flourished undetected under Levitt’s watchful eye.  Despite the SEC’s failure to catch Madoff even after whistleblowers raised questions that were dead on, Levitt thinks nothing is broken.

One key figure in the upcoming debate will surely be Mary Schapiro, who will be taking Levitt’s old job. Schapiro, who’s eminently qualified for the job, has already been the subject of much discussion. The question making the rounds is, will she make valuable changes, or will she rearrange the deck chairs on the Titanic?

Securities attorney Bill Singer, who blogs at brokeandbroker.com, knows Schapiro and recently pondered whether having another financial industry titan as the SEC head is likely to result in any meaningful changes.

A less optimistic perspective on Schapiro comes from journalist and financial planning guru Bob Veres, who has written a lengthy, rather critical assessment of Schapiro’s appointment:

“So now we have somebody running the SEC who has strongly supported the Merrill Lynch Rule (which was struck down by the courts) as best for customers,
without any concession that a fiduciary duty is a higher standard. She seems oblivious to the fact that large brokerage firms are clearly frightened by the
prospect of being held, by the courts, to a fiduciary standard; incurious as to why.  (Mary, if you’re reading this, it’s because their current business models embrace conflicts of interest against the consumer. Do you really believe it’s good public policy to allow brokers to pose as trusted advisors when they recommend the funds their firms manufacture, they sell to customers whatever dog stocks their employers no longer want in their own investment account, they take fees for IPOs and also recommend them to the public, and when they sell newly-minted creative products with hefty built in and undisclosed margins?)”

OK, Bob, quit holding back and tell us what you really think….

The “Merrill Lynch Rule” to which Veres refers was a rule initially enforced by the SEC in 1999 and unanimously approved by the Commission in April 2005.  The rule exempted broker-dealers from conforming to the requirements governing investment advisers as long as the investment advice they provided was “solely incidental” to their brokerage services.  Exempted broker-dealers were required only to offer advice to buy investments that were “suitable” to the client, rather than being held to the higher fiduciary standard that applies to investment advisers.  In 2005, in response to a lawsuit from the Financial Planning Association, the U.S. Court of Appeals for the District of Columbia overturned the Merrill Lynch Rule on the ground that it violated the protections provided to investors by the Investment Advisers Act of 1940.  The brokerage industry was understandably unhappy with this ruling.  By way of full disclosure, I should comment that I’ve always been held to a fiduciary standard as an adviser – so I have a definite bias here.  I’m also a member of the FPA, which sued to end the rule.

Veres’ concern is that the traditional regulatory environment, which Schapiro has vigorously defended in public, permitted some financial advisers to encourage clients to purchase investments in which the adviser had a clear conflict-of-interest.  Regulators let some advisers switch back and forth between fiduciary and non-fiduciary roles when working with the same client, which was confusing for the consumer.  He points out that Schapiro is leaving a $2.1 million job at the Financial Industry Regulatory Authority (FINRA), which helped create and defend a regulatory climate that now appears quite inadequate.  Veres also worries that Schapiro may push for additional regulatory red tape that would tend to favor large firms over small ones.

The issues surrounding the shortcomings of the financial regulatory system are likely to get a thorough hearing in Congress.  There’s at least a decent chance that the resulting regulatory changes will set higher standards for all financial advisers and create greater accountability for regulators.  Will Schapiro and other career regulators throw their weight behind these kinds of changes?  I hope so, but we’ll have to wait and see.

About the author

Thomas Fisher, CFP®

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