Signed into law last fall by President Obama, the Dodd-Frank Act has been described as the largest overhaul of financial regulation since the 1930s. It is a 1,200-page document calling for 243 new rules, 67 studies and 23 ongoing reports. Its impact looms large – creating new and overhauling existing financial regulatory agencies, requiring previously unheard of levels of reporting and restricting certain kinds of trades and products. The effects will be felt in every sector of the financial market, from banks, to brokerage houses, to Wall Street itself.
Reaction among Kentucky’s wealth management community is decidedly mixed.
“It’s 1,200 pages with a lot of open-ended questions,” said Steve Trager, CEO of Republic Bank. “On the whole, some of the new protections will help curb abuse and make a more educated investor. But I worry … the new rules may actually create a whole new bunch of consequences they didn’t intend.”
The new law covers every aspect of the financial community, with the new rules taking effect gradually over the course of the next five years. Some of the provisions that affect individual investors and the wealth management industry include:
New “fiduciary responsibility” standard
The new law empowers the Securities and Exchange Commission (SEC) to create a standard of “fiduciary responsibility” for individual investment advisors and broker/dealers who work with investors. What this means specifically is still unclear, as the SEC will be spending the next few months doing studies, making recommendations and looking for the gaps in existing consumer protections.
Most observers agree, however, that client planning and reporting will be tightly regulated. Advisors now will be legally required to produce clear, written client investment plans that prove they are making choices in the client’s best financial interest. The law also may result in advisors being more legally liable for bad advice than they currently are. Advisors and brokers/dealers all will be held to the same standards of client reporting.
Advisors who hold client money in a trust or investment will have to provide independent, third-party verification to ensure that money is being handled lawfully and according to their specific agreement with the customer.
“For individual investors and for the larger firms and institutions, I think Dodd-Frank, in general, will have a lot of positive effects,” said Louis Harvey, president of Dalbar Inc., a Boston, Mass.-based firm that helps financial institutions with evaluating and auditing their internal processes.
“Investors will get much more detailed reporting and have some protections from abuses,” Harvey said. “The larger firms will be able to strengthen their processes and improve service. They will be able to easily absorb the costs of the lawyers and consultants that will come with dealing with regulators, changing their IT systems, doing training and all the other things you have to do to be compliant.”
He worries, though, about the effect it could have on the smaller fish in the pond.
“For the little office of, say, six independent investment advisors, these new paperwork and compliance requirements could be a disaster. Just the lawyer’s fees you need to pay would be enough to eat your profits for the year,” Harvey said. “A lot of small firms will go out of business or get bought up by bigger firms.”
Crackdown on conflicts of interest
During the financial crisis of 2007-10, many investors fell victim to advisers/brokers whose companies created derivative funds from pooled, bad mortgage loans then sold them as products to their investment clients. The Dodd-Frank law is specifically designed to eliminate this kind of conflict of interest.
Under the new law, financial institutions such as banks and brokerages could not sell certain kinds of proprietary products without giving client a clear conflict-of-interest disclosure. Some institutions may, in fact, be limited to selling their proprietary investment products only to other brokerages or clients outside their own base. New studies are also in process to look for other places in the system where conflicts of interest may arise among market analysts, too.
James Allen, CEO of Louisville-based brokerage Hilliard Lyons, said his firm is well positioned to manage the changes, as they have never done proprietary trading and have always maintained a separation between their investment banking and their investment research services. But with any unfinished regulation, he said, the “devil is in the details.”
“I think there is a misconception out there that the Wall Street investment community doesn’t want reform. We do, as long as it’s done in a helpful way,” Allen said. “There’re a lot of broad mandates with no detail. For instance, how do we all agree on the definition of fiduciary responsibility?
“What if the price of compliance is so high, we have to start charging higher fees? This may squeeze the smaller investor out of the market completely, because their fees would be higher than their returns,” Allen said.
“What if the best choice for a client is a proprietary product produced by their broker’s firm? If this is not done correctly, consumers will have fewer choices.”
Qualifying accredited investors
Under the new law, certain types of investments can only be made by strictly defined “accredited” investors. Investments such as commercial real estate or real estate funds, for instance, will only be available to clients who can prove that they not only have the funds to make their purchase, but that they have enough liquid assets in reserve to weather any potential losses from the product in the future. Which investments this will apply to, though, and how it will be applied is still being determined.
However, one change is certain: Investors will no longer be able to list equity in their primary residence as part of their net worth.
John Gardner is the senior vice president for Wells Fargo managing the Bluegrass Complex, a network of 90 financial advisers in seven locations from Bowling Green to Louisville. Wells Fargo saw these changes coming years ago, he said, and has been aggressively training its advisers on its new “Envision” system: a complex planning platform for helping to line up a client’s goals with the right investment tools. The new software and training program will make the transition much easier for the organization, Gardner said.
Nonetheless, he predicts the law will bring changes to the structure of the investment industry.
“We’ve never provided financial disincentives to our clients for minimum investment levels – but some firms do, and they will squeeze that small client out. But small clients aren’t going to be a casualty just of this bill,” Gardner said. “It’s a change that’s already underway.”
He predicts more firms like discount retail broker ScottTrade will emerge for people with smaller investment levels, and more mutual fund companies may decide to go direct.
Reforming the mortgage industry
Dodd-Frank creates new restrictions and mortgage reporting structures in the banking industry. Banks and mortgage brokers now must use a universal standard of reporting to assure a consumer’s ability to pay back a loan, though the exact terms are yet to be announced. Caps will be placed on mortgage rates, points and fees banks can charge customers with lower credit scores.
Trager said in the past two years, Republic Bank has done $1.5 billion in business and mortgage loans – none of them sub-prime. But he worries what the new proposed rate caps will do to the availability of credit in the market.
“Banks that loan to the sub-prime market incur much higher costs, because you have to factor in that a certain percentage of those mortgages will default. That means you have to charge more to everyone in that bracket to spread your liability out,” Trager said. “If the government puts restraints on pricing, you’ll lose product, pure and simple. If you have less than perfect credit, it’s possible you won’t be able to get a loan at all.”
Though many in the investment and banking industry worry about how the coming changes will play out for consumers, they all welcome the idea of improved, consistent reporting for the industry.
“I think we all need to remember,” Allen said, “this whole thing is less about bad products and practices, and more about selling product in excess, to the wrong investors, for the wrong reasons, all done by firms and investors who didn’t understand what they were selling. The Dodd-Frank Act at its heart, is designed to change all that.”
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