Browsing October 19th, 2009
Your Clients Are Watching You
Financial Regulatory Reform: The Good, The Bad, and The Ugly
Regulation of the United States financial system throughout its history could be described as disjointed…at best. In response to the current regulatory framework, the administration presented its plan to overhaul the system with an emphasis on consolidating a fractured system of multiple regulators. It is in no way a guarantee that fewer individual regulators will translate into better regulation, but investors should feel cautiously optimistic that they will be better protected once the plan is implemented.
Of course the devils in the details, however on the surface the following provisions look promising: improved hedge fund regulation, derivatives oversight, elimination of the Office of Thrift Supervision and the creation of an agency that will oversee financial products targeted at consumers.
Hedge funds have traditionally operated outside the regulators’ reach. Unfortunately, it was only when hedge funds either collapsed or committed fraud that regulators got involved. Because they now control such a huge swath of capital and are responsible for such massive trading volumes, hedge funds pose significant risks to the system. Moreover, hedge funds are also big players in the commodities trading industry and have the capacity to impact food and energy prices. Registration of these funds, which includes confidential disclosures about strategy and assets under management, would help regulators assess their stability and impact on the system.
Derivatives, to borrow Warren Buffet’s expression, are financial weapons of mass destruction. Whether used to insure against losses, as an investment or as a hidden way to ramp up leverage, the use of derivative instruments needs to be controlled. The new plan to introduce transparency into this opaque side of the financial industry is well overdue. Exposure to these instruments, to recall, is what caused A.I.G. to collapse.
The elimination of the Office of Thrift Supervision will help guard against “regulator shopping.” One central bank regulator makes a lot of sense. And the creation of a special agency to oversee products targeted at consumers is certainly a good idea. One concern however, is that this agency does not oversee securities sold to individual investors. Rather, this new agency will focus on credit cards, loans and annuities. As we’ve seen, Wall Street approaches the sale of securities in the same way the corner electric store sells microwave ovens; therefore they should be regulated as such.
Oversight of securities sold to investors remains with the SEC and FINRA. While the SEC has made strides in the past few months, its ability to keep up with the mad scientists on Wall Street is questionable. For example, the mass marketing of risky structured products such as reverse convertibles, principal protected notes and auction rate securities was left unchecked. Individual investors were not adequately informed as to the risk of these instruments and ended up bearing the brunt of their losses while Wall Street earned fat commissions.
Increased responsibilities for the SEC should help in this regard. The SEC will require more transparency and improvement in the timing and quality of disclosures regarding securities products and will be required to perform “field tests” to ensure investors understand the risks. Perhaps the most important SEC-related provision is the establishment of a fiduciary responsibility for broker-dealers offering investment advice and to “harmonize the regulation of investment advisers and broker-dealers.”
Where the Plan Falls Short
Improvements, however, need to be made in the enforcement area. It’s great to have more stringent regulations, but if Wall Street is allowed to ignore them and pay pithy fines it’s worthless. The President’s plan supports ramped up efforts to ban crooked brokers and advisors from the industry, but seems to ignore the fines. As I’ve written before, fines have become the cost of doing business on Wall Street. They are viewed the same way as expenses for travel, office supplies and client entertaining. This cannot continue.
Fines for wrong doing, especially when the accusations involve individual investors, should be damaging. The multi-billion dollar auction rate securities debacle could have been prevented if Wall Street was more effectively policed when in 2006 regulators found impropriety. Not only do fines need to be larger, they need to be felt, which is why instead of coming out of the general litigation budget, fines levied with regard to frauds committed against retail investors should come out of the bonus pool. This is especially important for financial institutions that have received federal funds of late. To pay a fine using tax payer money adds insult to injury.
There are undoubtedly areas of improvement, but like many investors, I’m cautiously optimistic.
SEC Fines: The Cost of Doing Business?
I’ve long argued that SEC fines have become simply the cost of doing business on Wall Street. The benefits of violating rules outweighed the paltry sums firms had to pay when they were found to be engaged in wrongdoing. This is why I was not surprised to read today’s article from The New York Times entitled “SEC Fines Didn’t Avert Stanford Group Case.” The article details how the SEC charged Stanford Financial Group with allegations that among other violations, the firm:
- did not have adequate capital to meet the requirements of being a broker-dealer;
- provided misleading, unfair and unbalanced information about its certificates of deposit;
- failed in its research reports to adequately disclose a variety of research methods and the way it was valuing certain securities;
- distributed sales literature that did not disclose the affiliations between the company and a related bank; and
- failed to present fair and balanced treatment of the risks and potential benefits of instruments it was marketing as C.D.’s.
As a penalty, Stanford Financial Group reportedly paid fines of ten, twenty, and thirty thousand dollars. You cannot even compare this to a wrist slap. These fines wouldn’t even cover the dry cleaning bill of Stanford Financial Group CEO Robert Allen Stanford. The SEC’s previous charges certainly seem credible now that Stanford Financial allegedly cannot account for nearly $8 billion in deposits and its mutual fund is accused of overstating historical performance.
This is a stark example of how meaningless fines in no way acted as a deterrent to institutional wrongdoing and, once again, the average Joe is left holding the bag. By no means is this the only example.
As readers of this blog are no doubt aware, on May 31, 2006, the SEC’s Division of Enforcement issued a news release trumpeting that it had settled with 15 broker-dealer firms, including Merrill Lynch for what essentially amounted to rigging the auction rate securities market between January 2003 and June 2004. The penalty: a paltry fine totaling $13 million, of which Merrill Lynch’s piece was an insignificant $1.5 million.
According to the complaint filed last year by the State of Massachusetts, Merrill is accused of being badly conflicted when selling auction rate securities to its retail customers, some of whom I represent. The firm reaped a hefty $90 million in profits in 2006 and 2007 underwriting these securities for their corporate customers and priced them at interest rates ultimately advantageous to them.
Even Eliot Spitzer’s much heralded “Global Settlement” did little to deter conflicts of interest on Wall Street. The settlement was reached in 2001, but in 2004 the SEC found several large broker/dealers failed to disclose payment relationships they had with companies their research departments covered. The result was that seven firms split a fine of $3.65 million. Wall Street research hasn’t improved one iota since.
Research is still openly conflicted with investment banking (a “Chinese Wall” does NOT constitute a solution in my opinion) and as the economy soured in 2007, brokers continued to peddle financial services stocks armed with buy ratings from the research departments…earning commissions all the way.
High on the agenda of the SEC’s new regime is enforcement. In fact today, Chairwoman Schaprio announced that former U.S. Prosecutor Robert Khuzami will lead the agency’s enforcement division. Rest assured many will be watching to ensure that the “fine fits the crime,” because otherwise investors aren’t on a level playing field.