Keynote Address: Broker/Dealer Regulation and Enforcement 2016

Paul Atkins

Patomak Global Partners, CEO

Remarks at the

Practising Law Institute

Broker/Dealer Regulation and Enforcement 2016 conference
October 20, 2016

As Prepared for Delivery

Over the last eight years, American businesses, investors, and consumers have been buried under a mountain of costly red tape.  Now, I do not need to tell you that the economy is not as good as it could be.  One of the major reasons is the growth of legislation and consequent regulation emanating from Washington that has stymied growth.  Over the past decade, the US has failed to reach 3% growth in real GDP in any year – in some quarters it has been below 1%.  Chairman Jeb Hensarling of the HFSC likes to call this the non-recovery recovery.

Glib references to the financial crisis of 8 years ago and blaming George Bush or deregulation or the lack of regulation may play to some audiences, but they are facile and contrary to fact.  As in any organization, policy choices and priorities and tone from the top matter a great deal, and have real-world effects, whether it be taxes or regulation. Fiduciary duty of corporate officers and directors require them to figure out economical approaches for compliance. In fact, the current Administration has been perhaps the most prolific regulatory force in U.S. history.  To date, federal agencies have issued a record 392 major rules with economic impacts greater than $100 million annually.  Six of the seven highest Federal Register annual page counts now belong to President Obama.

The financial markets have borne their share of this deluge of post-financial crisis regulations mandated under the Dodd-Frank Act.  We now have half the number of public companies registered as 20 years ago.  IPOs have lost their lustre.

Say what you will about the JOBS Act:  at least it was a stab in the right direction.  One of the largest potential IPOs, Uber, openly disdains going the IPO route.  Why?  Cost, uncertainty, threats of frivolous claims from class-action suits, accountants who are more interested in selling consulting services than good independent audits, politicized shareholder activists (along with a certain Massachusetts senator whom I know well) focusing on immaterial issues, whistleblower rules that incentivize the wrong conduct (even from compliance personnel), prosecutors looking for headlines, and most of all the availability of real alternatives in the private markets that have become more liquid and diverse as people look for alternatives to the public markets.

Regulation affects choices in the registered entity space as well.  Largely as a result of the regulatory deluge, financial professionals increasingly are registering with the SEC and the states as investment advisers rather than broker-dealers.  In fact, over the past five years, the number of registered broker-dealers has declined by 13%.  Yet in just the last year alone, the number of SEC-registered investment advisor firms grew by 5%.

Of course, the Dodd-Frank Act, enacted in 2010 ostensibly for the sake of market stability and investor confidence, has been detrimental to consumers, savers, and investors, by raising prices and reducing choices.  This 2,319-page behemoth, requiring between 243 and 533 new rules, depending on how you count them, (many of which are still not in final form six years later – that is probably for the best, frankly) has spawned uncertainty among regulated financial entities and undermined the climate necessary for economic growth.

Dodd-Frank, like the Affordable Care Act, was not subject to what legislators call “regular order” – an open, normal way of considering legislation with hearings and informed debate of likely consequences.  Few substantive hearings were held, even on major provisions, not to mention supposedly minor provisions, which have turned out to be major headaches because of poor drafting. The process was truly a travesty of the democratic legislative process.  No wonder Chris Dodd in an unguarded moment was caught on tape saying:   “No one will know until this is actually in place how it works.”  Congress gave vague mandates and delegated unprecedented authority to the non-elected Officers of the United States and staff at the various regulatory agencies, including 13 new agencies and offices created by the statute.

So, it is in this context that the SEC must operate as overseer of the capital markets and it must deal with other financial services regulators in the US and abroad.  The political atmosphere is divided and poisonous.  Gone are the days, as when I worked for 4 years at the SEC from 1990-94, when politics did not affect much of the SEC’s day-to-day work.  No more is that true.

Believe it or not, there were no 3-2 votes along partisan lines from 2000 until 2009. There were 3-2 votes, but commissioners were split by other than party lines.  Even before 2000, dating back to when I worked at the SEC in the early 1990s, I can think of only one party-line vote, and that was the adoption of Reg FD in 1999 (and that was more because of basic ideology than political alignment – Laura Unger correctly thought that one does not cure unequal disclosure by banning disclosure; Arthur Levitt and Ike Hunt thought otherwise).  Since 2009, the beginning of this Administration, there have been more than two dozen 3-2, party-line votes.  This is a very sad state of affairs.

The source of these party-line votes is the mandatory rulemaking of Dodd-Frank.  Because Congress did not do its job in thrashing out the details through hearings, debates, and negotiations, and going back to diametrically opposed views of the financial crisis, the SEC’s normal process has broken down.  To add to that mix are Administration pressures on the Commission majority to toe the line in a jurisdictional battle between the SEC and bank regulators, where the Administration, especially the Treasury Secretary, is on the side of the bank regulators.

For example, to help achieve the goal of financial stability, Dodd-Frank established the Financial Stability Oversight Council, or FSOC, which is a non-transparent, not-well-known group whose voting members are the heads of nine financial services regulatory agencies plus one insurance regulatory expert appointed specifically for this task by the president.  The SEC is outmanned and outgunned around this table as the only capital markets expert.

FSOC has the authority to designate entities within the financial services industry as “systemically important financial institutions,” abbreviated S-I-F-I.  Former Congressman Barney Frank once quipped that “SIFFY,” as some pronounce it, sounds like a disease.  He is right.  But there is more.  First, I would argue with the pronunciation.

I would argue that a more accurate, and appropriate, pronunciation rhymes with HIFI and WIFI, thus SIFI.  Coincidentally (or not) it has an apt homonymn in the short-hand for science fiction.

What is the consequence of this determination that entities, products, or activities are systemically risky?  The FSOC is authorized to subject the designated firms to enhanced prudential supervision by the Federal Reserve, and to recommend additional regulation for systemically important activities and products, in the interest of promoting the safety and soundness of the U.S. financial system.

The SIFI label is, in fact, the first step toward allowing the Federal Reserve to exert more control over U.S. capital markets under the guise of—as Fed Governor Daniel Tarullo has termed it—“prudential market regulation.”  This form of regulation, Governor Tarullo explained, would “take into account such considerations as system-wide demands on liquidity during stress periods and correlated risks among asset managers that could exacerbate liquidity, redemption, and firesale pressure.”

Most worrisome to me is that the Federal Reserve could constrain investors’ ability to dispose of assets on demand.  That is no idle threat.  For example, the Fed could impose a delay on the effectiveness of an investor’s redemption decision or elect to require fund managers to remain in positions they would otherwise have elected to exit.  It could advise asset managers that they should not dispose of a particular kind of security, despite the judgment of the advisor that it is its fiduciary duty to sell, or despite the wishes of the client to sell.  At the moment, many central bank policies worldwide amount to passive, financial repression – but the current war on savers through zero or negative interest rate policies could morph naturally in times of stress into active transaction repression.

This is no longer a theoretical problem, and it is one that would be catastrophic for markets and our economy.  As my colleague at Patomak Dan Gallagher put it when he was an SEC Commissioner, prudential regulation “can and has evolved into an opaque regulatory system in which the government’s invisible hand replaces the market’s.”  In the process, this threat will send business and jobs overseas, and harm economic competitiveness.[1]

The idea of expanding the ambit of prudential regulation to U.S. capital markets in order to make these markets more safe and sound may seem to many like a good idea.  After all, no company wants to go out of business and no investor wants to look at losses on his monthly brokerage and retirement account statements.  The fundamental flaw with this de-risking approach, however, is that deep, liquid, and competitive capital markets actually require investors to take informed risks.  In fact, the risks investors take are critical for to capital allocation, which is, in turn, necessary for real economic growth.

This is particularly true when regulating capital requirements of broker-dealers.  The capital market sector and banking sector operate on different premises, and therefore need to be regulated differently.  In the capital markets, there is no opportunity without risk, with a real potential for losses.   Therefore, broker-dealer capital requirements are designed to manage risk, and capital requirements are put in place to provide support in case a failed broker dealer must liquidate in an orderly manner.  In the banking sector, capital requirements are designed with the goal of enhancing safety and soundness, both for individual banks and for the banking system as a whole.  They serve to reduce risk and protect against failure, and they reduce the potential that taxpayers will be required to backstop the bank in a time of stress.

Regulators of capital markets must accept the inevitability that some brokerage firms will fail, which is much different than the safety and soundness regime applied to the banking industry.   Indeed, our capital markets are too big – as well as vibrant, fluid, and resilient – not to allow for failure.  My former boss Richard Breeden famously and bravely let Drexel Burnham Lambert fail over the objections of the Federal Reserve.  The markets were stronger for that discipline and approach.

However, when it comes to setting capital requirements, bank regulators are increasingly seeking one-size-fits-all regulatory regimes for financial institutions.  FSOC, as well as the G-20-created Financial Stability Board, seem intent on applying the bank regulatory model to all financial institutions, including broker dealers.

Another example of this can be found in Section 165 of the Dodd-Frank Act, which requires, among other things, that the Fed’s Board of Governors establish enhanced prudential standards for bank holding companies with consolidated assets of greater than $50 billion.  Of course, Section 165 does not mention broker-dealers or asset management firms, but the Fed issued a rule requiring foreign banking organizations with U.S. non-branch assets of $50 billion or more to establish a U.S. intermediate holding company over their U.S. subsidiaries.  These holding companies will be subject to the same risk-based and leverage capital standards that the Fed applies to U.S. bank holding companies.

In addition, the Fed’s rule requires a foreign entity operating non-bank subsidiaries in the U.S. to superimpose an entirely new organizational structure for those non-bank U.S. holdings – one that artificially brings those holdings under the jurisdiction of the Fed and subjects them to regulations crafted to ensure the safety and stability of banking entities.

What does that mean for broker-dealers?  Well, in addition to being regulated by the SEC, the Fed’s Section 165 rulemaking forces a foreign bank organization to interpose a bank holding company into existence over its non-bank holdings, thus subjecting those entities’ broker-dealer subsidiaries to regulation by the Fed.

Of course, the SEC and Fed regulate differently, especially in the so-called “informal” rulemaking of non-transparent staff action and examination, especially on the bank regulatory side.  For example, we’ve seen bank regulators and examiners ignoring the SEC’s net capital rule.  One of my clients, a broker dealer regulated by the SEC and the Fed, told me that regarding one security, Fed examiners said they didn’t care how the SEC or net capital rule treated a particular security; they were only concerned with their own standards.  Hardly a recipe for regulatory clarity. How in the world is the firm supposed to handle that situation?

That leads us to another joint rulemaking mandated by Dodd-Frank Act:  the Volcker Rule.  As with so many other provisions of Dodd-Frank, hardly any sort of substantive hearing was held to consider the specific language, the potential effects, or unintended consequences of the provision.

At its core, the Volcker Rule is aimed at banning proprietary trading in commercial banks.  This was Paul Volcker’s lame way of addressing the Glass-Steagall issue.  It hit a political button in the Administration.  Unfortunately, cooler, more informed and knowledgeable heads did not prevail. Not only did the Volcker provisions of Dodd-Frank fail to address a key part of the financial crisis, but the rule as implemented may negatively affect market-making and liquidity.

First, it imposes new policies and procedures on banks and broker-dealers engaged in underwriting or making a market in securities in order to ensure that they do not run afoul of the ban on proprietary trading.  Second, the Rule has an incredibly broad scope:  its prohibitions apply not only to all banks, but also their holding companies and affiliates, and to the US operations of foreign banking organizations. Most of all, at its core it asks examiners to do the impossible – to don a psychoanalytic hat to divine the investment purpose (or lack thereof) of market transactions.  It will be interesting to see how the inevitable course of enforcement unfolds in this area.

Of course, the traditional regulators, SEC, CFTC, states, and bank regulators are not the only actors in the broker-dealer space.  On April 6, 2016, the Department of Labor finalized its fiduciary rule to regulate investment advice in retirement accounts, expanding the “investment advice fiduciary” definition under the Employee Retirement Income Security Act of 1974 (ERISA).  The rule dismissed suitability as a proper standard of care for brokers, as well as the FINRA arbitration system as a mechanism to resolve client disputes.  Instead, the rule is based upon the premise that charging fees based on the amount of assets under management is superior for every investor than charging commission-based fees.

The rule at is core is rather vague, to say the least.  Under the rule, fiduciaries are obligated to act in the best interest of their clients, and registered representatives are only to receive “reasonable” compensation for their services.  However, by not defining “best interest” or “reasonable compensation,” the DOL rule opens up the door to future customer litigation. In fact, Labor Department officials have been open about this, acknowledging the lack of a federal enforcement mechanism and inviting private litigants to fill in the gap.  Good for plaintiffs’ lawyers, bad for investors.  Will the SEC or FINRA examine for and enforce the Labor Department’s rule?  All of this is yet to play out.

Realistically, very few brokers will be able to receive commissions under the DOL’s proposal. Broker-dealers using a commission-based fee structure may find it impossible to navigate the prohibitions and exemptions contained in the rule, and many will stop servicing certain retirement accounts altogether.  This would be a tragic outcome for millions of small savers. Bank of America/Merrill Lynch has already decided that all of its client-facing representative will become investment advisors.

Some believe that an SEC rulemaking under Section 913 of Dodd-Frank could stave off the ill-conceived DOL rule.   Section 913 gave the SEC the authority to require a uniform fiduciary duty for investment advisers.  In the event that the Commission moves forward with a Section 913 rulemaking, the industry will most likely end up with two burdensome and redundant rules.

One need only look at what has happened in the United Kingdom to see the dangers of the DOL’s rulemaking.

Since 2013, the United Kingdom’s Financial Conduct Authority (FCA) has enforced rules to prohibit broker-dealers from receiving commission payments, thereby forcing all brokers to adopt fee-based compensation models. According to a report commissioned by the FCA, from April 2013 until March 2014, 310,000 customers stopped being served by their brokers because their wealth was too small for the broker to advise profitably. During the same period, brokers turned down an additional 60,000 applicant investors due to their low-balance accounts. The report found that some brokers have started accepting only customers with more than ₤50,000 (about $78,000) in savings, shutting out large numbers of lower- and middle-class investors.

If the SEC’s goal is truly to serve lower- and middle-class investors, they should develop a proposal that accomplishes their goal of protecting investors without preventing them from accessing the advice and products they need to save for retirement.

Our capital markets have undergone significant changes over the years.  From the earliest days of our nation–going all the way back to the formation of the New York Stock Exchange’s predecessor Board in 1792–self-regulation, rather than government regulation, has played a primary role in shaping our markets.

As you all know, it wasn’t until after the stock market crash of 1929 and the onset of the Great Depression that Congress established the SEC and codified comprehensive regulations to govern U.S. securities markets.  In the Securities Exchange Act of 1934, Congress recognized the important role that supervised self-regulation plays in regulating our capital markets.

While the need for self-regulation continues, today’s SRO structure has largely departed from the original goals of self-regulation envisioned by market participants and Congress for decades; namely, the balance of efficient and effective regulation with the need to be accountable and transparent.

A key question is whether SRO’s are and should be truly independent, with some SRO’s today behaving more like state actors.  The issue has already been raised in at least one case concerning the invocation of the Fifth Amendment when the defendant was a registered person being investigated by FINRA as well as by the SEC and the Department of Justice.

What are some of the other fundamental market structure and self-regulation questions we should be asking? For starters: should exchanges still be SROs?  The SRO framework was developed in the context of private, mutualized exchanges – a context that no longer exists. Second, are SRO’s truly “self” regulatory organizations?  For example, should exchanges be allowed to outsource the bulk of their regulatory responsibilities to FINRA through regulatory services agreements?

Lastly, do SRO’s have the resources to perform sufficiently rigorous analyses to support their rulemaking.  SROs must be committed to ensuring that the rules they send to the Commission for approval are the result of the same degree of rigorous analysis if they are to continue to play a central role in securities regulation.

Thank you for your attention.  There is a myriad of other issues that I could talk about – the Market Access Rule, Reg SCI, the Consolidated Audit Trail, the future of arbitration, market structure issues like Reg NMS, high-frequency trading, the importance of training and investment in staff and technology, new developments in the area of abuse of material non-public information, the need to stay ahead on the supervision and surveillance front in this era of constantly changing personal devices and burgeoning development of new social media apps, and on and on.  But, you have a conference to attend and I will leave you to it.

Thank you for your time.