Financial Reform Puzzle Taking Shape

Unfortunately, the picture that's emerging does not reflect the political rhetoric.

Unregulated as a profession, financial planners have been pushing Congress for a piece of regulatory oversight, but they suffered a sharp setback earlier this week when the House Financial Services Committee (HFS) relegated their plan to study and carved up financial planning piecemeal in the process.

The retail investor, in turn, will see only modest improvements in consumer protection, although there are some promising nuggets in the House reform package.

Institutional, Market Risk Reduced?
As Congress moves into high gear on a broad package of reforms, investors and advisers nonetheless should take some comfort that much of what caused the financial meltdown is being addressed in a substantive manner. New requirements that banks maintain higher levels of capital, mandates compelling them to put "skin in the game" by retaining shares of securitized mortgage packages, regulation of over-the-counter derivatives for the first time, and strengthened oversight of wayward credit rating agencies should, among other things, dampen the likelihood of a near-term relapse.

There were worries that the resurgent stock market would ease the political pressure on Congress to plug the largest gaps in financial regulation. However, while Congress has not gone as far as some reformers would have liked, the Obama reform program now seems back on track. Though lawmakers have been distracted by the protracted debate on health-care reform and controversy over a consumer protection agency, the House package on systemic risk is mostly in place and poised for a floor vote in early December.

Whether the key House and Senate chairmen, Barney Frank and Chris Dodd, can keep their pledge to have a full package on President Obama's desk by the end of the year remains questionable.

The New Consumer Financial Protection Agency
Recent passage by HFS of a bill creating the Consumer Financial Protection Agency suggests a modest improvement in consumer protection, but not the kind of grand vision suggested by the name.

The thrust of the new agency will be to curb abusive credit card and mortgage practices in the banking industry, but not all consumer products or services. Barney Frank had ambitious plans to mark up the bill last July, reserving several days for debate and passage. However, in the first sign that the reform effort was slowing down, he ran into a buzz saw when the politically connected independent community banks, 8,000 strong, raised the alarm. Many members of the committee agreed with their argument that big banks were to blame for the subprime mess. As a result, much of the CFPA's broad authority is limited to only the top 2% of the nation's largest banks, leaving smaller ones, with $10 billion in assets or less, under banking regulators' direct supervision, not the CFPA's. The CFPA would still be able to go after abusive marketing practices at any bank, but it would be forced to jump through regulatory hoops, making enforcement much more difficult.

The Upside
Consumers should be heartened by three key elements of the bill:

• Duties. Most importantly, the CFPA can set tough, groundbreaking standards of conduct for mortgage brokers and others covered by the new law. Currently there are virtually no standards in place for mortgage brokers, although Washington state recently adopted a fiduciary duty for them.
   
• Disclosure. Ditto with disclosure and sales practices. The new agency would have authority to issue disclosure rules on products and services, and regulate sales practices.
   
• Financial Literacy. The bill creates an Office of Financial Literacy, which, though seemingly minor, has interesting potential. Today financial literacy is largely uncoordinated and fragmented in Washington, with each federal agency pushing its own program. With the ability to conduct studies and serve as a bully pulpit to raise consumer awareness, the CFPA could eventually fill an important leadership void over time.

The Downside
Notwithstanding self-serving complaints by banking regulators or industry lobbyists, legitimate questions remain about the interaction of the new agency with existing laws. For financial planners, this is also a pertinent question since the law would cover certain nonbanking firms as well.

The broad definition of persons covered under the CFPA offers broad exclusions for numerous nonbanking persons: stockbrokers, lawyers, CPAs, tax preparers, real estate and insurance agents, and investment advisers regulated by the SEC and states. Singled out as not exempted, according to the bill's summary description, are financial planners.

Curiously, financial planners are not even mentioned in the bill itself, although financial advisors are broadly defined. By excluding areas of financial planning covered under securities and insurance laws, however, only pieces of a financial plan would be covered by the CFPA--tax planning and presumably estate planning.

Given the fact that no two planners placed in the same room can agree on a definition of financial planner, it will be fascinating to see if the CFPA can come up with a better solution. With their hands expected to be full with mortgage and credit card issues, it is unlikely the CFPA would even tackle financial planning regulation in the near term.

One of the principal areas of contention involves a three-way jurisdiction fight between state securities regulators, FINRA, and the SEC dating back to the time when Republicans took over Congress in 1994. Two years later, it pre-empted state securities laws in a number of areas and divided oversight of investment advisers between the SEC and the states, giving the states authority over advisers with less than $25 million in assets under management.

With growth in the stock market over the years, the states' turf eroded even more as advisers migrated to SEC registration. About the same time, FINRA also began to lose jurisdiction over stockbrokers who increasingly began charging fees for advice, which triggered registration under the Investment Advisers Act of 1940.

As a result, the states and FINRA have been pining for more authority in a rapidly growing area of the market--investment advice--with little in the way of elbow room. Bernie Madoff, the Wall Street broker forced belatedly to register as an investment adviser, presented a perfect opportunity to lobby for more turf at a time when the traditionally fragmented investment adviser lobby has been unable to disassociate itself from the scandal. (See Mercer Bullard's recent column for details.)

Questionable Reforms
The new reform measure does more than just react to Madoff by beefing up SEC inspections. It also would split advisory firms once again by handing roughly 42% of them to the states, and in an even more controversial move, shifting oversight of dually registered broker-advisers to FINRA, or about 88 percent of all individual advisers.

This last amendment has triggered howls of protest in nearly all camps except K Street, FINRA's headquarters. Consumer groups, like planners and state regulators, are suspicious that FINRA will dilute the bill's new fiduciary requirement for brokers. State regulators are concerned with FINRA's intrusion into adviser regulation for the first time ever. Many financial planners, intent on professional recognition, see their regulatory world rapidly falling apart for the same reasons, not to mention a provision in the bill that allows the SEC to charge new fees for adviser inspections where previously there were none.

Many brokerage firms are also unhappy. While not publicly admitting it, they are uncomfortable with the new fiduciary requirement, due to liability concerns. Moreover, concerned with the steady flight of top-producing brokers to registration as independent advisers, some firms are actively opposing the increased $100 million threshold for state registration, telling Congress that expanded state authority will dilute protections for smaller investors.

For advisers leaving the SEC for state pastures, there is not much solace. Some states already charge for inspections and others impose bonding and net capital requirements, unlike the SEC. A small consolation, perhaps, are special provisions of the 1940 Act that allow reciprocity for state-registered advisers, meaning if they are in compliance with the books and records and bonding requirements of their home state, they do not need to adapt to any different regulations of other states where they are registered.

Perhaps increased fees charged by the SEC and FINRA, along with cultural differences in state and FINRA regulation, would indeed drive more advisers willingly into the waiting arms of the states.

Consumer Concerns
Consumers have ample reason to be concerned, too, with the shortcomings of the IPA. Not only did some last-minute amendments in the House bill erode the fiduciary duty, but the bill--and regulatory reform measures overall--fail to establish a uniform standard of conduct and qualifications for all financial advisers.

In the IPA, for example, the provision establishing a fiduciary standard is limited only to personalized advice related to securities that is given by brokers and investment advisers. Yet current marketing by brokerage firms is not just about investment advice, but many other areas of financial planning, leading to gaps in fiduciary coverage.

One issue that may serve as a bellwether on how serious the SEC is in applying a strong fiduciary standard to brokers is an obscure rule in the Advisers Act set to expire at the end of this year. Granted to Wall Street firms a few years ago by the SEC, it provides regulatory relief from the Act's restrictions on self-dealing. What is interesting about the bill language is that it states the standard for brokers "shall be no less stringent than the [fiduciary] standard applicable to investment advisers," but references only two of the three main anti-fraud provisions in Section 206 of the Advisers Act. The other provision? The restriction on self-dealing. Omitting this section could make it more difficult for a brokerage customer to prove that the broker was required to act as a fiduciary if the SEC departs from its stated position supporting regulatory "harmonization" for brokers and advisers.

Nonetheless, there is some good news for investors.

Secondly, Obama reform generally provides consumers with optional dispute remedies. Consistent with this approach, under the IPA investors would be able to sue broker-dealers instead of being forced into arbitration.

Third, Congress and the SEC seem to be more aware of the need to understand the impact of regulation on investors, particularly disclosure rules, as strange as that might sound for an agency charged with protecting investors. The SEC began using consumer focus groups in this manner several years ago, and the IPA would appear to formalize this practice.

Fourth, the SEC has always been underfunded. By doubling its appropriation over six years, Congress will give the SEC the tools it needs to execute its increased responsibilities.

Finally, among the slew of studies mandated under the proposal, two of them are especially noteworthy for advisers. Previously mentioned, the GAO study of financial planning regulation might be viewed initially as a poor substitute for the real thing. On the other hand, if industry sales practices do not change and the GAO makes recommendations that accurately identify the gaps in current regulation of advice-givers, then over the long-term Congress could connect the dots and respond with stronger advisory standards when the next scandal erupts or too many retirees are forced back into the workplace due to incompetent or unsuitable advice.

The other study with the potential for change addresses the "revolving door" problem at the SEC, triggered by the Madoff scandal. This study, also by the nonpartisan General Accountability Office, would review the number of SEC employees, mostly securities attorneys, who left the agency for lucrative Wall Street positions and whether a "cooling-off" period is needed.

What's Next
The jigsaw puzzle of financial services reform has started to come together, beginning with the broad outline released in the Obama white paper last June. The result to-date is not a pretty picture, but then sausage-making, like legislation, isn't either. Many of the pieces have already been put in place by Barney Frank's committee, but the Senate will undoubtedly put its own imprint on reform, leading to even more changes.

For planners and investors, the devil still lies in each individual piece of the puzzle. The CFPA remains a lightning rod for controversy, and as one part of the puzzle, it still may affect financial planners in ways impossible to predict.

With regard to the IPA, Congress seems to be all consumed with fighting Ponzi schemes, yet it is readily including baggage from industry and regulator turf wars waiting years for this very moment. To be sure, it is doubling the SEC's budget and authorizing an independent review of its hidebound management structure. But congressional reform efforts so far have fallen short by mistakenly identifying Madoff and Stanford Financial as a regulatory "gap" between brokers and advisers, not a competency problem at the SEC. As a result, it will be difficult for investors, long confused by the question of who is a trustworthy adviser, to find the answer in regulatory reform.