Annuities and the Avoidance of the Fiduciary Standard

There’s a saying on Wall Street: “Structured products are never bought, only sold”. The same could be said of annuities.

Selling annuities is an extremely lucrative and virtually risk-free business, which is one of the reasons why insurance companies and some Wall Street firms are aggressively lobbying Congress not to require brokers and other purveyors of financial products to adhere to a so-called “fiduciary standard.” Under the proposed standard, brokers and insurance salesmen would be required to put their clients’ interests ahead of their own, likely forgoing high-commission annuities for other, more appropriate investments.

Not surprisingly, Morgan Stanley has voiced concerns that the fiduciary standard would cut into its business. Morgan Stanley has good reason to worry: The firm earned $37 million from selling annuities in the first quarter of 2009 alone, or 1.22 percent of its noninterest income, according to a report by the American Bankers Insurance Association (ABIA). A Morgan Stanley spokesman recently told Bloomberg that expanding the fiduciary standard to include brokers would impinge upon the firm’s ability “to provide clients with products and services they want.” Or, perhaps more accurately, don’t want.

Some annuities are suitable products for investors, however, more times than not, they come with hidden costs and penalties (commissions can be as high as 7-10%) that vastly diminish their value.  Even FINRA has acknowledged the problem.  Richard G. Ketchum, the head of FINRA, recently acknowledged in the New York Times that there “had long been problems with how brokers disclosed their conflicts and how they pushed products.” Last year FINRA fined Fifth Third Securities $1.75 million for what they declared to be 250 unsuitable variable annuity transactions and five other broker-dealers were fined a total of $1.65 million for unsuitable sales of annuities, mostly to elderly investors with conservative investment objectives.

The securities industry likes to say it supports a broad fiduciary standard, but that’s far from the truth.  SIFMA, Wall Street’s lobbyist, has publicly supported a proposal by the House of Representatives which would create a new, “limited” fiduciary standard for brokers only when they are giving “personalized investment advice” to their retail clients.  In other words, brokers would have the discretion to decide when they are providing financial advice and when they are selling snake-oil. FINRA also supports the House bill.

Senator Chris Dodd has issued a much needed proposal that removes the distinction between brokers, insurance agents and an investment advisers.  This, combined with a comprehensive fiduciary standard would go a long way to protecting investors.

However, it’s increasingly unlikely that the fiduciary standard, under pressure from the insurance lobby and Wall Street, will ever see the light of day. Once again the interests of individual investors will be ignored.

SEC Enforcement: The More Things Change…

In my last post I was downright jubilant that Wall Street endorsed the fiduciary standard for brokers. And don’t get me wrong, this is a major development. But, as they say, one step forward…two steps back.  To wit, I read with great dismay two recent cases where the SEC enforcement division levied fines equivalent to a love tap for what appears to be serious wrongdoing.

In what I’m sure was a delight to Morgan Stanley’s PR office, the first case was buried in the Wall Street Journal in a five paragraph blurb on page C4. So allow me to give you some background.

Morgan Stanley was recently censured a paltry $500,000 by the SEC for allegations that one of its former financial advisors misled his clients and failed to disclose conflicts of interests. According to the SEC, William Keith Phillips, who was based in a Nashville, Tennessee branch of Morgan Stanley, breached his fiduciary duty when he allegedly recommended “unapproved” money managers to clients.  Under the terms of a proprietary program, Morgan Stanley would provide custody, execution, performance reporting, and, importantly, due diligence on money managers for their clients.

The SEC alleged that Mr. Phillips had a financial incentive to recommend these three money managers, after developing a relationship with them and negotiating $3.3 million in commissions.  Moreover, two of the unapproved money managers convinced some clients to open advisory accounts with the Morgan Stanley Nashville branch, generating an additional $200,000 in fees and commissions, a portion of which was paid to Morgan Stanley.

Investors harmed by this will no doubt file arbitration cases.  And while I’m sure Morgan Stanley wasn’t happy to sign a check to the United States Treasury for $500,000, I’m pretty sure they did the math a realized they were still ahead.

The second case involved Perry Corp., a $6.6 billion hedge fund managed by Richard Perry.  According to the SEC, Perry Corp. withheld a critical regulatory filing which serves to give the market notice when an investor has amassed more than a 5 percent stake in a public company.  The goal of the rule is to ensure investors understand if there is another investor that could influence company decision making.  In this instance, it is alleged Mr. Perry bought a 10 percent stake in Mylan Inc. in order to throw his weight behind a potential merger in which he stood to profit.

Representing Mr. Perry was William McLucas, who ran the SEC’s enforcement division for eight years before leaving the agency in 1998. When I say the there is a “revolving door” phenomenon between the SEC and Wall Street, this is precisely what I mean.  Mr. McLucas negotiated a measly $150,000 fine with his old employer.

Not surprisingly, Mr. Perry called the settlement a “satisfactory conclusion.” What is “satisfactory” to Mr. Perry most assuredly isn’t for other shareholders in Mylan Inc.  Nor will it likely deter anyone else from playing the same game.

On the other side, David Rosenfeld, associate director of the SEC’s New York regional office, who oversaw the case, said he “[hopes this] will deter others from engaging in this type of conduct.” I wish I could be so hopeful but I’m afraid the fines are a far cry from a deterrent.

What happened to “getting tough” on Wall Street?

Shedding Light on DOJ’s Investigation into the Credit Swaps “Markit”

For those who are intimidated by the complexity of the esoteric $59 trillion credit default swaps market (CDS), let me explain in raw layman’s terms the likely nature and significance of the Department of Justice’s antitrust inquiry into Markit, a company owned by more than a dozen Wall powerhouses including Goldman Sachs and JP Morgan:  The DOJ wants to know whether Markit’s owners manipulated the company’s pricing data and index formulation to enrich themselves and screw their customers.  If the Obama Administration has the conviction and political temerity to investigate and prosecute the wrongdoing the DOJ suspects, it could forever change the “heads I win, tales you lose,” way the big Wall Street firms do business and could result in billions of dollars in fines and restitution, not to mention possible jail sentences.

Although no one has yet been accused of any wrongdoing, having cut my teeth at the Federal Trade Commission litigating antitrust cases (including the one that attacked “Big Oil’s” price-fixing scheme), I can say with considerable authority that the DOJ hasn’t opened this investigation merely on a hunch.   The potential for wrongdoing is enormous because Markit determines the critical month-end pricing that major financial institutions use to “mark” their CDS securities; Markit also compiles critical indexes and the company’s Wall Street owners could benefit greatly if they have input on how these indexes are compiled and weighed.

Even for those with unlimited charity in their hearts should find it difficult to give the big Wall Street firms the benefit of the doubt.  There are countless examples of these firms putting their interests ahead of their customers.  In 1996, NASDAQ market makers settled an antitrust case for more than $1 billion because they were artificially widening the spread on stock trades so they could pocket additional commissions.  Wall Street’s manipulation of the IPO market during the dot.com boom provides yet another example.  And let’s not forget Wall Street’s rigging of the auction rate securities market.

It’s one thing to launch an investigation, having the political will to see it through is another.  Wall Street’s influence in Washington is immeasurable and there is some disturbing evidence that Congress and the Fed serve at the pleasure of Goldman Sachs and not the other way around.  The financial consequences Markit’s owners could suffer is immense if wrongdoing can be found and proven.

Wall Street firms have long regarded regulators as mere gnats that can easily be swatted away.  If the DOJ aggressively investigates and pursues this investigation and holds the big Wall Street firms criminally and financially accountable for any wrongdoing, President Obama will have indeed made good on his pledge to achieve “Change We Can Believe In.”

SIPC and the Madoff Victims

Joe Nocera’s column in last Saturday’s New York Times about the victims of the Madoff fraud has been weighing on my mind.  Nocera passionately defends Irving Picard, the trustee of the Madoff bankruptcy, for refusing to accept the Madoff statements at face value and seeking to claw back any monies that were in excess of what investors put in.  The Securities Investor Protection Corp. will only reimburse Madoff investors for up to $500,000, regardless if the money they invested is well in excess of what they took out.

Nocera posits that Picard “almost certainly is not” misreading the law, but in focusing on the legal issue, he can’t see the forest from the trees.  Nocera would serve his readers considerably better by asking this question: “Why is SIPC coverage a mere $500,000?”

As I’ve noted before, the SIPC $100,000 maximum limit for stolen cash and $500,000 for stolen securities was set in the 1970s, when investor balances were considerably lower than today.  The agency is funded by Wall Street, so it’s hardly a surprise that the powerful brokerage house lobby has been successful in keeping the archaic limits in place.  Despite the slew of Ponzi schemes that have surfaced in the past year, there has been nary a peep on Capital Hill to raise SIPC’s insurance maximums to realistic levels.

An investor who has a good reason to believe that his investment returns are bona fide should be made whole if it turns out he or she was a victim of a scam. Ponzi schemes cannot be facilitated without the support or complicity of established banks and brokerage firms.  These firms must be held accountable for their duplicitous activities and there is no better way to do that than requiring them to make investors who have been scammed completely whole.   If SIPC had to cover all real and fictitious investment losses, Wall Street would be more aggressive policing itself and ferreting out fraudsters like Bernie Madoff.

Indeed, the time has come to require that any manager or firm who accepts investments, including hedge funds, contribute to an insurance fund that would make investors whole in the event of wrongdoing.  If such a rule were in place, people who invested with Bernie Madoff through so-called feeder funds would also be eligible for SIPC reimbursement.  Sadly, the only potential source of recourse for these investors is to sue the feeder funds, a long and costly process.

Wall Street firms had no shame taking taxpayer money to avert their near financial implosion, which was induced by their own recklessness and wrongdoing.  Innocent investors without question are entitled to an industry-funded bailout.