In the government's continuing probe of Wall Street, one of the key practices that senators hope to curb with pending financial reform legislation is that of firms betting against their own clients.
At least four amendments have been offered to address this practice, which some members of Congress, consumer advocates and academics refer to as a blatant conflict of interest, by assigning a standard to brokers that's long been applied to investment advisers -- forcing them to act in the best interests of their clients.
Presently, brokers, essentially middlemen between buyers and sellers of securities, aren't required to act in the best interests of their clients, otherwise known as a fiduciary duty. Brokers at firms like Goldman Sachs, for example, don't have to act with this in mind. The standard that governs their actions is suitability -- is this product "suitable," in other words.
Since the Securities and Exchange Commission charged Goldman and one of its employees on April 16 with civil fraud for defrauding investors by creating and selling exotic securities tied to subprime home mortgages in 2007 without disclosing that they were handpicked by a hedge fund that was betting on them to fail, the movement to apply a fiduciary standard to brokers on Wall Street has gained momentum. Senators quizzed Goldman executives about it during a hearing last month, and others have amplified their calls for legislation to apply the standard.
A fiduciary duty would require brokers, like those at Goldman Sachs, to put the interests of their clients first. Since the Goldman case became public, senators have renewed their push to establish the new standard for brokers who advise some institutional investors like states, municipalities and public pension funds. They also want those protections extended to retail investors.
Sens. Daniel Akaka of Hawaii, Robert Menendez of New Jersey, and Richard Durbin of Illinois, all Democrats, introduced a provision that would require the SEC to adopt rules that would impose a fiduciary duty on brokers when advising retail investors, and permit the SEC to apply that same standard to broker-dealers like Goldman Sachs when they give investment advice to institutional investors like pension funds and governments. The House passed a similar provision in December as part of its financial reform bill.
In a Thursday statement referencing recent reports on civil and criminal investigations into major Wall Street firms, Menendez said: "As consumers follow these investigations to see if there is guilt, we should at the very least give them peace of mind that their brokers are managing their hard-earned money honestly. The saying goes, 'The customer is always right,' not 'The customer is an afterthought,' and that is why we think keeping this provision in the final bill is so important."
The North American Securities Administrators Association, AARP and the National Association of Secretaries of State support the amendment. SEC Chairman Mary Schapiro has indicated her support for such a provision.
Sen. Barbara Boxer, a California Democrat, offered an amendment to the pending financial reform bill that would impose a fiduciary duty for advice to state and local governments and their agencies, pension funds, retirement plans, and endowments. That duty extends to advice regarding commodities and derivatives.
And Sens. Arlen Specter of Pennsylvania and Ted Kaufman of Delaware, also Democrats, proposed an amendment to the bill that would impose criminal sanctions on those that purposely violate their fiduciary duty.
All three amendment are strongly supported by pro-reform groups like Americans for Financial Reform and the Consumer Federation of America, as is an existing provision in the bill that imposes a fiduciary duty on dealers of swaps -- a type of derivatives product -- when dealing with state and local governments (and their agencies), pension funds and retirement plans, and endowments. Sen. Blanche Lincoln, an Arkansas Democrat, authored that measure.
"While not a panacea, expanding the fiduciary duty to brokers and swaps dealers could force a significant and beneficial change in the culture on Wall Street," the two consumer advocate groups wrote in a recent letter to members of the Senate.
However, those who stand to be most hurt by the change -- broker-dealers, big banks and their representatives -- oppose the Specter-Kaufman and Boxer amendments.
"That said, we remain supportive of a new, federal fiduciary standard for brokers and investment advisers when they are providing personalized investment advice to retail investors," said Andrew DeSouza, a spokesman for the Securities Industry and Financial Markets Association, a top trade group. Goldman chief executive and chairman Lloyd Blankfein expressed a similar position in January before the Financial Crisis Inquiry Commission, the panel charged with investigating the roots of the financial crisis.
Regarding a fiduciary duty when dealing with institutional investors, the main opposition stems from the argument that by serving both buyers and sellers, broker-dealers are put in the difficult position of having to serve the best interests of each: how is that possible? they ask, when the seller, who wants the highest price, and the buyer, who wants the lowest price, have opposing interests.
The senators who support the amendments argue that this function -- market-making -- is different than betting against one's clients, which is the activity they hope to curb.
Goldman Sachs, in particular, argues that its clients' interests "always come first."