Investment Advisors vs. Brokers

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I read the strangest article at Reuters reporting on a speech by Securities and Exchange Commission member Daniel Gallagher.

The gist of the article was:

The results of a new SEC review that showed an “eye-popping” percentage of licensed brokers have checkered histories, even though they are routinely inspected by regulators.

The strange conclusion drawn from this plethora of regulatory violations and customer complaints against brokers was that adviser violations must be just as prolific, but they are somehow going undetected. Here is the strange logic from the article:

In a recent statistical analysis, Gallagher said the SEC found that 20 percent of all 600,000 licensed brokers list regulatory violations, customer complaints and bankruptcy on the disclosure forms they submit to regulators.

One currently licensed person, he said, has 96 complaints and disputes, raising concerns about repeat offenders who migrate from firm to firm like “cockroaches” where they destroy peoples’ nest eggs.

These results are particularly troubling, he added, because brokerages face strict regulatory oversight, both by the SEC and by the Financial Industry Regulatory Authority (FINRA), the self-funded industry watchdog.

But investment advisers, which outnumber registered brokers by roughly 3 to 1, face far less oversight because they are not inspected by a self-regulatory organization and the SEC lacks the resources to police them all on a regular basis.

Only about 9 percent of registered advisers typically get examined by the SEC per year.

Last year the SEC set a goal for 2014 and 2015 of visiting firms which they had never visited before. As a result of this program, we were just visited on April 30th and May 1st, 2014 by the SEC. They reviewed our compliance program.

I suspect that our firm is a very low risk by any metric you could use. And I suspect that broker-dealers are a much high risk metric by these same standards:

  1. We do not have custody of client investments
  2. We do not advertise something which is “too good to be true.”
  3. We only invest in publicly priced and traded investments
  4. We buy investments which trend upward and are not dependent on market timing to make money.
  5. We educate our clients to understand their investment strategy. There is no “secret sauce.”
  6. We have no financial hooks
  7. We do not sugarcoat the reality of the markets
  8. We do not have a lavish lifestyle image which we are trying to promote or support
  9. We receive zero commissions or brokerage fees. The only fee we receive is from our clients.
  10. We are subject to a fiduciary standard of care rather than just a suitability standard.

All of these are principles in our Safeguarding Your Money Series. We even provide a PDF of the Ten Questions To Ask A Financial Advisor.

The financial services world is filled with, as Gallagher put it, “cockroaches.” But that is underestimating the harm they can do. “Shark” is a better term because they can be eating machines. Nevertheless, some of the proposed solutions are worse than the cure. Beware any government regulation changes as government regulation does not make us any safer.

Here are the three courses of action and what is wrong with each of the three:

1. Ask Congress to impose user fees on advisers so that the SEC can inspect them more frequently. If “strict regulatory oversight, both by the SEC and by the Financial Industry Regulatory Authority (FINRA)” failed to stop the “eye-popping” number of violations by broker-dealers, why do we believe that this is a good technique? Regulatory compliance requires hundreds of hours of work. I know because I am our firm’s Chief Compliance Officer. That work bring little value to our clients.

The list of 10 items is not illegal. But it does make a firm a higher risk. Firms that abide by the ten items I listed above SHOULD be rewarded by less frequent audits, visits, and inspections. I believe our firm truly is less sketchy because we avoid the practices that can be abused. But if I were a sketchy adviser, I would lobby hard to have as many audits on the pure-as-the-driven-snow advisers. And what better way to do that than to raise the funds for troubling them directly on them with higher fees.

With limited fees, the SEC will audit the higher risk firms because they will have to prioritize. This is a good thing.

2. Ask FINRA to oversee Financial Advisors. FINRA lobbies hard for broker-dealers. As a rule, FINRA does not like fee-only financial advisors because we are stealing their business as people understand the difference between fee-only and fee+commission based advice. The SEC + FINRA is doing a terrible job, that was the point of the study. In fact the SEC overseeing advisors without FINRA seems to be doing a better job. Asking the fox to oversee the hen house is always a bad idea.

3. Putting a fiduciary standard on everyone, including those currently under only a suitability standard. This is somewhat naive. Currently we put everyone in the United States under the law, but that doesn’t make everyone a law abiding citizen. Putting criminals under the law doesn’t solve the problem of crime. Law doesn’t change character. We already have regulations that they are not abiding by, adding more doesn’t change that fact.

A fiduciary standard of care is more than rules and procedures. Any attempt to turn it into compliance is doomed to dilute it so badly that everyone will now be practicing something else, some procedure based financial planning which looks more like a suitability standard than it would a fiduciary standard of care.

So what is the answer?

1. If we must have the SEC, then let the SEC continue to focus on targeting for the most frequent review the highest risk financial practices.

2. Let fee-only fiduciaries distinguish themselves with the highest ethical practices in a free market of choices.

3. Let investors continue to migrate away from commission-based agents and broker dealers and toward fee-only fiduciaries by their own free choice.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)