Financial Planners Can Do Better Than FINRA-FP

Organizations representing financial planners are on the spot. A subcommittee of the House Financial Services Committee will hear testimony Tuesday on a draft bill that would create a self-regulatory organization for investment advisors, or IA-SRO. If financial-planner organizations do not move quickly to develop an IA-SRO for their members, they might be consigning planners to regulation by the SRO for broker-dealers, the Financial Industry Regulatory Authority, commonly referred to as FINRA.

A group of my students has created an IA-SRO in anticipation of the IA-SRO bill becoming law. Their Self-Regulatory Organization for Independent Investment Advisors, or SROIIA, is intended to offer an alternative to FINRA for non-broker-dealer investment advisors. SROIIA has certain advantages over FINRA that would enable it to offer a superior IA-SRO alternative for financial planners. However, the financial-planner community will need to get behind SROIIA well before the IA-SRO bill becomes law in order to compete with FINRA in the IA-SRO market.

The IA-SRO Bill
The IA-SRO bill authorizes the SEC to approve an investment advisor self-regulatory association that would have broad rulemaking, examination, and enforcement authority over most advisors. The bill generally mirrors the broker-dealer law under which FINRA was created. Enactment of the IA-SRO bill would achieve FINRA's long-sought expansion of its jurisdiction to investment-advisory activities and make it the primary source of authority under the federal and state laws and rules that regulate investment-advisory activities.

The biggest impact of the IA-SRO bill would be felt by the retail advisors who are not dually registered as broker-dealers. These are the advisors who generally call themselves "financial planners" and hold designations such as the Certified Financial Planner. About 34,000 individuals fall into this category.

In contrast, dually registered advisors who are already members of FINRA (about 241,000 individuals) would not be greatly affected. FINRA would simply become their IA-SRO in addition to being their broker-dealer SRO. The SEC and the states already enforce advisory regulations that apply to dual registrants; as an IA-SRO, FINRA would simply enforce them, as well. This might increase these advisors' regulatory burdens somewhat, but they might also realize efficiencies to the extent that FINRA coordinates overlapping broker-dealer and investment-advisor rules.

Dual registrants could, in theory, choose an IA-SRO other than FINRA, but this is unlikely. They will almost certainly prefer the known-quantity FINRA, under which they would continue to be subject to only one SRO, over a new, unknown IA-SRO that would subject them to a second SRO.

The bill also would not affect advisors to nonretail clients who are not already FINRA members, such as managers of hedge, venture capital, and mutual funds. The bill exempts them altogether. This exemption is necessary to mollify the Investment Company Institute, Managed Funds Association, and other lobbying organizations that represent nonretail money managers and probably have the clout to defeat any SRO legislation that applied to them.

That leaves only retail advisors who are not broker-dealers--that is, financial planners--subject to a new SRO under the IA-SRO bill. This distinction should make financial planners major players in the IA-SRO discussion, but the House hearing does not include a single witness representing this group. The Investment Advisers Association is testifying, but it is by no means a voice for financial planners. The Financial Planning Association, CFP Board, and National Association of Personal Financial Advisors, each of which represents non-dual-registrants to a greater or lesser extent, did not make the cut. However, three broker-dealer and two insurance organizations will be there, along with FINRA--the IA-SRO's ringleader.

Each of the IAA, FPA, CFP Board, and NAPFA would prefer that weaknesses in the oversight of investment advisors be addressed through increased funding, even if that entails user fees collected from their members.

And that would, in fact, be the best approach.

But the IA-SRO bill is a blow to their hopes. If the House approves the IA-SRO bill, then the bill's--and financial planners'--fate will be decided in the Senate Banking Committee. Its chairman, Sen. Tim Johnson (D-S.D.), has not taken a position on the IA-SRO question, but the IA-SRO bill clearly has some effective lobbying forces behind it. Financial planners need to start planning for its probable enactment.

Is FINRA-FP Inevitable?
As noted above, there is little doubt that FINRA would become the IA-SRO for advisors who are already FINRA members. FINRA has been lobbying financial planners to accept it as their IA-SRO, as well. Many financial planners may disagree, but FINRA does have the capacity to offer a workable IA-SRO structure for financial planners, or FINRA-FP. FINRA has a regulatory infrastructure in place and credibility with the SEC. (The current SEC chairman Mary Schapiro was formerly FINRA's CEO; SEC commissioner Elisse Walter also came from FINRA.) It already enforces certain rules that indirectly regulate investment-advisory activities. It can directly or indirectly use its existing members' dues to create and finance a new regulatory structure for new, nonbroker members. And it will be prepared to apply to the SEC to be an IA-SRO before the ink is dry on final legislation.

Despite these advantages, there is an alternative to FINRA-FP, but the emergence of the IA-SRO bill threatens its viability. Earlier this year, students at the University of Mississippi School of Law created an IA-SRO--SROIIA--that is intended to create a regulatory home for financial planners. SROIIA hopes to tap the strong vein of "anyone-but-FINRA" sentiment among planners by offering an IA-SRO alternative that better suits planners' needs. Anti-FINRA sentiment alone, however, will not be enough for SROIIA to succeed.

SROIIA is seeking to exploit other advantages over FINRA. For example, SROIIA hopes to maintain the bona fide fiduciary standard that has become an effective marketing brand for financial planners, as I discussed in a previous article. FINRA's members are salespersons--not fiduciaries required to act in their clients' best interests. Even if FINRA imposes a fiduciary duty on them, it will be diluted to accommodate brokers' business practices, which are inherently more susceptible to conflicts of interest.

If SROIIA can maintain the fiduciary standard in a way that clearly distinguishes its members from FINRA salesperson-members, it will offer something to financial planners worth paying for. SROIIA members will be able to point to their SROIIA membership as evidence that they offer higher-quality services to their clients.

SROIIA has announced that it will hold its members to a tangibly higher standard and has backed that up with a proposed examination administered with fi360 that will focus on fiduciary conduct. It also may prohibit certain broker-dealer business practices that create conflicts of interest, such as engaging in principal transactions and/or charging commissions.

A survey conducted by SROIIA suggests that many financial planners would support such an IA-SRO. Of the 228 respondents, 87% stated that, if required to join an SRO, they would prefer an advisor-specific SRO over FINRA. More than 90% stated that they would not object to being held to a higher fiduciary standard than that imposed by FINRA. Eighty-nine percent would not object if they could not engage in principal transactions with clients, and 95% would not object if they could not be paid commissions. These data suggest that SROIIA will be able to back up its claim to maintain a bona fide fiduciary standard with concrete differences in its conduct rules, thereby offering advantages that FINRA cannot match.

 

A 'Self'-ish Self-Regulatory Organization
SROIIA also can distinguish itself from FINRA by adopting a more member-friendly, efficient approach to regulation. As illustrated by a recent Chamber of Commerce report, FINRA is perceived by many industry members as having taken the "self" out of self-regulatory and become, in effect, a government actor. Indeed, FINRA's rulemaking, examination and enforcement authority substantially overlaps with SEC and state activities. Some state regulators perceive FINRA as usurping their position.

FINRA is likely to expand this quasi-governmental role as legislators and regulators come to recognize the inherent advantages of the SRO structure in making and enforcing securities law, especially across national borders. The evidence is mounting that national governments and government agencies lack the responsiveness, sophistication, and jurisdictional reach that is necessary to effectively regulate complex aspects of securities markets and the world economy in general.

In fact, FINRA is likely to become a significant source of global corporate and securities law during the next few decades. Investor advocates may recoil from the delegation of regulatory oversight to non- or quasi-governmental authorities. However, it is difficult to survey the post-World War II development of corporate and securities regulation without being confronted with a broad coincidence of increasing market complexity/interdependence on the one hand, and the delegation of governmental authority to private associations on the other.

But enough of FINRA star-gazing; the dynamics of retail investment-advisor regulation are quite different. Compared with the complexity of FINRA's current and future responsibilities, the regulation of non-broker-dealer, retail financial planners is a relatively simple, low-risk task. Financial planners do not take custody of client assets, engage in principal transactions, or receive transaction-based compensation. Financial planners' opportunities for theft and self-dealing are minimal, and planners are subject to a fiduciary duty.

The simpler nature of investment-advisor regulation would allow SROIIA to offer a more selfish self-regulatory model. For example, by designing its examination structure to supplement and support--rather than supplant--SEC and state activities, SROIIA can reduce the costs of regulation for both its members and regulators. A truly self-regulatory organization should provide a voice for regulated persons that helps maximize society's overall return-on-regulation by more efficiently bridging the gap between the private and public interests. It should not and need not involve volumes of detailed conduct rules that a FINRA-model IA-SRO would entail.

Privatized Compliance for Financial Planners
This model of self-regulation embraces a kind of privatized compliance. The strong trend across all forms of business regulation in the United States is the emphasis on compliance structures with which regulated entities are expected to comply over a deterrence-through-punishment approach. Rules relating to antitrust, health care, environmental, communications, employment, workplace safety, privacy, financial services and other regulatory hot spots have increasingly taken the form of systems-based expectations that assign implementation to SRO-like associations and/or directly to individual firms.

SROIIA can provide an effective mechanism for maximizing the effectiveness of compliance-oriented regulation. For example, it can enlist private providers of financial planners' systems tools to adapt their products, such as the types of systems recently described by Bill Winterberg, to be proxies for regulatory examinations. SROIIA would establish the criteria for proof of compliance that a private product would have to achieve to be certified, and then work with states to obtain their agreement that such certified systems will be accepted as a substitute for aspects of state examinations.

If a securities law violation occurs under the auspices of a particular product, the provider's status will be at risk. The states would lead the investigation and prosecution of the advisor, with the support of SROIIA, while SROIIA would re-evaluate the product's certification. The success of privatized compliance depends on its achieving a net-net gain. Advisors would have to see a reduction in compliance burdens (thereby reducing overall costs and increasing lower-income access to advisory services) while states would have to see enhanced overall compliance.

Toward this end, SROIIA is developing a structure for such a privatized compliance system. On Sept. 29, SROIIA and the University of Mississippi School of Law are sponsoring a small gathering of financial planners and firms that provide software support, compliance consulting, and legal guidance to planners to advise SROIIA about designing a blueprint for a privatized model of financial planner compliance. This and other initiatives offer the best chance for SROIIA to provide an SRO experience for financial planners that FINRA cannot match.

Time for a Strategy Shift?
The biggest factor in SROIIA's success might be the policy position of groups representing SROIIA's target membership. As discussed above, the FPA, CFP Board, and NAPFA are opposed to an IA-SRO. They even support user fees to help fix the SEC's funding shortfalls as an alternative to being subject to a new regulator. As a practical matter, it would be difficult for them to simultaneously lobby for government oversight and user fees and embrace a non-FINRA IA-SRO, such as SROIIA. It must be one or the other; the issue for them is how long to cling to a user-fees strategy.

If these groups stick with their user-fees strategy too long, they risk ceding the IA-SRO market to FINRA. FINRA will apply for and receive SEC approval as an IA-SRO soon after the approval of the IA-SRO bill. If no alternative IA-SRO is available at that point, financial planners will have no choice but to join FINRA initially. It is unrealistic to expect that they would later switch to SROIIA; it will be a challenge for SROIIA to woo financial planners even if it is an option from the start. Thus, if FINRA is the first mover in the IA-SRO market, it will be game over for any competitor.

Mercer Bullard is president and founder of Fund Democracy, a mutual fund shareholder advocacy organization, an associate professor of law at the University of Mississippi School of Law, a senior adviser for financial planning firm Plancorp Inc., and a former assistant chief counsel at the Securities and Exchange Commission. The views expressed in this article do not necessarily reflect the views of Morningstar.com