INVESTMENT ADVISER SRO – The “Colorado Experiment.” Part Four

Written by: Phil Feigin

They say if you stick around long enough, everything will happen again. So it is for the IA SRO concept for me. It was many years (and pounds) ago, when I served as Colorado Securities Commissioner. I had succeeded in winning adoption of the Colorado Securities Act in 1990, replacing what I felt was the worst state securities law in the country. It had been adopted in a deregulatory wave of 1981. In late 1993, I undertook to amend the 1990 Act in the 1994 legislative session by adding investment adviser regulation. Colorado was one of the handful of states that had never regulated investment advisers or their advisory personnel.

Colorado’s General Assembly was always hostile to providing new authority, funding or staff to its regulatory agencies. The state was in what seemed to be an eternal fiscal crisis. Any new regulation with licensing and inspection authority, if adopted at all, could have no fiscal impact. That appeared to pose an irreconcilable problem unless we changed the parameters of the problem.

In desperation, I came up with what I thought would be a novel solution only available in Colorado. What I knew as the International Board of Standards and Practices for Certified Financial Planners (“CFP Board”) was headquartered here in Denver, and already had in place a form of testing, application screening, licensing, continuing education and an oversight program for certified financial planners. I approached the CFP Board director to see if naming the CFP Board some sort of self-regulatory organization (“SRO”) for Colorado investment advisers was even theoretically possible. When he didn’t say “absolutely not,” I at least floated the idea publicly.

At this point, I harken back to my classification a blog or two ago in which I divided the investment advisory profession into three general groups:  (i) money managers; (ii) retail advisors; and (iii) fee-only planners. Suffice it to say for these purposes that these three general groups are loosely bound together by the facts they deal in securities, they are generally subject to either federal or state investment adviser registration and regulation, they charge fees based on AUM, and they reside on Earth. Oh, and members of each group hold themselves in higher esteem than the other two groups.

Now, back to my Colorado story. My 1994 IA legislative proposal was plain vanilla, standard state investment adviser regulation, i.e., a bill I thought had a chance of passing. As I recall it now, a local, activist fee-only planner (and mind you, I have great respect for fee-only planners generally) with no regulatory or legislative experience decided that Colorado was uniquely situated to be the first state to outlaw anything but fee-only advice. He fashioned a rival bill that, as I recall it, would have given Colorado expansive and unprecedented authority over advisers. Thus, in my view, given Colorado’s tendencies, the bill was DOA.

Nonetheless, this planner apparently won the support of Gretchen Morgenson [now a New York Times (self-professed) Wall Street critic, but at the time, executive editor of Worth magazine]. Ms. Morgenson absolutely skewered me in her November 1993 Worth article (“Investor Watchdog or Industry Pussycat”), accusing me of betraying investors by lending regulatory credibility to the CFP Board and its accreditation program by suggesting it could serve as a state SRO. (It should be noted that, although CFPs are held to relatively high ethical standards by their Board, they are permitted to sell products as well as provide investment advice and financial planning services.) As I recall, Ms. Morgenson and this fee-only planner were critical that CFP qualification tests were flawed, and that advisers with the CFP certification were permitted to sell products as licensed securities and insurance agents as well as advise for fees. My 1994 IA bill was likely going to die in any event, with or without the “help” from my planner and Worth fan. And it eventually did.

To that point in time in my government career, one defense lawyer had called me a heartless, cut-throat regulator, and a Colorado state senator had assailed me and my staff in a public hearing, accusing us of using what he termed “Gestapo tactics” in our investigations (being of Jewish decent, that one was particularly sweet to me). However, until the Worth article, I had never been accused of being some sort of investment industry lap dog. (I still remember Gretchen’s article to this day, not that I would hold a grudge for almost 20 years.)

Anyhow, a few more years, one National Securities Markets Enhancement Act (1995), one Democratic Senate, and one or two major advisory frauds later, I finally succeeded in ramming a new, relatively standardized IA bill through, and Colorado at last had an investment advisor law, effective January 1999, sans SRO.

Now, almost 20 years after my desperation Colorado IA SRO trial balloon was “Hindenberged,” Rep. Spencer Bachus has (R-Ala.), Chair of the House Financial Services Committee, has proposed the “Investment Adviser Oversight Act of 2012.” If it passes, the measure will give the SEC the authority (read “order them”) to create and oversee one or more SROs for federal and state registered investment advisers and investment adviser representatives.

Where’s Gretchen when we need her?

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INVESTMENT ADVISER SRO – What makes sense. Part Three

Written by: Phil Feigin

We don’t need a new SRO for investment advisers. On top of that, a new SRO would be a marked detriment to the advisory profession, American investors and the economy. The essential reasons SROs arose in the first place are absent in the IA sector. What is needed is funding.

We’re already there where it counts most. FINRA already polices the advisory activities of those of its members who are dually registered as brokers and advisers. If FINRA is somehow limited in its oversight of dually functioning firms and reps, whatever those weaknesses are can be addressed easily in narrowly targeted legislation or rules.

In my view, it was a mistake way back whenever for the SEC, the states and the SROs to allow the Jekyll/Hyde arrangement of broker-IAs anyway. If you want to sell, be a broker; if you want to advise, be an IA, but they should not have allowed the two to be mixed. However, that cat’s long out of the bag. I think FINRA is well positioned to deal, i.e., to continue to deal, with the inherent and inescapable conflicts of interest that arise from the dual roles.

That said, I am pretty tired of the seemingly endless studies commissioned to find out if the investing public is confused about the differences between and the responsibilities of brokers and IAs. I am already on record as to my belief that the only real difference a uniform fiduciary duty would make is in customer arbitrations. There’s more persuasive state case law on fiduciary duty than there is on suitability.

Of course, people are confused. They are confused about all sorts of things. We have a Federal Trade Commission, Food and Drug Administration and state consumer protection laws, so those laser comb and other hair restoration technique and weight loss commercials rammed down my throat every night on TV and in newspaper ads (yes, I still read newspapers) must be legitimate, right? Certainly, if they weren’t legitimate, “they”—federal and state authorities—wouldn’t let them advertise. And then there are all the debt relief services that will help people under water keep all seven credit cards, their iPhones, premium cable, Lexus, gym memberships and Starbuck’s habits without sacrificing a thing, and for free; the companies that helped reduce that guy’s $5,000,000 tax liability from not filing returns since high school to $1,300; and the schools that teach people how to become real estate moguls, buying and selling houses risk free and without any money down; or pay off your mortgage in four months; or to day trade your way to millions. (Rant over.)

Are consumers really confused when they deal with an Ameriprise agent? Does the consumer really believe he will be offered a Merrill Lynch-sponsored mutual fund when he visits his Morgan Stanley rep? If you go to a Ford dealership, is anyone out there surprised when they are offered a Ford and not a new Audi? That they are confused by the differences between dealing with a broker and an IA is overly well-documented. But they are not confused about proprietary products.

For all the years I was Securities Commissioner, it was well-known that one of the NASD’s greatest fears, concerns and frustrations was that large producers at firms the NASD regulated were resigning, registering as investment advisers and placing their clients’ trades through accounts at Schwab or the like. It was apparently the NASD’s view that these reps turned advisers were then able to engage in violative conduct they could not engage in under the purview of the NASD.

We never quite knew what that wrongdoing was. Both NASD and IA regulation prohibited unsuitable recommendations. Neither the broker rep before nor the IA rep now could take custody of customer funds or securities. Both the broker rep and the IA rep could devise ways to steal from his customers. That was illegal under both regimes, yet, unfortunately, it still happened.

To us in the states, the IA model, particularly the fee-only model, freed the rep from having to sell stuff. Thus, the only (lawful) way for the IA to make money was if the client made money. The NASD feared losing control over the rep, but to us, a paramount basis for that control had been eliminated. Regulators, even self-regulators, always look over the river at the folks outside their regulatory grasp and seek more jurisdiction. It’s just the nature of the beast.

Show me the money. To me, FINRA has become nothing more than the securities regulatory version of private prisons. The perception is that hiring the private firm to build and run the private prison costs the government less than building and running its own facility. Maybe, maybe not. The functions FINRA now performs are all but indistinguishable from what OCIE, Trading and Markets, Enforcement and the states do, except they do more of it with their expanded resources. FINRA assesses/taxes its membership, which in turn “taxes” its clientele for the cost of that regulation. It is an off-book enterprise and off-book accounting that would make Enron’s Andrew Fastow proud. As for comparative cost to the investing public, one need only compare Mary Schapiro’s FINRA retirement package with whatever Arthur Levitt got as SEC Chair to get an idea as to how FINRA compensation compares to that of the SEC.

The SEC has tried, unsuccessfully, for years to become self-funded, i.e., to keep and spend what it takes in as fees. Under the plan, its fee levels would still be subject to Congressional control to prevent excesses. Relatively speaking, the amount the SEC estimates is needed to fully staff its inspection effort is miniscule in the grand scheme of the federal budget, and negligible when even the fees that would be required to pay for the increase are considered. Not a single additional tax dollar.

Yet, I am told, more money for the SEC is “off the table” in Congress. If that is the case, I say we should then get a new table. The costs of establishing an IA SRO will be astronomical in terms of what it will mean to day-to-day financial planners and their clients, to mutual fund advisors, their investors and their marginal returns since 2008. And for what? It is the SEC and the states that have been licensing and regulating advisers for more than 70 years. There is no legacy SRO as there was with the exchanges for brokers in 1934. And what will this new SRO, or heaven forbid, new SROs, be charged with doing? More inspections!

The SEC and states already have the granular body of IA “does and don’ts” rules and regulations. The belief is that more inspections will mean better oversight, catching the bad actors and improving the operations of the good ones. The regulators in place simply need more people. We do not need an industry/client-supported infrastructure, where the taxation and processes are hidden and largely uncontrolled.

Such a funding burden would all but surely take a punishing toll on a host of localized financial planners. Unlike the brokerage industry, fee-only financial planner practices are often one-person shops, managing $20 or $30 million with maybe 30 to 40 clients. The burdens posed in their having to support an IA SRO would be staggering. It may be more than they can withstand. The very people who are least likely to cause any IA-related problems would be the ones most hurt by the proposal. Per a survey in Massachusetts, 41% of its registered IAs would be driven from business.

Bait and switch? Surely, after winning jurisdiction in Dodd-Frank, the provision of the Bachus bill most offensive to state securities regulators is proposed section 203B(h). Under this unprecedented provision, state securities agencies—political arms of sovereign states—would, in essence, have to petition the IA SRO—a private company—and the SEC on an annual basis, in a report made at some sort of mandated (and no doubt unfunded) regulatory confab, for the power to regulate IAs within their jurisdictions. The petition would be based on the proposed “methodology of their examinations” for the coming year and how they did in meeting their goals the last year. NASAA, or something like NASAA—another private enterprise—is supposed to produce this report and itself make recommendations to the IA SRO and the SEC based on its vetting of how well the state agencies did and on state plans for the next year—another completely unfunded federal mandate. Based on the report and the confab, the IA SRO is to report to Congress each year. It is unclear in the bill, but I infer that, in this report, the IA SRO, with the advise and consent of the SEC, would determine conclusively which state either did not perform as planned last year, or whose plan is insufficient for the coming year, so that its state regulated investment advisers will be subject to IA SRO rather than state jurisdiction for the coming year. Not surprisingly, there is no provision for the states to submit their views as to how well or poorly the IA SRO performed last year or as to its methodologies for the coming year.

I can’t even begin to describe the constitutional problems the proposal entails, let alone the statutory and budgetary confusion and problems at all levels, for both regulators and regulated, it would cause were it to become law. It is just plain crazy.

WHAT MAKES SENSE

First, leave state IAs to the states. Under Dodd-Frank, the states were given the responsibility of overseeing advisers with less than $100 million AUM. The states have been gearing up to fulfill that responsibility ever since, and commencement of the grand design is all but upon us. They should be given the chance to succeed. No matter what Congress does about the advisers under post-Dodd-Frank SEC jurisdiction, Congress should leave regulation of these state registered IAs alone. Revisit the system five years from now and see how they did.

Second, if necessary enhance FINRA’s existing jurisdiction. As I said before, do whatever might be necessary to enhance FINRA jurisdiction so it is fully empowered to regulate those entities dually registered as BDs and IAs as well as their people and the unique problems they all may present. The involvement of the states in regulating this sector likewise should be their business to prioritize and to coordinate with FINRA, as they do today. How much or little the SEC involves itself in overseeing this sector should be a matter of coordination and prioritization with FINRA and the states as well, again, as it is today.

Third, impose user fees to fund SEC oversight of SEC IA-only registrants. Finally, fund the SEC to inspect what is left is the third sector, the IAs that are not affiliated with any retail broker-dealer, that are registered with the SEC that do not sell securities, i.e., essentially, the money management sector, the managers of our mutual funds, hedge funds and institutional portfolios. I would include in this group those mutual funds that have brokerage affiliates. The potential risks posed to the economy by problems in this sector mandate direct SEC oversight.

The SEC must be given the authority to impose on these IAs the user fees necessary to fund their regular and efficient inspections and regulation. It is simply nonsensical for Congress to deny the SEC this funding mechanism in favor of establishing, staffing and inventing a new self-regulatory bureaucracy. How can anyone rationally compare the costs of establishing an entirely new and separate self-regulatory regime with those of simply adding additional staff to an already functioning system, and without spending an additional tax dollar?

In my last part in this series, I’ll share an anecdote about my own dabbling with the IA SRO concept as Securities Commissioner.

INVESTMENT ADVISER SRO – Is an IA SRO workable or right? Part Two

Written by: Phil Feigin

My former state securities regulatory brethren must be steamed. Having seemingly assured themselves of a Congressionally recognized role in national investment adviser regulation for the next millennium in Dodd-Frank, I can appreciate the angst they must be feeling now. After gaining important, seemingly indelible ground in Dodd-Frank, they are then preemptively aced out of what they see as core functions involving private placement and small securities offerings in the JOBS Act, and now, the IA SRO boogeyman returns. They must, understandably, be having a federalist conniption fit.

The division of state and SEC authority over IAs instituted in 1996 was a bit of a crazy quilt to begin with, dreamed up at the last minute at 1:30 in the morning in a staff office. In Dodd-Frank, Congress added a bunch of “polka dots” and “paisley swirls” to the quilt. Confusing as that all is, Rep. Bachus would now apply yet another layer (or layers) of SRO rules, regulators, process and examination, cutting across everything else. The states have a good case to make that the IA SRO concept is a bad one. I do not profess to speak for them in any way, but, unless things have changed dramatically since my days in NASAA, state regulators will not be keen on the idea of surrendering the lion’s share of their IA responsibilities, let alone reporting, to what they perceive as a private, opaque, industry club, whether it be FINRA or some other group, existing or to be formed.

Allow me to “review the bidding” on the history of SROs and why we have them. Back in 1934:  (i) exchanges were a given; (ii) self-regulation was a favored theme of the New Deal across all industries; (iii) given the times, the OTC market was too far flung geographically for any authority, be it governmental or self-regulatory, to oversee effectively (rather the industry try and fail than hang the SEC for it); (iv) the SROs combined both regulatory and market functions; and (v) there was a reluctance on the part of the SEC to get into the minutiae of trying to regulate what they termed the “ethics” of industry, at least in 1934 terms.

The idea of an SRO for investment companies and investment advisers has been considered, rejected or simply ignored rather consistently, at some point during almost every decade since 1934. I think there are some fundamental reasons why.

Not one profession. As I perceive it, I think it a fair and workable means of classification to divide the profession into three general groups: 

(i)      money managersthey manage investment portfolios for mutual funds, hedge funds, institutional clients and the like, are paid advisory fees based on the assets under their management (“AUM”), but sell no products, and tend to be concentrated in urban money centers;

(ii)     retail advisors—they are paid advisory fees based on AUM and also serve as securities reps and insurance agents, selling products like securities and insurance on a commission basis—they tend to be affiliated with regional and national firms, with offices of all sizes located all over the country; and

(iii)    fee-only planners—they are paid exclusively by fees based on AUM and sell no products—they tend to be local, unaffiliated, and in single offices usually located in one state alone.

“Investment advisers” may be united by a definition, but that is about as far as it goes. My characterizations are surely imperfect. Certainly, dozens of mutual funds are affiliated with brokerage firms. But generally, money managers and fee-only planners are distinguished by the nature of their clients—essentially, the difference between those who manage the funds of institutions and those who deal directly with consumers. Those who both sell securities for commissions and also advise for fees as fiduciaries are already generally regulated for both functions by FINRA, as well as by the government regulators. (FINRA may take the position it does not have regulatory jurisdiction over their firms and member reps that are also IAs and IA reps, but try to convince brokerage firms and associated persons that have been the subject of FINRA “involvement” in their strictly advisory conduct as to that alleged lack of authority.)

They don’t sell anything. Many investment advisers sell nothing but their advice. They are compensated by the fees they charge alone. Even those that do also sell products do so as registrants/licensees under another regulatory regime, like securities brokerage or insurance regulation. The interests of fee-only advisers are virtually aligned with those of their clients. If the clients make money, the fee-only advisers make money, and vice versa. Are there opportunities for wrongdoing? Surely, but they are significantly fewer and rarer than when selling is involved.

It’s all about ethics. Back in 1938, SEC Chairman William O. Douglas expressed his belief that an organization of brokerage companies themselves was suited far better than the SEC to set and police the ethical standards of the industry. That notion appears quaint now. Neither did it seem to bother Congress in the enactment of the Investment Company and Investment Advisers Acts of 1940, less than two years later. Ethical considerations such as conflict of interest regulation abound in the Investment Company Act. In the Capital Gains case, the Supreme Court found that, in the Advisers Act, the Congressional definition of “investment adviser” meant IAs are fiduciaries, about the highest legal and ethical standard there is. Neither the SEC nor the states have had any difficulty crafting a regulatory scheme to impose and oversee investment advisers based on the concepts of fiduciary duty and statutory fraud. It is from those two pillars that virtually all IA regulation flows. The entire regulatory regime is based on ethical standards.

Not your father’s NASD. Today’s FINRA is a private army of regulating professionals, policing the securities industry for violations of a well-honed code designed to regulate selling and buying by its members and their staffs. FINRA is an army separate and apart from its broker members. It is an amalgamated clone of the SEC’s Divisions of Trading and Markets and Enforcement, and the Office of Compliance, Inspections and Examinations (“OCIE”). Today’s real differences between FINRA, and the SEC and the states: 

  • FINRA has more people, money, and other resources;
  • FINRA’s inner workings, deliberations and decisions are cloaked in secrecy;
  • the SEC and states have subpoena power that reaches beyond their registrants, and can investigate and pursue unregistered violators in court;
  • as governments, the SEC and state securities agencies are subject to direct oversight by and are accountable to Congress, state legislatures, elected officials, public records laws and general requirements for transparency.

What follows in Part Three are the reasons I think an IA SRO is unnecessary and inappropriate today, and what I perceive as a huge problem with the Bachus proposal.

INVESTMENT ADVISER SRO – Where did we get Self-Regulatory Organizations in the first place? Part One

Written by: Phil Feigin

Anyone who works with me learns pretty quickly that I am an historian at heart. To understand what is happening now, I need to know what led to it. That imperative led me to review the origins and history of self-regulatory organizations in considering the “Investment Adviser Oversight Act of 2012” proposed by (retiring) Rep. Spencer Bachus (R-Ala.), Chair of the House Financial Services Committee.

When you think about it, self-regulatory organizations (“SROs”) are weird ducks, peculiar to federal securities regulation. There probably are such entities elsewhere in the economy, but I can’t think of any offhand. There’s no federal SRO in banking or insurance or real estate. Members of an industry/profession regulating themselves at the national level, with federal government oversight? Isn’t that a bit like having convicts on the parole board—after all, who would know better if someone has truly learned his lesson and reformed?

So, how did the SRO concept come to be in federal securities regulation?* It was 1933, and Franklin Delano Roosevelt brought us the New Deal. A hallmark of the New Deal was the creation of permanent administrative agencies, the so-called “fourth branch of government.” Along with that development, the idealistic administration sought to jump start the economy from Washington by organizing its components and encouraging self-discipline. Under the National Industrial Recovery Act (“NIRA”) (among an alphabet soup of others), the National Recovery Administration (“NRA”) divvied up American industry into sectors, each to be led by a committee of private sector luminaries, charged with deriving, adopting and, using moral suasion, implementing best practices, wages, production, allocation of resources, competition and more. On the long list of foundational flaws in the concept was the absence of any realistic enforcement mechanism. It was all based on the premise of mutual cooperation in the face of a crisis.

The committees all met with varying degrees of failure. Activity was confused with productivity. While it all may appear quaint today, it is important to reflect that this was a period of worldwide crisis. In the U.S. and across the globe, unionism, socialism, even Bolshevism, were on the rise. They were also legitimate topics of discussion, and of real influence, in national politics as U.S. citizens increasingly sought answers from their federal government. Where the private sector had failed them and misery was pervasive, people turned to their central governments for solutions. At the extremes, we saw from the right, Italian and German Fascism and our own Bunds in America; from the left, the Soviet Union and the American Socialist and Communist Parties. The Roosevelt Administration was certainly more centrist than either, but from the dire circumstances of the worldwide Depression, people turned to national governments and leaders for answers.

The first, most venerated and well-known American financial SRO was the New York Stock Exchange, formed under the Buttonwood Agreement of 1792. The NYSE was in existence for 120 years before FDR and the New Deal came to power. Save for the piecemeal securities registration and broker licensing requirements of state “blue sky” agencies starting in 1911, in 1932, the only real national force and focus for the securities industry was the NYSE (other exchanges of the day tended to be more regional). The lack of intensity and depth of the oversight imposed by the Exchange were in evidence in the collapse of 1929. Even so, in 1932, any federal regulatory scheme was going to have to assume and incorporate the reality of pre-existing Exchange self-regulation. Even given the Crash in 1929 and the Whitney scandal a few years later, the securities industry and the NYSE still had considerable influence over Congressional decisions.

Sensing its vulnerability given these calamities, the Investment Bankers Association undertook in FDR’s “First 100 Days” to adopt its own code of practice for the securities industry. Codes of fair competition and trade under the NIRA, and gained NRA approval, to be administered by the Investment Banking Code Committee. With the beginning of the end for the NRA in 1935, industry leaders urged the new SEC to enforce the codes itself. While the NYSE was firmly in place when federal securities regulation was being fashioned, there was no such complement when it came to the over-the-counter securities market. There was no convenient centralizing focus for these brokers. Without the NRA to give some spine to the Committee, there was no statutory imperative for OTC firms to join any national group.

Again, we need to consider the times. In 1935, it still took days to cross the country, in person or by mail. Historically, the federal government hadn’t regulated much of anything, let alone any realm like the securities markets. There were no international models either. They were inventing securities market regulation on the fly, laying track just in front of the engine. The SEC had its hands full with attempting to reel in Wall Street, what was perceived to be the core problem.

Further, the thought of trying to impose and administer a regulatory structure on the over-the-counter market was seen as daunting (there were over 6,000 OTC brokerage firms spread all over the country), a distraction from the perceived main mission, and (perhaps rationalizing) as potentially compromising. An SEC Commissioner and a Division Director at that time were on record suggested that assuming day-to-day oversight of OTC brokers would be viewed as akin to getting “in bed” with them.

Perhaps the most compelling force on this and many other formative issues was the SEC’s second Chairman, William O. Douglas. He favored self-regulation for OTC brokers because he viewed competent oversight from Washington unworkable given the lack of OTC market centricity. Chairman Douglas also posited that self-regulation could establish ethical standards for the industry that were beyond those the government could ever hope to adopt or apply. In his view, the proper role of the SEC was to oversee the performance of the SROs, with a “well oiled shotgun behind the door” to use when necessary. This was consistent with the NIRA concept. 

This position of Chairman Douglas was ultimately manifested in the Maloney Act of 1938, granting to the SEC the authority to register national securities associations under the Securities Exchange Act of 1934. The Investment Banking Code Committee morphed into the National Association of Securities Dealers (“NASD”) in 1939.

In my view, this attitude of treating the OTC market as a sort of regulatory stepchild was pervasive at the SEC, and would last for decades well into the present day. Spending time on OTC regulation was viewed as detracting from the staff’s main mission of dealing with Wall Street and the NYSE.

The exchanges and NASD muddled along for the next few decades, until 1963, when a scathing SEC Special Study gave rise to an effort to strengthen their self-regulation. In 1975, sea change amendments were made to the Exchange Act to give the SEC far more oversight authority over SROs. The SROs were sorely tested in the 1987 Market Break. The Nasdaq market was reamed in the SEC’s 1996 “§21(a) Investigatory Report,” which led to the splitting of the NASD’s market and regulatory functions into two separate subsidiaries, Nasdaq and NASD Regulation (“NASDR”).

In 2007, the regulatory arms of both the NYSE and NASDR merged to form the Financial Industry Regulatory Authority, FINRA. The regulatory responsibilities and functions of the exchanges and the NASD had evolved dramatically from the original conception in 1939. Today’s FINRA may have a board of directors and committees composed of brokerage industry representatives, but its staff is a private army of highly paid enforcement and regulatory professionals that lords over its domain all but unchecked. The SEC required that FINRA receive unparalleled and unprecedented funding for its regulation and enforcement functions when it rose independent from the fetters of Nasdaq and the NYSE market. Like the machines of Skynet in the Terminator saga, with the split and funding, FINRA had become “self-aware” and proceeded to wreak havoc on its subjects.

My points in going through all this, in asking Where did we get Self-Regulatory Organizations?, are as follows:

1.      the exchanges as SROs for markets and exchange member brokers were already in place in 1933 and 1934 when the securities acts were fashioned, and industry governing itself was a compromise concept borne of the physical limitations of communication and travel of the era, not the first choice;

2.      notwithstanding the efforts of Chairman Douglas to convince the investment companies to form their own SRO along with the brokers, they showed no interest in doing so and the idea died;

3.      as a practical matter, the 1934 OTC market was too diffused to be regulated effectively from any centralized headquarters, be it governmental or self-regulatory;

4.      until 1995, SROs combined both competing securities market and member oversight; and

5.      SROs’ regulatory roles have evolved and transformed significantly since 1934—historically, both (before and) after 1934, the SROs underperformed as regulators, leading to successive substantive and radical reforms, and ultimately to the complete disengagement of the regulatory and market functions.

In the next three parts, I’ll discuss how the history and concepts I discussed here figure into the calculation for whether an SRO for investment advisers is needed, desirable or appropriate today. I’ll finish off with an anecdote about my own dabbling with the IA SRO concept.


*I’ll be happy to share my sources with anyone interested, but suffice to say I did a little research on the question, but owe general credit to Joel Seligman (“Transformation of Wall Street”) and Arthur M. Schlesinger (“The Coming of the New Deal”). The glory of blogging is that you get to write like you know what you are talking about. It is up to the reader to agree or disagree.

THE JOBS ACT – Is it Securities Regulation that Really Hurts Small Business? Part Five of Five

Written by: Phil Feigin

REPEAL FIVE:  Crowd funding—the Repeal of Common Sense

And then there’s crowd funding (I am still not able to bring myself to accept it as a new, single word), the concept that would turn traditional investing and capital formation into a national Tupperware party. State securities regulators are up in arms over the prospects for disaster, and rightly so. The least sophisticated issuers will be allowed to raise money from the least sophisticated investors, and thousands of them, with almost no regulatory oversight, through intermediaries who may not have much more sophistication than the issuers or investors. How is a start-up enterprise supposed to manage a shareholder list numbering in the thousands? Oh, and in addition to managing a hoard of shareholders, the issuers will be subject to section 12(a)(2) liability, and the states are preempted from regulating the deals.

As a general premise of traditional investing, an investor buying stock has three options:  (i) hold it and wait for dividends; (ii) try to sell it to someone else for more than they paid for it (the “greater fool” theory); or (iii) frame the stock certificate and hang it on the wall as a memento of a “great opportunity” gone to dust. While the crowd funding issuers we will see in 270 days or so (when SEC rules are due) may actually succeed in raising some money, the investors will have virtually no chance of doing anything but searching for a suitable frame. Market professionals, private equity firms, venture capital firms and broker-dealers are unlikely to touch one of these companies, ever. Ever! Too many questions and complications. This will be the Internet version of Glenn Turner, but without the tent.

At the end of the day, won’t we ever learn that the market is generally efficient, particularly at its extremes. An investor will always be able to buy or sell shares of Apple and Microsoft. At the other extreme, shares of companies with no track record and no generally and professionally analyzed information, i.e., shares of most small companies (and I mean start-ups and really small companies) are more than illiquid; they are nearly frozen solid. With rare exceptions, they are all “frame” material. Banks usually won’t touch lending to them. Friends and family are usually already tapped out, as are the owner’s credit cards. We all know that at least nine out of ten will fail within a year or two.

When state legislatures and, more importantly, Congress, react to tough economic times, they haul out the “small business is the engine of our economy and job creation” speeches, come up with hastily and poorly thought out legislature or regulatory proposals to gut some provision or other in the securities law, label them “jobs” initiatives, and we’re off the races. SECURITIES REGULATION IS NOT THE PROBLEM! It’s just an easy target.

Congress cannot make investors invest, cannot make banks lend money, and cannot make employers hire employees. Each must be confident they will benefit from doing so, and without unacceptable risk. If they don’t have the information they need, they will not write the check. If the risks of loss are too great and the opportunity for reward too remote, they will not wire the funds. No one likes laying off employees.

If Congress truly wanted to promote small business, they would provide the funding outright, or incentivize investors to invest, and banks to lend, and employees to hire, through federal grants, insurance and tax breaks sufficient and efficient enough to make the risks and illiquidity worthwhile. Community banks shy away from SBA loans because the process is simply too complicated. Federal banking regulators (OCC, Fed and FDIC) have imposed such onerous capital requirements on community banks that lending to small business has virtually been made illegal. Anyone in the truly small business community knows this to be the case. Local banks can’t lend because the regulators won’t let them. Without the money, businesses can’t afford to hire new people.

Ironically, federal banking regulators, fearful of allowing further failures and Congressional scorn, take the position that bank failures are not going to happen on their watch, so much so that we now have very stable, liquid, well-capitalized banks that are lending mostly to those who probably don’t need the money in the first place. If small business is the engine that drives America, community banks are the engine that drives small business. But the engine has been starved for fuel.

It is thus ironic that, with crowd funding, Congress has foisted off on private investors, and unsophisticated private investors, the opportunity to invest in the riskiest and most untested investments. Congress is unwilling to allow federally insured banks and the SBA to take the risk of lending or guaranteeing loans to these small companies, but Congress seemingly has no compunction at all about exposing investors, with meager resources and potentially less information, to the ventures, all with the fanfare of “democratizing” American investing and job creation, no less.

I recall from back in the days of the penny stocks here in Denver, at least at the beginning of the craze, the federal government was not overly concerned about penny stocks. The shares were not traded on traditional exchanges, and they did not really impact the national economy. The penny stock operators had devised the perfect crime. They had figured out a way to steal $100 from everyone in America. No one complained very loudly, and the crooks made off with billions.

I don’t foresee that crowd funding will precipitate the kinds of colossal losses as did the penny stock craze, but grand statistics only matter if it’s not your money that was lost. Everyone from crooks to the hopelessly naïve will hit the crowd funding bandwagon. The offerings are limited to $1 million per year. How will anyone but the issuer (and perhaps his offshore bank) know when they reach the $1 million limit? I know there is supposed to be a registered funding portal and escrow account. Do they really seem like insurmountable obstacles for crooks to you?

In pondering the impact of securities regulation on legitimate small businesses and the difficulties they have in raising the capital, I learned what I believe is a valuable lesson as a regulator through the Small Corporate Offering Registration (“SCOR”) program adopted by the states. SCOR requires small businesses to fill out a fairly granular but straightforward disclosure form to raise up to $1 million with no restrictions on the wherewithal of the investors. Over the years, we registered several such offerings in Colorado. Once registered, the SCOR issuers were free to advertise the deal to their heart’s content, in newspapers, radio, wherever, and they could call anyone in the state with their proposal.

The registered SCOR offerings all but universally failed. It was not securities regulation that was inhibiting these small businesses from raising capital—it was the inability of the promoters to reach likely investors. The ability to publicly solicit and advertise did not make any difference.

The deals failed because no brokerage firms were involved. One way to look at it is that investments are more sold than bought. Again, it takes relationships and trust to invest. Brokerage firms did not get involved because of the inherent risks in start-up ventures, and there wasn’t enough money to be made. It simply wasn’t worth it. Their clients could lose their principal, and even if the company grew, it would be years before any secondary market offered the opportunity for a profit. Thus, I do not see crowd funding going anywhere after the initial fad wears off. Unless brokers get involved, I do not see many Rule 506 offerings getting any further than they got before. The new Reg. A deals hold the greatest promise for issuer and investors because the numbers may be significant enough to warrant the interest and participation of a hungry brokerage and underwriting industry. It is that sector that is the fuel injector of the small business engine.

Crowd funding will not be the undoing of our economy. It will neither create many jobs nor be the birth of the next Apple. Thousands of people are likely to lose millions of dollars, to both scammers and innocent, unsophisticated, well-intentioned dreamers until this latest Internet/social media “hoola hoop” drops to the ground to be stored in the garage, along with all those framed stock certificates. It is just a naïve, dumb idea, meant for headlines more than assembly lines.