Wall Street Acting in Clients' Best Interests? Forget About It

Wall StAs Congress negotiates the details of financial reform, questions are being raised about whether Wall Street owes a duty to its clients to act in their best interests. Legally, the answer is: Usually not. With one exception, there's no legal reason why the public should expect Wall Street to be trustworthy.

So to improve the situation, we have to change the laws, or do a far better job of educating the American public about what Wall Street really does and why.

Currently, if a client asks a bank to carry out a financial decision that the customer has made, the bank doesn't legally have to act in the client's best interest. It's only when the client asks for financial advice that the bank owes a higher duty to the client by law.

How so? Well, when helping clients trade stocks or advising them on mergers, banks are acting as market makers. This means they must make an effort to carry out the clients' investment strategies but can take a position against the clients. It's only when Wall Street manages money for clients that it must act in clients' best interests -- as a fiduciary.

Tiny Revenue From Fiduciary Activities

As it turns out, the proportion of Wall Street's revenues that come from fiduciary activities is miniscule. Consider Goldman Sachs (GS), a bank that -- for reasons that elude me -- has been the main target of American blame for Wall Street's bad behavior. (Other banks like Bank of America's (BAC) top-ranked Merrill Lynch issued 4.6 times the volume of collateralized debt obligations (CDOs), the subject of the Securities and Exchange Commission's fraud charge, as sixth-place Goldman did. This is according to Anna Katherine Barnett-Hart, who wrote the summa cum laude Harvard thesis on CDOs that inspired Michael Lewis' best-selling book on the mortgage meltdown, The Big Short.)

Goldman barely does any fiduciary business. According to an Apr. 20 financial filing with the SEC, Goldman got a mere 11% of its first-quarter 2010 revenues from offering financial advice to businesses and investors.

That calculation is based on my assumption that only its financial advisory investment banking and asset-management businesses involve providing fiduciary services. Out of Goldman's $12.8 billion net revenues for the first quarter, these two businesses accounted for $464 million and $926 million, respectively. The other 89% of Goldman's revenues were from market making.

Huge Earnings Hit if Laws Change

So if Congress decides to change the laws to force Goldman into a fiduciary role in all of its businesses, this could affect most of its revenues. According to The Washington Post, "key senators" are trying to change the law so that financial firms always act in the clients' best interest. Banks oppose this change on what appears to me to be flimsy grounds.

The Post suggests that banks don't like the idea because it would force them to turn down business: "If a client approaches a firm wanting to conduct a transaction that the firm thinks is unwise, then the firm may have to refuse to conduct the transaction."

This seems like a weak argument because if the client is really seeking advice and respects the company's analytical skills, then the bank ought to be able to win the client's business by providing a compelling argument that an alternative, wiser investment strategy should be considered.

No Fiduciary Expectations With Gambling

Assuming these key senators lose their bid to change the law, it's not as if Americans despise all market-making activity. They seem to have no problem with the gambling industry, which runs casinos where the odds are consistently stacked against those who play there. Yet for some reason, America expects Wall Street to be a fiduciary when most of its business is run like the gambling industry.

(To be fair, most gamblers who go to casinos know they're going to lose and that the casinos will take their money. Unlike Wall Street, casinos profit from selling additional products and services, like alcohol, hotel rooms, and entertainment, to take peoples' minds away from the money they're losing.)

This leaves two choices for the big banks -- convince the public that it's OK for Wall Street to be a casino, or outlaw all Wall Street's casino-like activities, leaving it with a much smaller business of acting as a fiduciary for those who entrust their money to it.

Most likely, what we'll end up with is a little public education about what Wall Street does, plus a bit of extra disclosure to clients who ask banks to be market makers.
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