There's nothing like a crisis to bring about change. And as last autumn's existential economic crisis raised a loud hue and cry about the need for wholesale financial services reform, government officials in Washington pledged to rewrite the rules and change the face of financial services as we knew it with the goal of preventing future implosions.

One year later, the reform effort appears to be more rhetoric than reality. With the markets having rebounded smartly and the economy taking baby steps toward recovery, coupled with health care reform becoming the hot potato issue du jour, it seems the financial services debate has stalled.

Nonetheless, reform is pushing ahead. In June, the Obama administration issued its blueprint for reform with an 88-page manifesto entitled Financial Regulatory Reform: A New Foundation. In July, the Treasury Department released its proposed Investor Protection Act of 2009 aimed at implementing some of the ideas in the blueprint. And this autumn, the House Financial Services Committee is working to have a bill in place by year-end so that the Senate can get something passed early next year.

The finished product is likely a long way off, and it isn't shaping up to be as radical as some folks had feared or hoped. Still, the Obama administration's suggested blueprint covers a range of issues running the gamut from addressing the mission of the Securities and Exchange Commission (SEC) and regulating derivatives, to proposing that hedge fund advisors register with the SEC and creating a Consumer Financial Protection Agency to oversee retail financial products such as mortgages and credit cards.

Two issues are of particular interest to financial advisors: whether mandatory arbitration clauses should be eliminated and the call to harmonize the legal standards for SEC-registered investment advisors and broker-dealers. And although it's not explicitly part of the Obama blueprint, one of the big current debates is the long-running issue of who ultimately will regulate investment advisors.

(Dis)Harmonic Convergence
The SEC's reputation was burned by its perceived ineffectiveness in preventing the meltdown and by its failure to catch Bernard Madoff's massive Ponzi scheme. As a result, some people called for the SEC to be dismantled and merged with other agencies.

Clearly, that's not happening. The Obama plan doesn't recommend merging the SEC with the Commodity Futures Trading Commission, as some had suggested. Instead, it directs the agencies to harmonize their regulatory and statutory systems. The plan also recommends expanding the Federal Reserve Board's supervision of the largest financial holding companies and its responsibility to prevent risks that threaten the U.S. financial system. But the SEC's authority would remain largely intact.

The Obama blueprint and the Investor Protection Act want all advisors who give investment advice to be held to the same fiduciary standard, one that would be clearly defined and would put clients' interests first. Currently, SEC-registered investment advisors are required to act as fiduciaries, although there's some flexibility in that standard. On the other hand, advisors at broker-dealers subject to Financial Industry Regulatory Authority (FINRA) oversight are held to a suitability standard that requires them to make recommendations that fit a client's risk tolerance, objectives and financial status. The Obama administration's proposals would authorize the SEC to require all advisors to be fiduciaries, and would prohibit certain conflicts of interest and sales practices not in an investor's best interest. That could result in activities such as underwriting, trading as a principal and sales of proprietary products being more closely scrutinized for conflicts.

"Obama's proposal is what I call a super-fiduciary standard that says firms have to act solely in the interest of their customers without regard to its own financial interests," says W. Hardy Callcott, a partner in the Bingham McCutchen law firm in San Francisco. "That's a higher standard than investment advisors have to live up to today. Investment advisors are allowed to have conflicts of interest, but they have to disclose them in their ADVs, and customers have to consent to them before the account is opened. What I understand is that a lot of people are telling Congressional committees that it [Obama's proposed fiduciary standard] needs to be more flexible because neither broker-dealers nor investment advisors live by that standard."

Nor do they live by a harmonized, or so-called universal standard. "The universal standard of care that would apply to broker-dealers is a critical issue," says Clifford Kirsch, a partner in the law firm Sutherland Asbill & Brennan LLP's financial services practice in New York. "What needs to be determined is the shape it will take and what it will mean for day-to-day operations regarding disclosure and compensation."

Kirsch says he anticipates a universal standard would mean more regulation, enforcement and litigation for broker-dealers, particularly involving disclosures.

The proposed harmonized standard is also a critical issue for registered investment advisors (RIAs) who abide by the fiduciary standard. "We don't want to see the definition of fiduciary watered down just so it can be applied to broker-dealers," says William Baldwin, president of Pillar Financial Services in Waltham, Mass., and chairman of the National Association of Personal Financial Advisors (NAPFA).

Suitability Of Fiduciary
The call for a fiduciary standard that is the same for all advisors sets the stage for a contentious debate. Then again, that's the nature of this inherently muddled issue.

Broker-dealers are mainly regulated under the Securities Exchange Act of 1934, and investment advisors under the Investment Advisers Act of 1940. The fiduciary standard of care concept, which requires advisors to act in their clients' best interests, was embedded in the Advisers Act and subsequently upheld in the 1963 Supreme Court decision, SEC v. Capital Gains Research Bureau.

Broker-dealers weren't included in the Advisors Act because investment advice is "solely incidental" to their business and their pay is based on product commissions, not advice-related fees. Thus, they're held to the suitability standard.

The RAND Report, which was conducted for the SEC and released in early 2008, noted the boundaries between the two camps have increasingly blurred in recent years and that retail investors don't understand the differences between broker-dealers and RIAs or how they're regulated.

In a speech in June, SEC Chairman Mary Schapiro commented on the need to harmonize the regulatory structure for broker-dealers and RIAs. "If both broker-dealers and investment advisers are providing virtually identical services to retail investors," she said, "then the regulatory regimes that govern those activities should be virtually identical as well."

Other financial services officials-including Rick Ketchum, FINRA's chief executive, and Tim Ryan, president of the Securities Industry and Financial Markets Association (SIFMA)-also support a harmonized standard.

"To me, the word 'harmonization' is unfortunate because I think people who use it are imposing the broker-dealer rulebook on investment advisors, not the other way around," says David Tittsworth, executive director of the Investment Adviser Association (IAA).

For Tittsworth and like-minded allies, there's no need to tinker with the existing fiduciary standard. Because the standard is embedded-not defined-in the Advisors Act, they say it remains a flexible, principles-based concept for SEC enforcement purposes.

Marilyn Mohrman-Gillis, managing director of public policy at the Certified Financial Planner Board of Standards Inc., says her group and others are lobbying Congress to resist defining the fiduciary standard concept. "If you try to put it into a definitive definition in statute, it'll take away the flexibility to apply those principles on a case-by-case basis," she says. "You run the risk of diluting the standard and creating a 'fiduciary light' or 'suitability plus' type of standard."

Regulatory Gaps
Dale Brown, president and CEO of The Financial Services Institute (FSI), a trade group for independent broker-dealers, says he opposes applying the fiduciary standard to broker-dealers because it's not appropriate for that business model.
Instead, he says, a universal standard of care that works across all client situations and business models is the best way to improve regulation.

Brokers are governed by more rules than RIAs, entailing more reporting requirements. RIAs, on the other hand, follow the principles-based fiduciary standard that "has an eloquent definition and the requisite altruistic notion of consumer protection," says Matthew Bienfang, senior research director of brokerage and wealth management at the consulting firm the TowerGroup. "In practice, however, it is proving difficult to police."

The solution, at least according to TowerGroup, is a mix of rules-based and principles-based regulation for both brokers and advisors that would result in FINRA examiners conducting RIA audits, under the oversight of the SEC. FINRA currently performs a similar role, under SEC oversight, as the self-regulatory organization (SRO) for broker-dealers.

"What's the alternative [to FINRA audits of RIAs]?" asks Bienfang. "RIAs wish to have nothing happen at all, and that won't happen. The next most preferable outcome is to have their own SRO, and that also won't happen because none of them can pay for it."

The brokers' SRO, FINRA, gets its operating budget from its members. "Unless Congress [which sets the SEC's operating budget] is willing to fund an agency for governance and oversight of RIAs, it probably won't happen," Bienfang says.

The SEC regulates roughly 11,300 RIAs, or about 70% more than 10 years ago. In addition, the SEC oversees approximately 5,500 broker-dealers. The SEC acknowledges that, due to a lack of resources, it expects to examine only 9% of RIAs in both 2009 and 2010.

And that's prompting calls in some circles to create an SRO to help share the regulatory burden with the SEC. The oft-mentioned candidate is FINRA.

In a June speech, FINRA's Rick Ketchum cited the disparity between oversight regimes for broker-dealers and investment advisors as a regulatory gap that needs fixing. He said that FINRA is "uniquely positioned to build an oversight program that ensures investment advisors are properly examined and their customers are adequately protected." But he added that's for Congress and the SEC to decide.

In a May speech, SEC Commissioner Elisse Walter, who formerly worked at FINRA and one of its predessor organizations, the NASD, indicated she was on board with the concept of an outside SRO empowered with both enforcement and standard setting under SEC oversight. She noted that SROs traditionally are authorized to establish ethical and legal standards.

Investment advisor groups recoil at the thought. Their take is that SROs have inherent conflicts of interest, and they specifically fear that FINRA would try to weaken the fiduciary standard. Mohrman-Gillis from the CFP Board says financial planning groups see a huge gap in regulations where financial intermediaries are calling themselves planners and advisors without proper professional credentials. "They don't have a baseline competency standard and often are selling a product and using the title of planner/advisor to make the client think they're acting in their best interest when they're basically selling products."

Her solution: Can the SRO idea and establish a financial planning oversight board under the SEC's authority that would be similar to other boards that set standards for lawyers or doctors. "The goal is that planners registered with this board tell the public that they meet certain baseline competencies and are required to adhere to the fiduciary standard of care," she says.

Instead of having an SRO, Tittsworth from the IAA wants adequate funding for the SEC so that it can do its job. "There's a lot of different ways to get there," he says. One possible solution came from a proposal in October by Congressman Paul E. Kanjorski (D-PA), chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises. Among other things, it would impose user fees on investment advisors to pay for SEC inspections.

"I think our members would rather pay the SEC directly than have an SRO," Tittsworth says. Another solution, he adds, is for the SEC to increase the $25 million in assets threshold that separates federally registered and state-registered investment advisors.

The National American Securities Administrators Association (NASAA) wants the states to regulate all investment advisors with assets under $100 million. "It would allow the SEC to use its limited resources to regulate larger firms," says Denise Voigt Crawford, Texas Securities Commissioner and president of NASAA. "And it would be more efficient because it's easier and less money for me to send a team to look at an investment advisor in Texas than to have the SEC send a team from Washington, D.C."

The Advisers Act authorizes the SEC to increase the dollar threshold. In a May speech, SEC Commissioner Luis Aguilar said raising the threshold to $100 million would trim the number of SEC-registered advisors by almost 45%. The flip side, he acknowledged, is that state budgets are stretched thin and that the regulatory burden would "merely move the problem from the SEC to the states."

Unmandatory Arbitration
The Obama blueprint for reform recommends legislation that would grant the SEC authority to prohibit mandatory arbitration clauses in broker-dealer and investment advisor contracts with retail customers. While it acknowledges that arbitration sometimes is a viable way to handle disputes, the report says that "mandating a particular venue or upfront method of adjudicating disputes-and eliminating access to courts-may unjustifiably undermine investor interests."

But before authorizing changes in arbitration, the SEC would have to study whether these clauses have harmed consumers by preventing them from seeking more effective ways to redress claims.

"We believe you shouldn't have to sign a mandatory contract to open a brokerage account," says Crawford. "You should have the option to go through FINRA arbitration, another forum or to go to court. A lot of these situations could be resolved in small claims court that might be better for investors because a lot of studies show that FINRA-run arbitration isn't a fair forum." 

W. Hardy Callcott, the Bingham McCutchen attorney, believes that arbitration is better for customers because it's faster and customer win rates are better than in court cases. Nonetheless, he says the prospects of imposing an industrywide fiduciary standard--coupled with a stricter interpretation of that standard in courts--could significantly impact broker-dealers.

"Broker-dealers have generally concluded that in arbitration, non-lawyer arbitrators don't apply the fiduciary duty standard for investment advisors and the suitability standard for broker-dealers any differently," he says. "However, if there is no longer mandatory arbitration and cases are decided in courts by judges, the difference between a fiduciary duty standard and a suitability standard is likely to be much more meaningful."

Of course, how this and other proposed measures ultimately play out remains to be seen. But a little Friday morning quarterbacking can help advisors grasp how some of these proposed reforms could affect them.

For example, the TowerGroup expects that greater rules-based reporting requirements could add 10% to 20% more compliance costs to RIA firms. And smaller firms will feel the biggest squeeze. In a report, the consulting firm estimates that RIA firms with less than $100 million in assets under management currently spend between $6,000 to $35,000 annually on compliance costs. And that doesn't include labor or opportunity costs when advisors do their own compliance work.

The TowerGroup believes broker-dealers can better handle regulatory changes because they already employ "relatively robust" rules-based programs. But if brokers are required to adopt a fiduciary standard they will have to either build technology for fiduciary oversight and transparency, or have vendors do it for them.

"The fiduciary standard is very open-ended," says Bienfang, the TowerGroup research director. "There's a lot of judgment within that standard of what's in the best interest of the client. I don't know how you can map that out with programming language."

Similarly, RIAs will have to rely on more extensive compliance reporting tools to meet the expected regulatory changes. According to Bienfang, some platform providers don't currently provide RIAs with enough tools to meet tougher reporting requirements. But that could easily be rectified.

Handicapping The Outcome
Financial services reform is complicated, and it usually takes a long time to get through Congress. The Gramm-Leach-Bliley Act, otherwise known as the Financial Services Modernization Act of 1999, was actively considered by Congress for six years before it was passed. Among other things, the act eliminated the separation of investment banking and commercial banking mandated by the Glass-Steagall Act of 1933. This subsequently set off a wave of mergermania in the financial services industry that created the likes of megafirms such as Citigroup.

The Gramm act also exempted security-based swap agreements from SEC regulation. Critics of the act claim these two provisions led to financial excesses that paved the way for the Great Recession.

"Some of these big bills are so complex that they end up with compromises," Callcott says. "Some parts work better than others."

Callcott questions whether Congress will be able to get a comprehensive financial services reform package done before the 2010 election because the issues are so complex and Congress has so many other items on its plate.

"The Obama administration said all parts relate to the other parts, and they should be in one bill," he says. "I think some in Congress think a big bill is too hard to get done. But they don't want to go back to their districts not passing any legislation after the nation suffered the worst financial crisis since the Depression. My current view is we'll have a bill, but that it won't be comprehensive."

Others agree. "I think we'll see some things get done, but it'll probably be more down the path of least resistance," says Duane Thompson, who recently left his job as managing director of the Financial Planning Association's Washington, D.C., office. "They'll probably make some progress with the so-called regulatory gaps to make sure they spot warning signs before the next big implosion. But when it comes to the nitty-gritty, including how investment advisors and broker-dealers are regulated, that'll probably be ongoing for the next couple of years."