IBD Regulation: Broken Windows, Broken System

Broker-dealers have the additional risk of having numerous representatives under heightened supervision becoming a red flag to FINRA as a firm that willfully affiliates with "high-risk" reps. If a firm gets this "friendly to high-risk reps" reputation with regulators, the frequency and length of examinations may increase significantly. For a representative subjected to five years of heightened supervision, there are two options: find a firm willing to take on the burden, or switch to fixed insurance or go fee only. 

As the 'broken windows' method of enforcement unfolds, more advisors will be forced out of the industry by minor incidences, or need to find shelter at the ever shrinking number of firms willing to do heightened supervision, which will increasingly be available only to those representatives with ample production numbers. 

The Argument for Simplification

The answer to our dilemma lies in what Dale Brown said: "The current regulatory environment is far too costly and complex." The key word here is "complex." 

Just as we can simplify our tax code with a flat tax, we could streamline regulation with clear boundaries to work within. Tax preparers justify their existence by the increasing complexity of our tax code just as the SEC and FINRA justify their existence by making regulations extremely complex, so they will fight tooth and nail for the status quo.  Economist Thomas Sowell goes to the core of the problem when he said, "The fatal attraction of government is that it allows busybodies to impose decisions on others without paying any price themselves. That enables them to act as if there were no price, even when there are ruinous prices—paid by others."  

A recent article by Stuart Isacoff, entitled "The Genius of Miles," has clear parallels to our industry and the liberation that comes with simplification.  His article is about the working relationship between jazz piano pioneer Herbie Hancock and his time playing with trumpeter and jazz giant Miles Davis. Isacoff writes of the time when Mr. Hancock felt musically stuck. "Everything I played sounded the same," he confessed. Davis saw his frustration and offered some enigmatic advice. "Don't play the butter notes," he said.

"Butter notes?" thought Mr. Hancock. "What is that? Does butter mean fat?  Or does it mean obvious? I had to think about it, and finally realized that if I left out the notes that most clearly define the chords it would allow the harmonies to open up to various views.  It affected my playing for the rest of my life. And the audience responded—they felt my openness." 

We have a growing sameness in our business as the SEC and FINRA try to regulate risk out of the industry by limiting the availability of a wide variety of products such as alternative investments, REITs and leveraged ETFs, while heaping rules on us with Dodd Frank (14,000 pages of regulations). This is on top of the thousands of pages of regulation prior to Dodd Frank. If we could get the "butter" out of our industry we could open up to greater innovation, initiating an explosion of new firms with resources once directed to regulatory "butter" now applied to better serve clients and offer more product choices.

It's inspiring to think of the possibilities, but then the realities of the current reactionary administration creep back in and I must defer my hope. Government does have the ability to simplify rules and regulations greatly. The Federal Reserve Act was 31 pages long, while the Glass-Steagall Banking Act of 1933 was only 37. A more recent example of this was at the height of the financial services crisis in 2008. At that time, the application to apply for TARP (Troubled Asset Relief Program) was only two pages long, with four clear concise bullet points. In a time of crisis, when the governing powers are in a time crunch, they can make things simple. But given a choice, they much prefer complexity.  

Selling Advice to Those They Previously Regulated

Peter Schweizer, author of the book Extortion: How Politicians Extract Your Money, Buy Votes, and Line Their Own Pockets, explains, "Complexity is a useful and lucrative method of legal extortion for politicians" because, as University of London economist Anthony G. Heyes puts it, "it is precisely the complex, opacity and user-un-friendliness which underpin the value of the expertise." And that translates into "selling advice to those they previously regulated."

Many of those who drafted Dodd-Frank now work for consulting firms such as Promontory Financial Group, that advise financial services companies and banks on how to traverse and interpret Dodd-Frank in order to avoid legal vulnerability. This advice doesn't come cheap, with their fees going as high as $1,500 an hour. The former head of the SEC, Harvey Pitt, calls Dodd-Frank, "The Lawyers and Lobbyists Full Employment Act." 

Professor Alan Dershowitz estimates that today the average professional commits three felonies a day without realizing it, thanks to the complex layers of regulation and legal requirements that have been built up over time. Given that the financial services industry is the most regulated of any industry, we can assume brokers and broker-dealers average about five felonies a day without realizing it. As Dodd Frank is further implemented, the number of arbitrations will increase while the 'broken windows' approach to enforcement will cause fines to flow like Niagara Falls.

Securities attorneys are salivating at the thought.