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					Financial Services Reform:
How Will It Affect Financial
Planning?
  Presentation to the FPA Major Firms
  Symposium, Oct. 9, 2009

  By: W. Hardy Callcott
  Bingham McCutchen LLP
The Financial Crisis of 2008
The Collapse of:
 •Fannie Mae
 •Freddie Mac
 •AIG
 •Washington Mutual
 •Wachovia
 •IndyMac
 •Downey
 •Bear Stearns
 •Lehman Brothers
The Financial Crisis of 2008
The TARP Bailouts of:
 •AIG (up to $182.5 billion)
 •Citigroup ($50 billion)*
 •Bank of America/Merrill Lynch ($45 billion)*
 •JP Morgan Chase ($25 billion)
 •Wells Fargo ($25 billion)
 •General Motors/GMAC ($13.4 billion)
 •Morgan Stanley ($10 billion)+
 •Goldman Sachs ($10 billion)+
   *- not including asset guarantees
   +- converted to bank holding companies
The Financial Crisis of 2009?

The Collapse of:
 •Corus Bank (Illinois)
 •BankUnited (Florida)
 •Guaranty Bank (Texas)
 •Colonial Bank (Alabama/SE)


Despite the equities market recovery, many
observers fear a “double dip” recession triggered
in part by commercial real estate problems
Result: Bipartisan Consensus on
the Need for Reform
•Paulson Plan
•Volcker/G30 Plan
•Obama/Geithner Plan

But the bipartisan consensus largely ends at the
conclusion that reform is necessary
The Congressional Agenda
•Health Care
•Budget
•Afghanistan/Iraq
•Environment/Climate Change
•Energy
•Education

Financial services reform is on the agenda, but
there are many competing priorities
Financial Services Reform -
Controversial Non-SEC Issues
•The Role of the Federal Reserve Board
•Oversight and Wind-down of Systemically
Significant Financial Institutions/“Too Big to Fail”
•A Single Federal Bank Regulator
•The Consumer Financial Protection Agency
•Federal Regulation of Insurance
•Regulation of OTC Derivatives
•Executive Compensation Limits
Financial Services Legislation:
The History
•Wall Street paperwork crisis of the late 1960s led
to major financial services reform legislation - but
not until 1975
•Gramm-Leach-Bliley Act, allowing bank holding
companies to enter brokerage and insurance,
was actively considered by Congress for six
years before it passed in 1999
•The counter-example: Sarbanes-Oxley Act was
introduced after Enron, and passed within weeks
of the WorldCom bankruptcy
Financial Reform - Who is an IA?

•In the wake of the failure of Long Term Capital
Management, in 2004 the SEC adopted a rule
requiring hedge fund advisers to register
•The DC Circuit struck down the rule in Goldstein
v. SEC, 451 F.3d 873 (D.C. Cir. 2006)
•All of the major reform plans recommend
requiring not only hedge fund advisers, but also
private equity and venture capital fund advisers,
to register
Financial Reform - Who is an IA?

•Hedge fund advisers (many of whom remained
registered after 2006), generally do not appear
strongly opposed to registration
•But private equity and venture capital fund
advisers argue that they do not pose systemic
risks and registration would be difficult,
expensive and counter-productive
•Why should financial planners care about this
debate: because IA status legislation is likely to
be linked to IA standard of care legislation
How Will SEC Oversee New IAs?

•Currently over 7,000 SEC-registered advisers
•Over 11,000 state-registered advisers
•At least 2,000 new advisers would be required to
register with the SEC under the current proposals
•In 2008, the SEC only examined 9% of SEC-
registered advisers, implying an average of 11
years between exams (even longer for firms that
do not advise mutual funds)
•SEC never examined Madoff IA business from
its registration in 2006 until its failure in late 2008
How Will SEC Oversee New IAs?

•Paulson and Volcker reports (but not Obama/
Geithner) propose SRO for investment advisers
•FINRA has suggested that it become an SRO for
advisers (already runs IARD system)
•NASAA and IAA oppose SRO for advisers, and
especially oppose FINRA
•NASAA suggests raising standard for SEC
registration from $25 million AUM to $100 million
•But state funding for securities regulation is
even more uncertain than SEC funding
The Financial Crisis - the SEC
Enforcement Response
•Former senior leadership removed
•New team with criminal prosecution background
 •Specialized teams to provide experience and expertise,
  including in investment management
 •Removed a layer of management
 •Investigating and bringing cases faster
 •No more “informal” investigations
 •New remedies, such as deferred prosecutions
 •New emphasis on tips and whistleblowers, including
  possible expansion of “bounty” programs
The Financial Crisis - the SEC
OCIE Response
•Division director removed
•New leadership not yet in place
 •Enhanced emphasis on custody
 •More frequent outreach to service providers
 •Review of due diligence for subadvisers and “feeders”
 •More frequent outreach directly to clients
 •Also emphasis on control over inside information
 •National standardization of exams
 •Joint IA/BD exams of dual registrants
 •More changes likely with new leadership
 •Could OCIE be broken up?
The IA Standard of Care Debate:
The History
•In 1940, broker-dealers and investment advisers
were easy to distinguish
•Broker-dealers gave advice, and were paid by
high fixed commissions set by the NYSE
•Investment advisers gave advice, and were paid
by fixed or asset-based fees
•IA Act exempted advice “solely incidental” to
brokerage if no “special compensation”
•Business model differences started to break
down after commissions were unfixed in 1975
The IA Standard of Care Debate:
The History
•SEC Tully Report in 1995 recommended that
broker-dealers use fee-based brokerage to align
broker incentives with customers and prevent
churning and unsuitable recommendations
•In 1999, SEC proposed (but did not adopt) Rule
202(a)11-1, which explicitly permitted fee-based
brokerage accounts
 •“No action” position in release allowed broker-dealers
  to proceed as if rule were final
 •The FPA sued, arguing that SEC “no action” position
  illegally had become de facto final rule
The IA Standard of Care Debate:
The History
•The SEC reproposed, and then adopted, a final
Rule 202(a)11-1 in 2005
 •All fully discretionary accounts were deemed advisory
  accounts, although there were many discretionary
  brokerage accounts in 1940
 •Financial planning was deemed advisory - but financial
  planning was not defined or distinguished from a BD’s
  suitability obligation
 •Offering a discount brokerage service does not turn full-
  price accounts into advisory accounts
The IA Standard of Care Debate:
The History
•During the first half of this decade, BD fee-based
accounts grew dramatically, to over $300 billion
in assets under management
•Increasingly, BD representatives provided both
commission-based and fee-based accounts, and
used titles like “financial adviser” or “financial
counselor” that blur the IA/BD distinction
•After the tech crash, most large BDs offered reps
incentives for stable, fee-based income
The IA Standard of Care Debate:
The History
•FPA sued the SEC again, arguing that Rule
202(a)11-1 was inconsistent with the IA Act
•The D.C. Circuit, in FPA v. SEC, 482 F.3d 481
(D.C. Cir. 2007), overturned rule
 •Held SEC could not create a new exemption for
  brokers separate from the exception already in the Act
 •Held fee-based accounts involve advice that is not
  “solely incidental” to brokerage, and involve “special
  compensation”
The IA Standard of Care Debate:
The History
•As a result, over $300 billion in fee-based
brokerage accounts moved to non-discretionary
advisory accounts at BD-IA dual registrants
•The SEC repeated its interpretative view that
fully discretionary accounts must be advisory,
and that offering discount brokerage does not
make full-fee accounts “special compensation”
•But SEC did not address financial planning,
which now may be offered by IAs or BDs
The IA Standard of Care Debate:
The History
•SEC adopted temporary Rule 206(3)-3T which
allows firms to conduct principal trades with non-
discretionary advisory accounts for some
securities pursuant to a blanket consent (rather
than trade-by-trade consent)
•Does not apply to fully discretionary accounts
•SEC characterizes accounts as both advisory
and brokerage, subject to both sets of regulation
•Rule expires in December 2009 but is expected
to be renewed
The IA Standard of Care Debate:
The History
•After the FPA decision, the SEC hired the RAND
Institute to study customer understanding of the
IA and BD industries
•RAND found that customers did not understand
the distinction between IA and BD businesses, or
between IA and BD regulation - even after the
distinctions were explained to them
•RAND found that customers believed IAs and
BDs should be regulated in the same way
The IA Standard of Care Debate:
The History
•SEC Chairman Cox directed the Divisions of
Investment Management and Trading and
Markets to propose ideas for IA/BD regulatory
harmonization
•The SEC’s staff’s ideas (which have never been
made public) went to Cox in early summer 2008
•But in summer 2008, the financial crisis pushed
all other issues to the sideline
•In December 2008, the Madoff scandal exposed
weaknesses in SEC regulation of BDs and IAs
The IA Standard of Care Debate:
The Standards
•The Investment Advisers Act imposes a uniform,
federal fiduciary standard on IAs
•Although the word “fiduciary” does not appear
in the statute, the standard was announced in
SEC v. Capital Gains Research Bureau, Inc., 375
U.S. 180 (1963)
•Ironically, there is no federal cause of action to
enforce this standard, except to seek rescission
of advisory fees - cases for damages must be
brought under state law
The IA Standard of Care Debate:
The Standards
•The standard for broker-dealers is more muddled
•In some cases, such as order-handling, BDs are
fiduciaries as a matter of federal law, see Newton
v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 135
F.3d 266 (3d Cir. 1998) (en banc)
•In some states, such as California, BDs are state
law fiduciaries, see Duffy v. Cavalier, 215 Cal.
App. 3d 1517 (1989)
•In most states, BDs (usually) are not fiduciaries,
see Fesseha v. TD Waterhouse Investor Servs.,
305 A.D.2d 268 (N.Y. App. Ct. 2003)
The IA Standard of Care Debate:
The Standards
•All BDs are subject to a suitability standard
when they recommend securities transactions,
under SEC Rule 10b-5 and Rule 2310
•IAs have traditionally viewed suitability as a
lower standard than fiduciary duty
•Many BDs have concluded that in arbitrations,
where most securities disputes are resolved,
there is no real difference between the standards
 •Note that legislative proposals likely will end mandatory
  pre-dispute arbitration
•As a result, SIFMA has endorsed a fiduciary
standard for BDs and IAs
The IA Standard of Care Debate:
The Standards
•Fiduciary duty is not a single standard
  "But to say that a man is a fiduciary only begins
  analysis; it gives direction to further inquiry. To whom
  is he a fiduciary? What obligations does he owe as a
  fiduciary? In what respect has he failed to discharge
  these obligations? And what are the consequences of
  his deviation from duty?"
SEC v. Chenery Corp., 318 U.S. 80 (1943)
(Frankfurter, J.)
The IA Standard of Care Debate:
The Standards
•The scope of fiduciary duty is subject to
negotiation and disclosure
 •“The scope of an agency relationship defines the scope
  of an agent's duties to a principal and a principal's
  duties to an agent.” Restatement of Agency § 1.01
  comment e
 •“[A]n agent's fiduciary duties to the principal vary
  depending on the parties' agreement and the scope of
  the parties' relationship.” Restatement of Agency §
  8.01 comment c
The IA Standard of Care Debate:
The Standards
•The scope of fiduciary duty is subject to
negotiation and disclosure
 •An act that might otherwise violate an agent’s fiduciary
  duties is permitted so long as the agent obtains the
  principal’s prior consent, and in doing so acts in good
  faith, discloses all material facts, and otherwise deals
  fairly with the principal, and the consent concerns
  transactions that could reasonably be expected to
  occur in the ordinary course of the agency relationship.
  Restatement of Agency § 8.06(1)
•For IAs, disclosure of potential conflicts of
interest and client consent occurs in the Form
ADV process
The IA Standard of Care Debate:
The Legislative Proposals
•All of the major legislative proposals have
suggested a uniform fiduciary standard of care
for investment advisers and broker-dealers
•IA trade association and consumer groups have
expressed skepticism about any uniform
standard, on the theory that it necessarily will
dilute the existing IA fiduciary standard of care
•In light of the RAND findings, it is difficult to
imagine Congress endorsing different standards
for functionally similar entities
The IA Standard of Care Debate:
The Legislative Proposals
•The Obama/Geithner proposal suggests a “super
fiduciary” standard: “solely for the benefit of the
customer or client without regard for the financial
or other interest of the broker, dealer or
investment adviser providing the advice”
 •Higher than the current standard for IAs or BDs
 •No suggestion standard can be modified by disclosure
  or client consent
 •Would only apply “when providing investment advice”
  which is to say, does not impose an ongoing duty to
  monitor
The IA Standard of Care Debate:
The Legislative Proposals
•Current lobbying efforts revolve around adding
flexibility to the Obama/Geithner proposal
 •Adding the concepts of disclosure and consent
 •Clarifying that ERISA fiduciary liability does not
  necessarily apply to every broker-dealer or investment
  adviser that deals with a benefit plan
 •Likely to be a high-level statement of principals, with
  authority delegated to the SEC to adopt rules to define
 •Concept of an SRO for IAs still very much alive -
  concern about SEC’s ability to oversee all IAs
The IA Standard of Care Debate:
The Legislative Proposals
•The time-table: House Financial Services
Committee hopes to have legislation ready by
end of 2009
•Senate Banking Committee is unlikely to have
legislation ready until sometime in 2010
•Historically, very difficult to move controversial
legislation in an election year
•But no one in Congress wants to face voters in
2010 if they have done nothing about financial
services reform
The IA Standard of Care Debate:
The Legislative Proposals
•The biggest question: will Congress pass a
comprehensive financial services bill, or will it
address less controversial issues separately?
•The Obama/Geithner proposal stated it was a
unified whole and should not be viewed as a
menu of choices
•Even if Congress moves in stages, is investment
adviser reform a “less controversial” issue?
•Note - a major new scandal could completely
change the calculation at any time

				
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