Trial Magazine

How did you start working on investor protection issues for the Consumer Federation of America (an alliance of nearly 300 pro-consumer organizations)?

I was hired by the CFA in 1986 to edit its publications. I had worked as a newspaper reporter and an editor at Colorado College. When I was hired at CFA, my boss had just gotten funding to do a study on abuses in the financial planning profession, and he figured with my background as a newspaper reporter, I could do the research with his oversight.

When we released the study in 1987, investor protection issues had not made a large mark on the consumer movement—in part because we were just starting to see the securities market open up to a wider range of investors and a significant increase in the percentage of households that invested. Then-Rep. Ed Markey and former Rep. John Dingell had jurisdiction over securities issues in the House Energy and Commerce Committee and were interested in being active in that area, so we started working with them and state securities regulators who were documenting abuses. So by default, I became the consumer ¬movement’s investor protection person.

What are the biggest investor and financial management issues that affect consumers? Where do you see the most fraud and abuse?

One of the most basic issues is that individual investors who are looking for a trusted adviser—someone to help them navigate complex investment decisions—are being misled by broker-dealers and insurance agents into relying on them as if they were trusted advisers. But these people are regulated and act as salespeople.

It’s difficult to find, for example, a major broker-dealer or insurance company that doesn’t market itself to the public as a financial adviser, retirement planner, or wealth manager as if these are relationships of trust. Meanwhile, they go into court and argue that they are mere salespeople engaged in arms-length commercial sales transactions with no obligation to do what’s best for the customer.

And that’s important because the typical investor is not financially sophisticated. The consumer-investor relies on an expert—just like you rely on a doctor to offer expert advice about your health—to give financial advice, but too often investors are being misled. And it’s not necessarily that they’re being actively defrauded, but investors get steered into investments with higher costs and higher risks because those are the investments that are most lucrative for the broker or insurance agent to sell. It may be perfectly legal for the broker or insurance agent to make that recommendation, but it’s not in the customer’s best interests.

What are some practical consequences to investors when that happens?

It can be the difference of tens or even hundreds of thousands of dollars in investor savings over the lifetime of a long-term retirement investment. The specific areas where you see this play out are, for example, in the sales of nontraded REITs [a type of real estate investment], fixed index annuities, and variable annuities when the investor is paying very high prices for very questionable investments. These investments lock up investors’ money and expose them to excessive costs.

One thing that I’ve been looking at more lately is the “horror” that is the 403(b) plan world: These plans are the equivalent of 401(k) plans for teachers and other state employees, except they’re not covered by the ERISA fiduciary standard. The result is that underpaid teachers (who are already reaching into their pockets to buy classroom supplies) have retirement plans loaded with high-cost variable and fixed index annuities that erode the value of their retirement savings. It’s a difficult issue to tackle.

A legislative solution at the federal level would be to apply ERISA to the plans, but a lot of work on the issue gets done at state or school district levels. These teachers can’t afford to waste money on their retirement investments. They need access to high-quality, low-cost investment options to make the most of their retirement savings, and instead they are in some of the worst plans available in the retirement market.

The U.S. Department of Labor’s (DOL) 2016 fiduciary rule was a major step forward in protecting retirement investments for consumers. What has happened since the Fifth Circuit overturned the rule in 2018?

What was revolutionary about the fiduciary rule—and what I think is responsible for the fervor of industry’s opposition—is that the DOL said the conflicts of interest that industry has embedded in this market are not inevitable. With appropriate regulations, we could significantly diminish some of these conflicts. One reason you see so much abuse with nontraded REITs, fixed index annuities, and variable annuities is because they pay so much to the people who sell them: for example, a 6 percent sales commission instead of the 3 percent that a broker might get for selling a mutual fund.

The DOL’s fiduciary rule told firms to rein in these incentives that could encourage recommendations based on the firms’ and the financial advisers’ interests rather than the best interests of the customers. So we started to see the development of “clean” shares—a way to sell mutual funds when the broker’s compensation is set independently between the investor and the broker and is not dictated by the fund. With clean shares, the broker’s compensation is transparent, consistent across products, and subject to market forces. We also saw a dramatic drop in the sale of nontraded REITs and certain types of annuities. In other words, the regulations were proving effective in reining in problematic practices.

The sad reality is that since 2018, most of those reforms have either receded or disappeared entirely. It’s back to business as usual. And that’s true despite the fact that the SEC is working on a rule that purports to adopt a best interest standard for brokers and reduce some of these conflicts. The rule really just gives lip service to those concepts rather than require meaningful changes. What the SEC basically has done is take the existing suitability standard under FINRA (Financial Industry Regulatory Authority) rules, renamed it as a best interest standard, added some largely meaningless disclosures, and pretended that it’s done something significant to protect investors. So industry is looking at that and going, yeah, we can live with this.

You’re an adviser with the SEC’s Investor Advisory Committee, which was established by the Dodd-Frank Act to make regulatory recommendations to the agency. What are some of the takeaways you’ve had from that experience?

What’s been most interesting to me about that committee—and I’ve been on it since it first met in 2012—is that the members have a range of ideological and professional backgrounds, and a fair number of industry members are on the committee too. I have been impressed by the committee’s ability to come together across significant differences in ideology, perspective, and background to develop consensus recommendations that are meaningful.

The flip side is, it’s very difficult to point to ways in which our recommendations have been embraced by the SEC. That’s not to say the commission hasn’t acted on any of our recommendations, but it’s a disappointing record. I do what I do because I believe in the importance of harnessing government forces to ensure that the market is fair, transparent, and functions well for all participants. But it’s been disappointing in my several-decades career working with the SEC, in Democratic and Republican administrations alike, how difficult it is to get the agency to embrace a pro-investor agenda.

How does forced arbitration in the financial system affect investors?

There are two forms of forced arbitration in securities: Investors are forced to arbitrate their disputes with broker-dealers in FINRA arbitration because they almost universally sign pre-dispute binding arbitration clauses. But FINRA rules do not allow firms to preclude investors from participating in class actions, so that option still exists for a dispute against a broker for widespread abuse that involves many investors.

Then there’s shareholder litigation of the disputes that arise when a company engages in fraud and misleads the investing public, and people overpay for the stock or lose money on the stock due to those misleading practices. While the SEC has traditionally taken the position that forced arbitration of such disputes violates securities laws, we’re seeing increased efforts to get the SEC to reverse that position.

It’s important to recognize at the outset that arbitration is simply not a viable option for investors in shareholder disputes against major corporations. With the possible exception of a few of the largest institutional investors—with an emphasis on possible—no individual investor is going to be able to afford the millions of dollars of costs in hiring expert witnesses and deposing witnesses and doing discovery and analyzing the financial statements necessary to bring one of these complex fraud claims. The point isn’t that they’ll be forced to bring those disputes in arbitration; the point is that they won’t bring able to bring them at all.

There are two results from that: One is that defrauded investors cannot recover their losses. The SEC’s ability to make defrauded investors financially whole is quite limited. The second is that it undermines market integrity and the deterrence of fraud. If a forced shareholder arbitration policy is adopted, it’s not just that investors will suffer a devastating loss or that people will lose confidence in the marketplace because of this evidence of unchecked fraud—we would have the added problem that defrauded investors would have no way to seek justice. It’s a denial of rights. The people who push this policy like to say, “It’s not a question of whether you can bring a claim, it’s a question of where you can bring that claim.” But that is just not true in the majority of cases for the majority of investors.

What’s the broader impact of forced arbitration on the financial markets?

Given the SEC’s limited resources, we rely on private lawsuits to help police the markets. Going back several decades, SEC officials from both parties have emphasized the importance of private litigation as a supplement to the agency’s enforcement actions. If you take away that private enforcement mechanism, there’s no reason to believe that Congress is going to provide the funding necessary to let the SEC fill that role. This leads to diminished deterrence against financial fraud.

Our markets benefit from the reputation of having tougher enforcement and more rigorous protection of investor rights than is available elsewhere.

When you dismantle those protections, and if investors see that the risks associated with capital are going up, there’s every reason to believe that the cost of capital will go up. So this issue is important to the health and integrity of the financial markets as a whole.

What do you see as the solution to ensure investors can exercise their rights?

For decades, it has been the SEC’s position that forced arbitration clauses are not permitted in the context of shareholder litigation. When companies have tried to bring IPOs to market with forced arbitration clauses, the SEC has indicated that it would not accelerate those filings, so the companies withdraw their proposals. The best outcome for investors is for the SEC to keep doing what it’s done in the past and not change its policy.

SEC Chairman Jay Clayton has told Congress that he would not change SEC policy in this area without an open and deliberative process. Recently, the SEC permitted Johnson & Johnson to exclude from its proxy ballot a proposal that would have required arbitration of all shareholder disputes on the grounds that it would violate New Jersey state law. But that doesn’t resolve the issue, because the SEC based its decision on state law, leaving unanswered the question of whether it believes forced arbitration is permitted under federal law, and because the decision is being challenged in court.

Why do you think the pace of change is frustratingly slow and there is constant pushback on reforms to better protect consumers and their investments? Will it take another financial crisis for widespread change?

I worked a lot on the Sarbanes-Oxley Act, which was adopted in the wake of the Enron and WorldCom accounting scandals. It was designed to ensure that audits of public companies would be more independent, more rigorous, and subject to better oversight. Imperfect as it was, it felt like a pretty significant achievement at the time. But it’s hard to look at that area today and see evidence that the audits are truly independent.

I worked on Dodd-Frank too, which adopted sweeping reforms in the wake of the 2008 financial crisis. But Dodd-Frank relied on regulators doing all of the things well that they had done poorly in the run-up to the financial crisis—standing up to industry lobbyists and adopting strong rules and enforcing them effectively. With both of those laws, you see how quickly the momentum shifts. If you can’t stick to reforms when you’ve brought the global economy to the brink of collapse, I don’t know what it would take.

I think it’s difficult to get pro-consumer and pro-investor reforms without a compelling crisis to make the case for the reform—the resistance to reform is so entrenched and powerful. But as soon as the crisis has dissipated, we see an effort to roll back the regulations adopted to address those dire circumstances. I still think it’s worth fighting the fight. You don’t go into this line of work without a pretty serious David complex, and I wouldn’t take the other side for anything. There’s satisfaction to be had from working on the things that you firmly believe make the world a better place.

Kate Halloran is the senior associate editor for Trial magazine.