The Regulators’ Conflicts of Interest

Carlo V. di Florio was the director of the Securities and Exchange Commission (SEC) Office of Compliance Inspection and Examination. In 2012 he gave a speech in which he explained his definition of conflicts of interest.¹ He warned that “conflicts of interest . . . are a leading indicator of significant regulatory issues for individual firms, and sometimes even systemic risk for the entire financial system.”² Mr. di Florio defined conflicts of interest to include the following situations:

• (i) “where a persons or firm has an incentive to serve one interest at the expense of another interest of obligation.”

• (ii) “serving the interest of the firm over other clients or an employee or group of employees serving their own interests over those of the firm or its clients.”

Mr. di Florio noted the broader – connected – issue: “Is it the right thing to do?” The issues of conflicts of interest and broker-dealer behavior should be combined and must follow the spirit of the law. One might interpret the word “spirit” as the purpose and guiding principles adopted by the law. He noted that almost any bad behavior could be interpreted as a conflict of interest. That is true if we add to the list the interests of society at large, which aims to induce and enforce fair and honest behavior. In addition, Mr. di Florio noted the broad pressures of culture: Everyone does it! Why not I? Pressure includes financial incentives, and personal weaknesses, such as vanity.

Having listed the risk and harm of conflict of interests, Mr. di Florio emphasized the importance of an antidote by the regulators and directives aimed at avoiding conflicts of interest by financial institutions, including a strong and internalized ethics program in the organizations.

The past teaches us about the bitter fruits of conflicts of interest. Financial disasters were followed by legislation based on the evidence of horrendous conflicts. The 1929 market crash spawned the legislation of securities regulation.³ The 1934 legislation covered the brokerage services.⁴ The 1980s produced prohibitions on insider trading.⁵ The 1990s and early 2000 uncovered scandals that triggered the regulation under the Sarbanes-Oxley Act.⁶ The financial crisis of 2008 spawned the Financial Crisis Inquiry Commission (FCIC) report⁷ preceded in 2007 by the SEC’s investigation.⁸

Mr. di Florio proudly noticed the tradition of the SEC’s staff to focus on conflicts of interest. He pointed to the 2003 concerns about conflicts, which led to the 2008 disaster. He stated: “It is important to recognize that regulators also have an obligation to be diligent about identifying and addressing conflicts of interests as they emerge.”⁹ The SEC issued “risk alerts” guides, identifying new financial risks, to avoid surprises by the financial industry leaders.

The SEC practiced what it preached. The heads of the SEC have a practice of putting their assets in a blind trust.¹⁰ All employees have to disclose their securities investments.¹¹ The officials are careful to avoid conflicts of interest.

Personally, when I lunched with a long-time friend and practicing lawyer who represented clients before the SEC, I insisted on paying for my lunch. I could afford it. This was a principle that did not depend on the possibility of bribing me. Both of us knew better. Principles required my action. He understood.

In recent years, the SEC greatly weakened the key principle of the Advisers Act that advisers and brokers should be regulated separately and that advisers should be held to a strict fiduciary standard.

Now the SEC has effectively repealed at least part of the Advisers Act of 1940.¹² The new rule takes the approach that every prohibited action must be specifically stated as being prohibited, presumably everything that is not specifically stated is permissible!!!¹³ Furthermore, the “defining” term of the new rule, “best interest,” has purposely been left open for brokers-dealers to interpret as they see fit.

This action by the SEC is a “dictionary” rule that opens the door to any fraudulent activity that is not specifically prohibited in the rule. No rule can address all the free lunches, words, winks, and other types of behavior that brokers may use to convince uninformed customers to invest in ways that benefit them at the customers’ expense.

The rule does not prohibit conflicts of interests that are fed and affected by political considerations and the traditional, reliable Investment Advisers Act of 1940 interpretation. This interpretation would have included conflicts of interest. Instead, conflict is “massaged,” weakened and perhaps gone.

The Labor Department joined the approach by watering down the meanings and requirements of the Employee Retirement Income Security Act of 1975 (ERISA).¹⁴ ERISA was originally aimed at prohibiting conflicts of interest in managing pension funds and protecting the workers” savings by their employers. Yet its purpose is being watered down, reducing the strict prohibition on conflicts of interest by managers of pension funds.

Trust, honesty and culture

In 2006, my book was published entitled, Trust and Honesty: America’s Business Culture at a Crossroad.¹⁵ The book’s last chapter, titled “Towards an Honest Society,” outlined and proposed the elements necessary to create and maintain an honest society. The key to an honesty society is ensuring an honest culture.

The first part of this chapter revisited the issue of why a culture of trust and honesty is vital to society. The second part posed the question of whether American culture follows the principles of trust and honesty. Sadly, there are too many examples that led to a negative answer: American culture is losing and undermining its culture of trust and honesty. Soon, we will no longer trust others at all. Clearly, we have reached that point in key respects.

Culture is a conglomeration of rules, similar to laws, but more innate in a particular society and its members. Culture rules may be embodied in laws but can exist and be followed even if law does not repeat and back these rules fully.

Change requires awareness. This means examination and analysis of government, corporate leadership, or another authority, and leaders who seek to enforce trust and honesty. The American people must lead this change.

This is difficult. After all, the power of government was granted mostly voluntarily. People vote for the president of the country, and go willingly to lawyers and medical doctors. People chose their investment advisers and their brokers.

Elected and appointed government officials, corporate managers and experts, financial experts and power holders of the financial system, judges, lawyers, medical doctors, teachers and university management all are power holders. All have an expertise that others do not and cannot acquire quickly. All must be trusted; verification is hard, if at all possible.

This is why America needs experts to act and lead with trust and honesty. We need specialists and their services. We cannot live alone, nor be experts to meet all our needs.

When people must rely on their life savings to survive after retirement, they must trust advisers and sellers of securities. They must believe that their advice is given for the clients’ benefits. Trust and honesty becomes not a “nice way to behave” but a crucial element for the survival of this country’s residents.

We should follow the paradigm of honesty and trust. Even if we do not succeed in reaching it fully, the ambition of moving towards trust and honesty should never be compromised. During the attack of the coronavirus, the Americans’ tendency to help each other rose, while our leadership trailed behind. This observation should charge those engaged in servicing the financial system as well as their regulators to better and more permanent leadership based on the values of trust and honesty.

Wide acceptance among federal regulators and the financial industry of conflicts and the rejection of principles in Advisers Act is startling. It should especially worry investment advisers.

This rejection of the Advisers Act means that:

• Government is politicized. Conflicts are neither prohibited nor prevented directly.
• This is corrupting money managers and government personnel as well.
• We may “return” to darker days in history, as in the early 1900s, and deteriorated trust and honesty and financial disasters of the late 1930s, which drove new regulations in 1933, 1939, and 1940.

This return to darker days contaminates the financial system: advisers, brokers and dealers, money managers and those who work for them. It also touches those who are subject to conflicts of interest.

The description above of the SEC’s Rule and the Labor Department’s behavior and approach demonstrate this observation. The SEC’s rule leaves everything not specifically prohibited as potentially permitted.

Have we not learned that conflicts of interest are the virus of the financial system that infects its managers and regulators? Did we not learn that conflicts of interest defraud small and large investors, and employees?

History might repeat itself unless the government, advisers and broker-dealers realize that we are on our way to the crash. Regulators must avoid it by imposing a strict prohibition on conflicts of interest

Regulators should: (i) Maintain strict enforcement against conflicts of interest; (ii) Avoid political pressure, conflicts of interest and influence from some regulated parties; (iii) Give fiduciary duties a real meaning and enforcement; and (iv) Introduce a culture of avoiding conflicts of interests, and generally prohibit breaches of fiduciary duties both by the regulators as well as the actors in the financial markets.

Congress established the SEC after one of the greatest disasters in history

Congress established the SEC in 1929 after one of the greatest financial disasters that this country ever experienced. The SEC has supervised the financial system, its growth, and internationalization, evolving securitization, and adjustment to new technologies and more. It is difficult to find any action by the SEC that fostered conflicts of interest.

To be sure, the SEC was sensitive to the political environment. Yet, it is difficult to identify any situation, in which the SEC changed the style of any of its rules that opened the door to conflicting interests by any part of the financial system. The SEC’s rule 10b-5 demonstrates its historical approach. The rule is short and defines fraud broadly. It enveloped insider trading without ever mentioning these two words. Fraud is fraud in its enormous variety.

Hopefully the SEC will focus on its mandate to protect the financial system's integrity and prevent its decaying dishonesty. The time of "dictionary law" and unbridled freedom is now! The SEC is not a political arbitrator. It was, is, and should remain the protector of the total honesty and trustworthiness of America's financial system. The current so-called "rule" must be erased, and the faster the better for the financial system, as well as for the SEC’s reputation and place in history.

Tamar Frankel is professor of law emerita, Boston University Law School.

¹ Carlo V. di Florio, Conflicts of Interest and Risk Governance (Oct. 22, 2012), available at https://www.sec.gov/news/speech/2012-spch103112cvdhtm (last visited May 20, 2020) (speech delivered in a meeting of the National Society of Compliance Professionals).

² Id.

³ See id.; Securities Act of 1933, 15 U.S.C. §§ 77a-mm (2018).

⁴ See di Florio, supra note 2; Securities Exchange Act of 1934, 15 U.S.C. §§ 78a-qq (2018).

⁵ See di Florio, supra note 2; Insider Trading Sanctions Act of 1984, Pub. L. No. 98-376, 98 Stat. 1264 (codified as amended in scattered sections of 15 U.S.C.); Insider Trading and Securities Fraud Enforcement Act of 1988, Pub. L. No. 100-704, 102 Stat. 4677 (codified as amended in scattered sections of 15 U.S.C.).

⁶ See di Florio, supra note 2; Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (codified as amended in scattered sections of 11, 15, 18, 29 U.S.C.).

⁷ See di Florio, supra note 2; Financial Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report (Jan. 2011), available at https://www.govinfo.gov/content/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf (last visited May 20, 2020).

⁸ See di Florio, supra note 2; Financial Crisis Inquiry Comm’n, supra note 9, at 211-12, citing SEC, Office of Compliance Inspections and Examinations, Examination Report for Moody’s Investors Services, Inc. 2.

⁹ di Florio, supra note 2.

¹⁰ Tamar Frankel, Trust but Verify: The Legal Duties of Broker-Dealers in the Financial System, May 1, 2018, available at https://verdict.justia.com/2018/05/01/trust-but-verify (last visited May 20, 2020).

¹¹ See 17 C.F.R. § 200.735-11 (2019) (requiring statement of employment and financial interests); 5 C.F.R. pt. 2634 (2019) (executive branch financial disclosure); 5 C.F.R. §§ 2634.401-414 (2019) (qualified trusts).

¹² Investment Advisers Act of 1940, 15 U.S.C. §§ 80b-1 to -18c (2018).

¹³ Regulation Best Interest: The Broker-Dealer Standard of Conduct, Exchange Act Release No. 86,031 (June 5, 2019), 84 Fed. Reg. 33,318, 33,491-92 (July 12, 2019), to be codified at 17 C.F.R. § 240.15l-1.

¹⁴ Dept. of Labor, Definition of the Term ‘‘Fiduciary,’’ 81 Fed. Reg. 20,946 (Apr. 8, 2016), codified at 29 C.F.R. § 2510.3-21 (vacated 2018).

¹⁵ Tamar Frankel, Trust and Honesty: America’s Business Culture at a Crossroad (2006).

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