Financial Services Reform:

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Financial Services Reform:

  1. 1. Financial Services Reform: How Will It Affect Financial Planning? Presentation to the FPA Major Firms Symposium, Oct. 9, 2009 By: W. Hardy Callcott Bingham McCutchen LLP
  2. 2. The Financial Crisis of 2008 <ul><li>The Collapse of: </li></ul><ul><ul><li>Fannie Mae </li></ul></ul><ul><ul><li>Freddie Mac </li></ul></ul><ul><ul><li>AIG </li></ul></ul><ul><ul><li>Washington Mutual </li></ul></ul><ul><ul><li>Wachovia </li></ul></ul><ul><ul><li>IndyMac </li></ul></ul><ul><ul><li>Downey </li></ul></ul><ul><ul><li>Bear Stearns </li></ul></ul><ul><ul><li>Lehman Brothers </li></ul></ul>
  3. 3. The Financial Crisis of 2008 <ul><li>The TARP Bailouts of: </li></ul><ul><ul><li>AIG (up to $182.5 billion) </li></ul></ul><ul><ul><li>Citigroup ($50 billion)* </li></ul></ul><ul><ul><li>Bank of America/Merrill Lynch ($45 billion)* </li></ul></ul><ul><ul><li>JP Morgan Chase ($25 billion) </li></ul></ul><ul><ul><li>Wells Fargo ($25 billion) </li></ul></ul><ul><ul><li>General Motors/GMAC ($13.4 billion) </li></ul></ul><ul><ul><li>Morgan Stanley ($10 billion)+ </li></ul></ul><ul><ul><li>Goldman Sachs ($10 billion)+ </li></ul></ul><ul><ul><li>*- not including asset guarantees </li></ul></ul><ul><ul><li>+- converted to bank holding companies </li></ul></ul>
  4. 4. The Financial Crisis of 2009? <ul><li>The Collapse of: </li></ul><ul><ul><li>Corus Bank (Illinois) </li></ul></ul><ul><ul><li>BankUnited (Florida) </li></ul></ul><ul><ul><li>Guaranty Bank (Texas) </li></ul></ul><ul><ul><li>Colonial Bank (Alabama/SE) </li></ul></ul><ul><li>Despite the equities market recovery, many observers fear a “double dip” recession triggered in part by commercial real estate problems </li></ul>
  5. 5. Result: Bipartisan Consensus on the Need for Reform <ul><li>Paulson Plan </li></ul><ul><li>Volcker/G30 Plan </li></ul><ul><li>Obama/Geithner Plan </li></ul><ul><li>But the bipartisan consensus largely ends at the conclusion that reform is necessary </li></ul>
  6. 6. The Congressional Agenda <ul><li>Health Care </li></ul><ul><li>Budget </li></ul><ul><li>Afghanistan/Iraq </li></ul><ul><li>Environment/Climate Change </li></ul><ul><li>Energy </li></ul><ul><li>Education </li></ul><ul><li>Financial services reform is on the agenda, but there are many competing priorities </li></ul>
  7. 7. Financial Services Reform - Controversial Non-SEC Issues <ul><li>The Role of the Federal Reserve Board </li></ul><ul><li>Oversight and Wind-down of Systemically Significant Financial Institutions/“Too Big to Fail” </li></ul><ul><li>A Single Federal Bank Regulator </li></ul><ul><li>The Consumer Financial Protection Agency </li></ul><ul><li>Federal Regulation of Insurance </li></ul><ul><li>Regulation of OTC Derivatives </li></ul><ul><li>Executive Compensation Limits </li></ul>
  8. 8. Financial Services Legislation: The History <ul><li>Wall Street paperwork crisis of the late 1960s led to major financial services reform legislation - but not until 1975 </li></ul><ul><li>Gramm-Leach-Bliley Act, allowing bank holding companies to enter brokerage and insurance, was actively considered by Congress for six years before it passed in 1999 </li></ul><ul><li>The counter-example: Sarbanes-Oxley Act was introduced after Enron, and passed within weeks of the WorldCom bankruptcy </li></ul>
  9. 9. Financial Reform - Who is an IA? <ul><li>In the wake of the failure of Long Term Capital Management, in 2004 the SEC adopted a rule requiring hedge fund advisers to register </li></ul><ul><li>The DC Circuit struck down the rule in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006) </li></ul><ul><li>All of the major reform plans recommend requiring not only hedge fund advisers, but also private equity and venture capital fund advisers, to register </li></ul>
  10. 10. Financial Reform - Who is an IA? <ul><li>Hedge fund advisers (many of whom remained registered after 2006), generally do not appear strongly opposed to registration </li></ul><ul><li>But private equity and venture capital fund advisers argue that they do not pose systemic risks and registration would be difficult, expensive and counter-productive </li></ul><ul><li>Why should financial planners care about this debate: because IA status legislation is likely to be linked to IA standard of care legislation </li></ul>
  11. 11. How Will SEC Oversee New IAs? <ul><li>Currently over 7,000 SEC-registered advisers </li></ul><ul><li>Over 11,000 state-registered advisers </li></ul><ul><li>At least 2,000 new advisers would be required to register with the SEC under the current proposals </li></ul><ul><li>In 2008, the SEC only examined 9% of SEC-registered advisers, implying an average of 11 years between exams (even longer for firms that do not advise mutual funds) </li></ul><ul><li>SEC never examined Madoff IA business from its registration in 2006 until its failure in late 2008 </li></ul>
  12. 12. How Will SEC Oversee New IAs? <ul><li>Paulson and Volcker reports (but not Obama/ Geithner) propose SRO for investment advisers </li></ul><ul><li>FINRA has suggested that it become an SRO for advisers (already runs IARD system) </li></ul><ul><li>NASAA and IAA oppose SRO for advisers, and especially oppose FINRA </li></ul><ul><li>NASAA suggests raising standard for SEC registration from $25 million AUM to $100 million </li></ul><ul><li>But state funding for securities regulation is even more uncertain than SEC funding </li></ul>
  13. 13. The Financial Crisis - the SEC Enforcement Response <ul><li>Former senior leadership removed </li></ul><ul><li>New team with criminal prosecution background </li></ul><ul><ul><li>Specialized teams to provide experience and expertise, including in investment management </li></ul></ul><ul><ul><li>Removed a layer of management </li></ul></ul><ul><ul><li>Investigating and bringing cases faster </li></ul></ul><ul><ul><li>No more “informal” investigations </li></ul></ul><ul><ul><li>New remedies, such as deferred prosecutions </li></ul></ul><ul><ul><li>New emphasis on tips and whistleblowers, including possible expansion of “bounty” programs </li></ul></ul>
  14. 14. The Financial Crisis - the SEC OCIE Response <ul><li>Division director removed </li></ul><ul><li>New leadership not yet in place </li></ul><ul><ul><li>Enhanced emphasis on custody </li></ul></ul><ul><ul><li>More frequent outreach to service providers </li></ul></ul><ul><ul><li>Review of due diligence for subadvisers and “feeders” </li></ul></ul><ul><ul><li>More frequent outreach directly to clients </li></ul></ul><ul><ul><li>Also emphasis on control over inside information </li></ul></ul><ul><ul><li>National standardization of exams </li></ul></ul><ul><ul><li>Joint IA/BD exams of dual registrants </li></ul></ul><ul><ul><li>More changes likely with new leadership </li></ul></ul><ul><ul><li>Could OCIE be broken up? </li></ul></ul>
  15. 15. The IA Standard of Care Debate: The History <ul><li>In 1940, broker-dealers and investment advisers were easy to distinguish </li></ul><ul><li>Broker-dealers gave advice, and were paid by high fixed commissions set by the NYSE </li></ul><ul><li>Investment advisers gave advice, and were paid by fixed or asset-based fees </li></ul><ul><li>IA Act exempted advice “solely incidental” to brokerage if no “special compensation” </li></ul><ul><li>Business model differences started to break down after commissions were unfixed in 1975 </li></ul>
  16. 16. The IA Standard of Care Debate: The History <ul><li>SEC Tully Report in 1995 recommended that broker-dealers use fee-based brokerage to align broker incentives with customers and prevent churning and unsuitable recommendations </li></ul><ul><li>In 1999, SEC proposed (but did not adopt) Rule 202(a)11-1, which explicitly permitted fee-based brokerage accounts </li></ul><ul><ul><li>“No action” position in release allowed broker-dealers to proceed as if rule were final </li></ul></ul><ul><ul><li>The FPA sued, arguing that SEC “no action” position illegally had become de facto final rule </li></ul></ul>
  17. 17. The IA Standard of Care Debate: The History <ul><li>The SEC reproposed, and then adopted, a final Rule 202(a)11-1 in 2005 </li></ul><ul><ul><li>All fully discretionary accounts were deemed advisory accounts, although there were many discretionary brokerage accounts in 1940 </li></ul></ul><ul><ul><li>Financial planning was deemed advisory - but financial planning was not defined or distinguished from a BD’s suitability obligation </li></ul></ul><ul><ul><li>Offering a discount brokerage service does not turn full-price accounts into advisory accounts </li></ul></ul>
  18. 18. The IA Standard of Care Debate: The History <ul><li>During the first half of this decade, BD fee-based accounts grew dramatically, to over $300 billion in assets under management </li></ul><ul><li>Increasingly, BD representatives provided both commission-based and fee-based accounts, and used titles like “financial adviser” or “financial counselor” that blur the IA/BD distinction </li></ul><ul><li>After the tech crash, most large BDs offered reps incentives for stable, fee-based income </li></ul>
  19. 19. The IA Standard of Care Debate: The History <ul><li>FPA sued the SEC again, arguing that Rule 202(a)11-1 was inconsistent with the IA Act </li></ul><ul><li>The D.C. Circuit, in FPA v. SEC, 482 F.3d 481 (D.C. Cir. 2007), overturned rule </li></ul><ul><ul><li>Held SEC could not create a new exemption for brokers separate from the exception already in the Act </li></ul></ul><ul><ul><li>Held fee-based accounts involve advice that is not “solely incidental” to brokerage, and involve “special compensation” </li></ul></ul>
  20. 20. The IA Standard of Care Debate: The History <ul><li>As a result, over $300 billion in fee-based brokerage accounts moved to non-discretionary advisory accounts at BD-IA dual registrants </li></ul><ul><li>The SEC repeated its interpretative view that fully discretionary accounts must be advisory, and that offering discount brokerage does not make full-fee accounts “special compensation” </li></ul><ul><li>But SEC did not address financial planning, which now may be offered by IAs or BDs </li></ul>
  21. 21. The IA Standard of Care Debate: The History <ul><li>SEC adopted temporary Rule 206(3)-3T which allows firms to conduct principal trades with non-discretionary advisory accounts for some securities pursuant to a blanket consent (rather than trade-by-trade consent) </li></ul><ul><li>Does not apply to fully discretionary accounts </li></ul><ul><li>SEC characterizes accounts as both advisory and brokerage, subject to both sets of regulation </li></ul><ul><li>Rule expires in December 2009 but is expected to be renewed </li></ul>
  22. 22. The IA Standard of Care Debate: The History <ul><li>After the FPA decision, the SEC hired the RAND Institute to study customer understanding of the IA and BD industries </li></ul><ul><li>RAND found that customers did not understand the distinction between IA and BD businesses, or between IA and BD regulation - even after the distinctions were explained to them </li></ul><ul><li>RAND found that customers believed IAs and BDs should be regulated in the same way </li></ul>
  23. 23. The IA Standard of Care Debate: The History <ul><li>SEC Chairman Cox directed the Divisions of Investment Management and Trading and Markets to propose ideas for IA/BD regulatory harmonization </li></ul><ul><li>The SEC’s staff’s ideas (which have never been made public) went to Cox in early summer 2008 </li></ul><ul><li>But in summer 2008, the financial crisis pushed all other issues to the sideline </li></ul><ul><li>In December 2008, the Madoff scandal exposed weaknesses in SEC regulation of BDs and IAs </li></ul>
  24. 24. The IA Standard of Care Debate: The Standards <ul><li>The Investment Advisers Act imposes a uniform, federal fiduciary standard on IAs </li></ul><ul><li>Although the word “fiduciary” does not appear in the statute, the standard was announced in SEC v. Capital Gains Research Bureau, Inc. , 375 U.S. 180 (1963) </li></ul><ul><li>Ironically, there is no federal cause of action to enforce this standard, except to seek rescission of advisory fees - cases for damages must be brought under state law </li></ul>
  25. 25. The IA Standard of Care Debate: The Standards <ul><li>The standard for broker-dealers is more muddled </li></ul><ul><li>In some cases, such as order-handling, BDs are fiduciaries as a matter of federal law, see Newton v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266 (3d Cir. 1998) (en banc) </li></ul><ul><li>In some states, such as California, BDs are state law fiduciaries, see Duffy v. Cavalier, 215 Cal. App. 3d 1517 (1989) </li></ul><ul><li>In most states, BDs (usually) are not fiduciaries, see Fesseha v. TD Waterhouse Investor Servs. , 305 A.D.2d 268 (N.Y. App. Ct. 2003) </li></ul>
  26. 26. The IA Standard of Care Debate: The Standards <ul><li>All BDs are subject to a suitability standard when they recommend securities transactions, under SEC Rule 10b-5 and Rule 2310 </li></ul><ul><li>IAs have traditionally viewed suitability as a lower standard than fiduciary duty </li></ul><ul><li>Many BDs have concluded that in arbitrations, where most securities disputes are resolved, there is no real difference between the standards </li></ul><ul><ul><li>Note that legislative proposals likely will end mandatory pre-dispute arbitration </li></ul></ul><ul><li>As a result, SIFMA has endorsed a fiduciary standard for BDs and IAs </li></ul>
  27. 27. The IA Standard of Care Debate: The Standards <ul><li>Fiduciary duty is not a single standard </li></ul><ul><ul><li>&quot;But to say that a man is a fiduciary only begins analysis; it gives direction to further inquiry. To whom is he a fiduciary? What obligations does he owe as a fiduciary? In what respect has he failed to discharge these obligations? And what are the consequences of his deviation from duty?&quot; </li></ul></ul><ul><li>SEC v. Chenery Corp. , 318 U.S. 80 (1943) (Frankfurter, J.) </li></ul>
  28. 28. The IA Standard of Care Debate: The Standards <ul><li>The scope of fiduciary duty is subject to negotiation and disclosure </li></ul><ul><ul><li>“The scope of an agency relationship defines the scope of an agent's duties to a principal and a principal's duties to an agent.” Restatement of Agency § 1.01 comment e </li></ul></ul><ul><ul><li>“[A]n agent's fiduciary duties to the principal vary depending on the parties' agreement and the scope of the parties' relationship.” Restatement of Agency § 8.01 comment c </li></ul></ul>
  29. 29. The IA Standard of Care Debate: The Standards <ul><li>The scope of fiduciary duty is subject to negotiation and disclosure </li></ul><ul><ul><li>An act that might otherwise violate an agent’s fiduciary duties is permitted so long as the agent obtains the principal’s prior consent, and in doing so acts in good faith, discloses all material facts, and otherwise deals fairly with the principal, and the consent concerns transactions that could reasonably be expected to occur in the ordinary course of the agency relationship. Restatement of Agency § 8.06(1) </li></ul></ul><ul><li>For IAs, disclosure of potential conflicts of interest and client consent occurs in the Form ADV process </li></ul>
  30. 30. The IA Standard of Care Debate: The Legislative Proposals <ul><li>All of the major legislative proposals have suggested a uniform fiduciary standard of care for investment advisers and broker-dealers </li></ul><ul><li>IA trade association and consumer groups have expressed skepticism about any uniform standard, on the theory that it necessarily will dilute the existing IA fiduciary standard of care </li></ul><ul><li>In light of the RAND findings, it is difficult to imagine Congress endorsing different standards for functionally similar entities </li></ul>
  31. 31. The IA Standard of Care Debate: The Legislative Proposals <ul><li>The Obama/Geithner proposal suggests a “super fiduciary” standard: “solely for the benefit of the customer or client without regard for the financial or other interest of the broker, dealer or investment adviser providing the advice” </li></ul><ul><ul><li>Higher than the current standard for IAs or BDs </li></ul></ul><ul><ul><li>No suggestion standard can be modified by disclosure or client consent </li></ul></ul><ul><ul><li>Would only apply “when providing investment advice” which is to say, does not impose an ongoing duty to monitor </li></ul></ul>
  32. 32. The IA Standard of Care Debate: The Legislative Proposals <ul><li>Current lobbying efforts revolve around adding flexibility to the Obama/Geithner proposal </li></ul><ul><ul><li>Adding the concepts of disclosure and consent </li></ul></ul><ul><ul><li>Clarifying that ERISA fiduciary liability does not necessarily apply to every broker-dealer or investment adviser that deals with a benefit plan </li></ul></ul><ul><ul><li>Likely to be a high-level statement of principals, with authority delegated to the SEC to adopt rules to define </li></ul></ul><ul><ul><li>Concept of an SRO for IAs still very much alive - concern about SEC’s ability to oversee all IAs </li></ul></ul>
  33. 33. The IA Standard of Care Debate: The Legislative Proposals <ul><li>The time-table: House Financial Services Committee hopes to have legislation ready by end of 2009 </li></ul><ul><li>Senate Banking Committee is unlikely to have legislation ready until sometime in 2010 </li></ul><ul><li>Historically, very difficult to move controversial legislation in an election year </li></ul><ul><li>But no one in Congress wants to face voters in 2010 if they have done nothing about financial services reform </li></ul>
  34. 34. The IA Standard of Care Debate: The Legislative Proposals <ul><li>The biggest question: will Congress pass a comprehensive financial services bill, or will it address less controversial issues separately? </li></ul><ul><li>The Obama/Geithner proposal stated it was a unified whole and should not be viewed as a menu of choices </li></ul><ul><li>Even if Congress moves in stages, is investment adviser reform a “less controversial” issue? </li></ul><ul><li>Note - a major new scandal could completely change the calculation at any time </li></ul>

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