Banks and brokers and bricks and clicks: an evaluation of FINRA's proposal to modify the "bank broker-dealer rule".

AuthorGross, Jill I.
  1. INTRODUCTION

    Paula P., a risk-averse individual with no investment experience and no significant assets, (1) walks into her local bank branch recently, intending to renew her one year Certificate of Deposit ("CD") and seeking interest on her $20,000 in savings accumulated over a lifetime of modest employment. Pat, the bank teller, recommends that she talk to Joe D. who works in the office and who may be able to help her obtain a higher rate of return on her money. Paula agrees, and Joe takes her over to his cubicle, eagerly explaining that he has "something better" for her than the CD she sought to renew. Paula, pleased to learn she could earn a higher interest rate on her savings, agrees to work with Joe. After signing a few papers that Joe says are merely "red tape," they complete the transaction, and Paula leaves the bank a satisfied customer. Paula does not realize, however, that she just purchased shares of a speculative "junk bond" mutual fund--an investment product wholly different in risk than a CD.

    This is the story of countless unsuspecting and unsophisticated banking customers who enter the seemingly "safe and sound" confines of their trusted financial institution (2) seeking low-risk, insured, depository savings products, but are lured into purchasing volatile, uninsured non-depository investment products they often do not understand, only to later suffer substantial losses and learn that FDIC (or FSLIC) insurance is unavailable to make them whole. (3) Customers like Paula have been victimized by a regulatory scheme that permits broker-dealers to operate on the premises of financial institutions without fully disclosing to customers the fundamental differences between a depository institution and a broker-dealer and the products and services each respectively markets. (4) Financial regulators repeatedly have failed to proscribe this manipulative behavior, to the detriment of countless retail investors.

    This article evaluates the Financial Industry Regulatory Authority's ("FINRA") (5) proposal to adopt a modified version of National Association of Securities Dealers ("NASD") Rule 2350, known as the "bank broker-dealer rule," (6) which, if approved by the SEC, would be designated as FINRA Rule 3160 within FINRA's Consolidated Rulebook ("proposed rule change"). (7) The proposed rule change ostensibly seeks to prevent FINRA member firms that offer broker-dealer products and services through contractual "networking arrangements" with financial institutions--both on and off the premises of those institutions from undertaking certain business practices that might tend to confuse or harm customers of financial institutions. (8) The proposed rule change also aims to prevent customer confusion by, inter alia, ensuring that certain disclosures are made to customers so they can understand and appreciate the distinction(s) between the products and services sold by a financial institution and those sold by its broker-dealer affiliate. (9)

    As discussed in this article, the proposed rule change protects bank customers who may be solicited for the purchase of investment products and services, but only to a limited extent. It does not rectify sales practices of broker-dealers--affiliated with financial institutions--which tend to confuse, and even mislead, financially unsophisticated investors of modest means who can least afford to be exposed to excessive risk. Additionally, the proposed rule change adds no meaningful surveillance, inspection, enforcement, or punitive mechanisms to prevent and/or redress insidious practices that are akin to "bait and switch" tactics and are particularly effective against financially unsophisticated investors. In fact, the proposed rule change even rolls back some key regulatory provisions, an especially unsettling retreat when one considers the lack of oversight during the recent market malaise and the contribution that such abridgement may have made to the present economic contraction as a reverse "wealth effect" impinges upon consumer behavior. In short, as demonstrated below, the proposed rule change is inadequate to sufficiently protect investors and promote genuine market integrity.

  2. THE HISTORY OF REGULATING NETWORKING ARRANGEMENTS

    Prior to implementation of the "bank broker-dealer rule," the SEC governed networking arrangements between financial institutions and broker-dealers through the issuance of interpretive "no-action" letters. (10) On November 24, 1993, SEC staff issued what became known as the "Chubb Letter," which detailed SEC policy relating to certain broker-dealer operational activities that occurred on the premises of financial institutions. (11) After the release of the Chubb Letter, the four main federal bank regulators issued an "Interagency Statement on Retail Sales of Nondeposit Investment Products" ("Interagency Statement") on February 15, 1994. (12) The Interagency Statement adopted many of the Chubb Letter provisions and directed banks and savings institutions to adhere to those principles when either: (1) effecting direct sales of securities to customers; or (2) overseeing NASD members in connection with the purchase or sales of securities on their premises. (13)

    In 1995, NASD proposed new Conduct Rule 2350 ("Broker-Dealer Conduct on the Premises of Financial Institutions"), based largely on the Chubb Letter and the Interagency Statement, in order to establish uniform and consistent standards to govern "the activities of NASD members that are conducting broker-dealer services on the premises of a financial institution where retail deposits are taken." (14) Three years later, on November 4, 1997, the SEC approved Rule 2350, also known as the "bank broker-dealer rule." (15)

    On November 12, 1999, through "the culmination of a $300 million lobbying effort by the banking and financial-services industries," (16) Congress passed the Gramm-Leach-Bliley Act ("GLB"), repealing key provisions of the Glass-Steagall Act of 1933 (17) and eliminating the long-standing separation of insurance, banking, and securities businesses. (18) GLB did nothing to enhance investor knowledge or awareness, yet it permitted--and even fostered--the blending of seemingly secure depository savings institutions with the high-flying speculative culture of investment banking. (19)

    Following the passage of GLB, unsophisticated depository customers were exposed to a slew of new offerings from giant hybrid financial services entities which, according to at least one observer, "were given the right to merge into behemoths, but regulators remained scattered and focused on a world that had ceased to exist." (20) Just months before the recent economic decline accelerated, John Reed, the "architect" of the merger of Travelers (insurance), Citibank, N.A. (commercial banking), and Salomon Smith Barney (securities brokerage and investment banking)--which was then the world's largest financial services firm, Citigroup--reflected on that transaction and admitted it was a "mistake." (21)

    Years after GLB's passage, Congress promulgated the Financial Services Regulatory Relief Act of 2006, which, inter alia, required the SEC and the Federal Reserve Board to adopt final rules addressing the matter and to implement the exceptions to the definition of "broker" under GLB section 201 to govern the joint activity of banks and broker-dealers. (22) Commentators may differ about the root causes of the 2008-09 market collapse and the "Great Recession" that followed, but even some of the staunchest GLB proponents point to insufficient regulatory oversight as one main cause for recent market and economic turmoil. (23)

  3. PROPOSED FINRA CONDUCT RULE 3160

    The proposed rule change aims to harmonize FINRA rules (24) with relevant provisions of GLB and Regulation R. (25) The proposed rule change calls for FINRA members to: (1) establish written networking agreements with banks identifying responsibilities and compensation; (2) segregate the retail deposit-taking area from all securities activities occurring on bank premises; (3) permit some inspection and examination access by the SEC and FINRA; (4) require customer communications to "clearly" identify that all brokerage services are provided by the broker-dealer, not by the bank; (5) disclose that securities products offered are not insured like savings products; and (6) make reasonable efforts while opening an account to obtain a customer's written acknowledgement of the receipt of the required disclosures. (26)

    While the proposed rule change contemplates broker-dealer internet activities generally, adoption of the setting regulations of the proposed rule change would address--by implication through the FINRA by-laws--only "on premises" activities in the "retail deposit-taking area." (27) Unfortunately, this provision ignores the fact that there are an ever-increasing number of bank deposits. These include "substitute drafts," as defined and permitted by the "Check 21 Act," and electronic payroll deposits, (28) both of which are facilitated online, and which should logically result in expansion of the covered "area" to include cyberspace--at least for the purposes of appropriate setting regulation. (29) In our view, the proposed rule change, in its present form, is a regulatory setback that substantially undermines the maxims of market integrity and investor protection, particularly in light of the increasing information asymmetry that exists between broker-dealers and their customers.

  4. INVESTMENT ILLITERACY AND CUSTOMER CONFUSION: THE NEED FOR REGULATION

    Over the past twelve years, individual investors have been confused regarding the role of the financial institution--as defined within the proposed rule change--with respect to the securities activities of affiliated broker-dealers through network arrangements. (30) Investment illiteracy research conducted by the SEC in conjunction with the Office of the Comptroller of the Currency revealed...

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