Uniform Fiduciary Standard For Retail Investment Advisers And Broker-Dealers Is Unworkable

From the SEC "Study on Investment Advisers and Broker-Dealer" as required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act:

The Staff [of the U.S. Securities and Exchange Commission] therefore recommends establishing a uniform fiduciary standard for investment advisers and broker-dealers when providing investment advice about securities to retail customers that is consistent with the standard that currently applies to investment advisers. The recommendations also include suggestions for considering harmonization of the broker-dealer and investment adviser regulatory regimes, with a view toward enhancing their effectiveness in the retail marketplace.

The full staff report is available here.

Fiduciary Standards Are A Pandora's Box Of Legal Problems For Retail Stock Brokers

Investment advisers perform a different function than retail stock brokers.

Investment advisers have specific investment objectives, an investment style, that they use to identify the way they invest or that their clients asked them to follow. For example, an investment adviser may be told by his client, or may identify his investment style in his promotional literature, as one that maximizes dividends and income while preserving capital. Another may identify himself, or be asked by a client, as seeking to maximize capital appreciation; an aggressive investor in small drug and biotech companies with the greatest potential for developing a blockbuster drug; for finding companies with extraordinary gains in profitability over the previous year, or for investing and trading in foreign currencies.

Fiduciary duty compliance for an investment adviser requires fair dealings without conflicts, with transparency and adherence to investment objectives.

Investment advisers and their clients have a mutual, agreed to understanding of investment goals and objectives for the money under advisement. Even if investment policy is never discussed, there is tacit acceptance of the policy by the customer just by going to an adviser who holds himself out to be a particular type of investor manager or adviser.

A retail stock broker, who does not currently by law, regulation or industry practice, have a fiduciary duty to a customer, is a salesperson. Salespeople in all other walks of life generally do not have fiduciary relationships with buyers. Does you supermarket have an obligation to tell you that their store brand is made by the same company you are buying and costs a few cents less? or that you should buy a few more cans of soup this week because prices are going up tomorrow?

Brokers can only sell to a retail customer investments, stocks, bonds, mutual funds, etc., that are on the brokerage firm's approved list. Is a retail broker with a fiduciary obligation required to tell you that the fees or transactions costs for the same investment are lower at another firm?

Are retail brokers with a fiduciary obligation obligated to tell a customer for a mutual fund that mutual fund managers cannot consistently beat an index fund? or that their firm's stock analyst cannot pick winning stocks any better than a someone who randomly picks a stock?

Will brokers be forbidden from selling commodities such as gold and silver to clients because they have a zero correlation with a market investment portfolio and therefore will not over time increase the value of the portfolio?

The functional difference between an investment adviser and a retail broker makes the application of a fiduciary standard impossible to implement effectively.

Imposition of a common fiduciary standard on advisers and brokers will lead to an enormous increase in lawsuits and arbitration claims against retail stock brokers and their firms. It will force the SEC to enact a very limited definition of fiduciary and that will create unmet retail broker client expectations, untold customer confusion and resentment by retail customers.

Let the lawsuits begin.

My Comment To Wall St Journal About SEC And Goldman Facebook Offering Disclosures

A comment I posted on The Wall Street Journal to an opinion piece, "What Really Merits Disclosure? Goldman clients are the ones who should be ticked off" by Holman W. Jenkins, Jr:

The SEC thinks the only way a stock can go down is due to fraud or misreporting of financial data. The SEC measures it success by the number of legal actions it takes against companies or investment firms and it is not measured by key positive indicators important to the US economy, such as the number of IPOs, the amount of company market debt financings, the liquidity of the market, the costs of transactions, etc. Imagine running a manufacturing firm and giving bonuses for poor quality instead of good quality goods. The SEC is rewarded for market and investment failures with more staff and more money. Instead, it should be rewarded for more of the positive things markets do, such as IPOs, etc.

If it viewed the markets positively instead of negatively and was measured by indicators of success in the market instead of the few failures, the SEC would have worked with Goldman to find a way to make the Facebook domestic private offering happen. Instead, the SEC comes in looking for ways to find a guilty party before the deal ever takes place. The SEC should be penalized for preventing sophisticated US investors from participating in a domestic stock offering.

There was occasional fraud and misreporting in the stock market before the SEC was established 75 years ago and there is no indication that there is any less fraud and misreporting since the SEC began.

The SEC only real goal always seems to be to complain that it needs more staff and more funding to do its work.

If I remember correctly, there are more financial experts and economists at the Department of Agriculture than there are at the SEC. The SEC is overstaffed with inexperienced young lawyers and government bureaucrats who know little, if any, about finance, investing, starting a company or taking a business or investment risk. The SEC should be abolished and replaced. A new agency that is more pro-business, pro-markets, pro-investment measured by positive economic, and market attributes should replace the SEC.

Excellent Legal Risk Analysis Of Goldman Sachs' Decision To Cancel Facebook 's Domestic Share Offering

The New York Times Dealbook has an excellent discussion of Goldman Sachs' legal risks in the Facebook private equity offering, "Why Did Goldman Blink?" by Steven M. Davidoff:

Goldman Sachs’s decision to offer shares of Facebook only to offshore investors is simple risk management. The risk here can be attributable to the scrutiny that this transaction, and Goldman Sachs generally, are now under.

Read the complete New York Times article here.

SEC-CFTC Issues Report On May 6, 2010 Stock Market Flash Crash

The SEC and CFTC issued their joint report on the stock market flash crash of May 6, 2010. The full 104 page report is available from the SEC here or from my upload on Scribd here.

The executive summary was not released as a separate document and is included in the full report.

I have reprinted from the Executive Summary part of the report, the Lessons Learned section below:

One key lesson is that under stressed market conditions, the automated execution of a large sell order can trigger extreme price movements, especially if the automated execution algorithm does not take prices into account. Moreover, the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets. As the events of May 6 demonstrate, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.

May 6 was also an important reminder of the inter-connectedness of our derivatives and securities markets, particularly with respect to index products. The nature of the cross-market trading activity described above was confirmed by extensive interviews with market participants (discussed more fully herein), many of whom are active in both the futures and cash markets in the ordinary course, particularly with respect to “price discovery” products such as the E-Mini and SPY. Indeed, the Committee was formed prior to May 6 in recognition of the continuing convergence between the securities and derivatives markets, and the need for a harmonized regulatory approach that takes into account cross-market issues. Among other potential areas to address in this regard, the staffs of the CFTC and SEC are working together with the markets to consider recalibrating the existing market-wide circuit breakers – none of which were triggered on May 6 – that apply across all equity trading venues and the futures markets.

Another key lesson from May 6 is that many market participants employ their own versions of a trading pause – either generally or in particular products – based on different combinations of market signals. While the withdrawal of a single participant may not significantly impact the entire market, a liquidity crisis can develop if many market participants withdraw at the same time. This, in turn, can lead to the breakdown of a fair and orderly price-discovery process, and in the extreme case trades can be executed at stub-quotes used by market makers to fulfill their continuous two-sided quoting obligations.

As demonstrated by the CME’s Stop Logic Functionality that triggered a halt in E-Mini trading, pausing a market can be an effective way of providing time for market participants to reassess their strategies, for algorithms to reset their parameters, and for an orderly market to be re-established.

May 6, 2010 Market Event Findings In response to this phenomenon, and to curtail the possibility that a similar liquidity crisis can result in circumstances of such extreme price volatility, the SEC staff worked with the exchanges and FINRA to promptly implement a circuit breaker pilot program for trading in individual securities. The circuit breakers pause trading across the U.S. markets in a security for five minutes if that security has experienced a 10% price change over the preceding five minutes. On June 10, the SEC approved the application of the circuit breakers to securities included in the S&P 500 Index, and on September 10, the SEC approved an expansion of the program to securities included in the Russell 1000 Index and certain ETFs. The circuit breaker program is in effect on a pilot basis through December 10, 2010.

A further observation from May 6 is that market participants’ uncertainty about when trades will be broken can affect their trading strategies and willingness to provide liquidity. In fact, in our interviews many participants expressed concern that, on May 6, the exchanges and FINRA only broke trades that were more than 60% away from the applicable reference price, and did so using a process that was not transparent.

To provide market participants more certainty as to which trades will be broken and allow them to better manage their risks, the SEC staff worked with the exchanges and FINRA to clarify the process for breaking erroneous trades using more objective standards.13 On September 10, the SEC approved the new trade break procedures, which like the circuit breaker program, is in effect on a pilot basis through December 10, 2010.

Going forward, SEC staff will evaluate the operation of the circuit breaker program and the new procedures for breaking erroneous trades during the pilot period. As part of its review, SEC staff intends to assess whether the current circuit breaker approach could be improved by adopting or incorporating other mechanisms, such as a limit up/limit down procedure that would directly prevent trades outside of specified parameters, while allowing trading to continue within those parameters. Such a procedure could prevent many anomalous trades from ever occurring, as well as limit the disruptive effect of those that do occur, and may work well in tandem with a trading pause mechanism that would accommodate more fundamental price moves.

Of final note, the events of May 6 clearly demonstrate the importance of data in today’s world of fully-automated trading strategies and systems. This is further complicated by the many sources of data that must be aggregated in order to form a complete picture of the markets upon which decisions to trade can be based. Varied data conventions, differing methods of communication, the sheer volume of quotes, orders, and trades produced each second, and even inherent time lags based on the laws of physics add yet more complexity.

Whether trading decisions are based on human judgment or a computer algorithm, and whether trades occur once a minute or thousands of times each second, fair and orderly markets require that the standard for robust, accessible, and timely market data be set quite high. Although we do not believe significant market data delays were the primary factor in causing the events of May 6, our analyses of that day reveal the extent to which the actions of market participants can be influenced by uncertainty about, or delays in, market data.

Accordingly, another area of focus going forward should be on the integrity and reliability of market centers’ data processes, especially those that involve the publication of trades and quotes to the consolidated market data feeds. In addition, we will be working with the market centers in exploring their members’ trading practices to identify any unintentional or potentially abusive or manipulative conduct that may cause system delays that inhibit the ability of market participants to engage in a fair and orderly process of price discovery.

My May 19, 2010, blog post on the preliminary version of the SEC-CFTC report on the flash crash is available here.

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Is The Goldman Sachs-SEC Settlement In Trouble?

A federal judge has refused to approve the Citigroup settlement with the SEC without more information. See "Judge won't approve SEC-Citigroup settlement over risky mortgages without fuller information" by Marcy Gordon, AP Business reporter. Also see The Wall Street Journal article, "Judge Won't Approve Citi-SEC Pact" by Kara Scannell.

From Scannell's article:

The judge, striking a frustrated tone, fired several questions at the SEC, among them why it pursued only two individuals in the case and why Citigroup shareholders should have to pay for the alleged sins of bank executives.

The judge's refusal to rubber stamp the The Citigroup-SEC settlement is a recent reminder of the things that are wrong with the SEC-Goldman Sachs settlement. ACA was never charged. There is no admission of guilt or wrongdoing by Goldman. The penalty is far in excess of the alleged or admitted harm.

See my earlier post, "Fair Analysis Of SEC Goldman Settlement: Will The Court Accept It?"

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