This Financial Reform Isn't What State Securities Regulators Want


At state securities regulators' annual public policy conference on Tuesday in Washington, they made no secret of their unhappiness with financial service reform legislation that Congress is considering. In fact, they're in open revolt.

After hearing the litany of complaints the state securities officials have with the proposed legislation, Pennsylvania Securities Commission member Tom Michlovic stood up during a question-and-answer session and asked: "What are we supporting this turkey for? Let's just call it where it is. We haven't got a single thing in this legislation."

"What Would the Tea Baggers Do"

The legislation aimed at reform the financial services industry was clearly top of mind at the North American Securities Administrators Association's meeting. Michlovic suggested that NASAA publicly oppose the bill and ask President Obama to veto it if Congress passes it. In December, the House approved its version of the bill, the Wall Street Reform and Consumer Protection Act, and the Senate is expected to take up the Restoring American Financial Stability Act the week of April 26.

"This isn't financial reform, and we're putting our name on it as financial reform," Michlovic said. Congress has "been eroding everything we've been working for" because the bills being considered won't provide strong enough regulation to fix the ills that plague the current system, he said.

"What would the tea baggers do?" Michlovic asked the approximately 200 regulators attending the conference. He referred to the Tea Party movement that's causing waves in American politics by opposing health care reform and other legislation that Congress and the administration are crafting. "The tea baggers would fight it tooth and nail, and they'd be running down the street trying to deal with those folks. And we do have some credibility right now."

Less Onerous Rules for Brokers

State securities regulators have lobbied in vain to win inclusion of stronger provisions that would require brokers who provide investment advice to come under the same fiduciary legal obligations that are imposed on investment advisers under the Investment Advisers Act of 1940.

Brokers are now regulated under different securities legislation, the Securities Exchange Act of 1934. They're required to make securities sales recommendations that are suitable for their customers, but they're not required to act in their customers' best interest. Nor are brokers required to provide the types of disclosures that investment advisers give customers, warning of possible conflicts of interest, such as earning higher commissions for selling particular securities.

In recent years, brokers have moved toward providing clients with investment advice. That has led investment advisers to challenge the legal exemption brokers currently retain from having to register and be regulated under the Investment Advisers Act. In 2007 the Financial Planning Association won a ruling from the U.S. Court of Appeals for the District of Columbia that overturned a Securities and Exchange Commission rule that would have allowed brokers to charge advisory fees on assets they manage without having to be regulated as investment advisers. The SEC has continued to grapple with the issue of broker-adviser regulatory harmonization since then.

Scuttled for a Study

The House bill contains provisions that would require brokers who provide personalized investment advice to retail investors to act as fiduciaries. But the provision doesn't include advice given to institutional investors, such as endowments and pension funds. The House bill contains a provision, which many state officials oppose, that would exempt brokers from fiduciary obligations after initially giving retail clients investment advice.

Senate Banking Committee Chairman Christopher Dodd (D-Conn.) had initially issued draft legislation that the state regulators supported, but that provision was scuttled and replaced with a requirement that the SEC merely study the issue of how to harmonize regulations of brokers and advisers. Brokerage groups and insurance agents who act as financial advisers have opposed the fiduciary requirement, arguing that such an obligation could limit the choices they're able to offer investors. They also claim it would raise consumer costs by making it more difficult to sell on commission, or make it impossible to sell securities owned by their brokerage firms, both of which could create conflicts of interests.

Sens. Robert Menendez (D-N.J.) and Daniel Akaka (D-Hawaii) may offer an amendment when the bill is taken up by the full Senate that would be similar to the House provision, according to a press aide for Menendez, though it's not certain. The senators are likely to offer the amendment only if they believe the Senate would approve it, according to a lobbyist working on the legislation.

Private Offerings Get Ignored

The possibility that state securities regulators could actively oppose the legislation "should be an option that remains on the table," said Indiana Securities Commissioner Chris Naylor, who spoke on a panel about what the regulatory reform would mean to Main Street investors. "It's passion like that that we have to take to our members," Naylor said, referring to Michlovic's fervor.

In addition to the fiduciary issue, the state officials are unhappy that neither of the bills Congress is considering would provide them with more power to oversee private securities offering. Private offerings don't carry the regulatory filing and disclosure requirements that public securities offerings need to be sold. Since state securities regulators were barred from reviewing private offerings under the National Securities Markets Improvement Act of 1996, the number of such offerings have increased to nearly 30,000 from about 12,000, according to Pennsylvania Securities Commissioner Steve Irwin, who spoke on the panel.

Fraud complaints have increased dramatically as well, Irwin said. The SEC hasn't been able to review the private offerings adequately, he said. Such offerings have become "the preferred method for microcap fraudsters to raise or misappropriate funds from investors," Irwin said.

While states still have power to stop fraud, the limits on their powers make it difficult to shut down illegitimate operators before they cause damage to investors, Irwin said. "That's why we have a black hole of regulatory reform. The feds aren't doing anything, and left it to us when we were handcuffed."

"There Ought to Be a Choice"

State securities regulators also want to ban the use of mandatory arbitration provisions in securities contracts. Most brokerage contracts currently require customers to take disputes to arbitration, and many investor advocates argue that investors should be given the option of taking cases to court as well.

Both the House bill and the bill approved by the Senate Banking Committee in March would give the SEC the discretion to restrict or prohibit mandatory arbitration clauses, but the NASAA doesn't believe that goes far enough. It argues that the SEC has historically been unwilling to take up the issue of mandatory arbitration.

"Pre-dispute arbitration is a bad idea," said Marc Minor, bureau chief of New Jersey's Department of Law and Public Safety, who spoke on the panel. "There ought to be choice."

The number of securities arbitration cases, which are administered by the Financial Industry Regulatory Authority, rose to about 65,000 in 2009, the highest number since 2004, Minor said. Most claimants in arbitration cases don't, and the numbers of claims that prevail has been going down in recent years, he said. Securities arbitration panels usually include an industry participant.

The state securities regulators have spoken. Whether Congress listens is another matter.