Today on “The Breakdown,” NLW briefly covers yesterday’s bitcoin price crash and why it was driven by market structure more than news. The main topic focuses on revelations from Coinbase that after months of engagement around its upcoming Lend product, the SEC is now threatening to sue. NLW examines the controversy from five dimensions:
The argument for and against lending as a security The SEC’s pattern of regulation by litigation How the SEC is rewarding bad actors by punishing compliance The concerning surveillance implications of one of the SEC’s requests Why these strong-arm tactics are doomed Should Coinbase take the battle to court?
Brokers won their fight against the controversial fiduciary rule. Now, a battle is brewing over a new proposal by securities regulators that would require them to cut back on sales incentives tied to customer advice.
The battle with the Securities and Exchange Commission will play out in 2019. Major brokerages including Morgan Stanley, Bank of America’s Merrill Lynch and Fidelity Investments are pressing the SEC to let them maintain current broker pay practices, arguing the plan could limit the products and services they provide.
SEC Chairman Jay Clayton, meanwhile, is staking his legacy on changes that would require more broker disclosures and limit sales incentives.
The proposal says that brokers should avoid “compensation incentives for employees to favor one type of product over another” and suggests pay for brokers be based on “neutral factors” such as the amount of time and complexity of the work involved. Brokers claim such a system could put their business model at risk.
.. The industry is hopeful Mr. Clayton’s statements mean the SEC won’t force brokers to eliminate all forms of variable compensation, but instead boost disclosure of pay arrangements and weed out some extreme practices such as sales contests.
.. Most brokerages pay their employees more for selling certain products over others, depending on how lucrative they are. This practice can result in customers paying more for products and services than they need to, though brokers defend the practice as the only way to reasonably offer a range of investment options. Without assurances their pay practices comply with government regulations, investment firms say they could stop offering certain products to avoid possible legal liability... To advocates of a tougher rule, pay incentives call into question whether a product is being presented to a customer for their benefit or for the broker’s.“Brokerage firms artificially create all sorts of perverse incentives to encourage brokers to make certain recommendations that are very profitable for the firm and the broker, even if they aren’t really good for the customer,” said Sen. Elizabeth Warren (D., Mass.) at the December hearing.
Why did no top bankers go to prison? Some have pointed out that statutes weren’t strong enough in some areas and resources were scarce, and while there is truth in those arguments, subtler reasons were also at play. During a year spent researching for a book on this subject, I’ve come across case after case in which regulators were reluctant to use the laws and resources available to them. Members of the public don’t have a full sense of the issue, because they rarely get to see how such decisions are made inside government agencies.
.. Kidney, for his part, came to believe that the big banks had “captured” his agency—that is, that the S.E.C., which is charged with keeping financial institutions in line, had become overly cautious to the point of cowardice.
.. The bank, IKB, was cautious enough to ask that Goldman hire an independent asset manager to assemble the deal and look out for its interests.
.. This is where things got dodgy. Unbeknownst to IKB, Paulson & Company improved its odds of success by inducing the manager, a company called ACA Capital, to include the diciest possible housing bonds in the deal. Paulson wasn’t just betting on the horse race. The fund was secretly slipping Quaaludes to the favorite. ACA did not understand that Paulson was betting against the security. Goldman knew, but didn’t give either ACA or IKB the full picture. (For its part, Paulson & Company contended that ACA was free to reject its suggestions and said that it never misled anyone in the deal.)
.. When S.E.C. officials discovered this, in 2009, they decided that Goldman Sachs had misled both the German bank and ACA by making false statements and omitting what the law terms “material details”—and that these actions constituted a violation of securities law.
.. When Kidney looked at the work that had been done on the case, he found what he considered serious shortcomings. For one, S.E.C. investigators had not interviewed enough executives. For another, the staff decided to charge only the lowest man on the totem pole, a midlevel Goldman trader named Fabrice Tourre
.. Charging only Goldman, he said, would send exactly the wrong message to Wall Street. “This appears to be an unbelievable fraud,” he wrote to his boss, Luis Mejia. “I do
.. The S.E.C. team had not interviewed Tourre’s direct superior, Jonathan Egol. Nor had they questioned top bankers in Goldman’s mortgage businesses or any of the bank’s senior executives. Even more surprising to Kidney, the agency had not taken testimony from John Paulson, the key figure at his eponymous hedge fund. It seemed to Kidney, as he reviewed the case materials, that the agency had spent more time and effort investigating much smaller insider-trading cases.
.. Part of the problem was that high-level Goldman executives had been savvier in how they communicated: when topics broached sensitive territory in e-mails, they would often write “LDL”—let’s discuss live.
.. In a December 30th e-mail, sent to the entire group investigating the deal, Muoio offered an explanation for what had happened during the bubble years: “Now that we are gearing up to bring a handful of cases in this area, I suggest that we keep in mind that the vast majority of the losses suffered had nothing to do with fraud and the like and are more fairly attributable to lesser human failings of greed, arrogance and stupidity of which we are all guilty from time to time.”
.. Kidney told me that he thought the S.E.C. could avail itself of a broader interpretation of securities law. He argued that the agency should file civil actions against top players at both the bank and the hedge fund under a concept called “scheme liability”—a doctrine of securities law that makes it illegal to sell financial products whose main purpose is to deceive investors.
.. Muoio, in a recent interview with me, dismissed Kidney’s complaints. “I cannot imagine any basis for claiming ‘regulatory capture,’ given that I have never worked in industry or finance and given the cases I have made, including very significant cases against banks, auditing firms, companies and senior executives,” he said.
.. But to Kidney, the driving force was something subtler. Over the course of three decades, the concept of the government as an active player had been tarnished in the minds of the public and the civil servants working inside the agency. In his view, regulatory capture is a psychological process in which officials become increasingly gun shy in the face of criticism from their bosses, Congress, and the industry the agency is supposed to oversee. Leads aren’t pursued. Cases are never opened. Wall Street executives are not forced to explain their actions.