PROBLEM: FRAUDBernard Madoff perpetrated a $50 billion scheme in which he falsified paperwork for more than a decade. Madoff ensnared 15,000 investors, big and small, and gave the SEC a black eye.
Solution: As the SEC ramps up enforcement, policymakers want to make it harder for con artists to pass off fraudulent documents. A House bill that just passed calls for better oversight of investments, and it would require money managers with more than $10 million to use an independent custodian for client accounts; the Senate may consider a similar measure next year as part of its reforms. Madoff used a custodian that he controlled, which made it easier to falsify investment records. The move should offer a bulwark against some fraudulent activities, though it is by no means a cure-all. Legislating against immoral behavior is difficult, says Kurt Brouwer, chairman of financial advisory firm Brouwer & Janachowski in Tiburon, Calif. "I'm not sure you can do that."
Change: The move should offer a bulwark against some fraudulent activities, though it is by no means a cure-all. "Legislating immoral behavior" is difficult, says Kurt Brouwer, chairman of financial advisory firm Brouwer & Janachowski in Tiburon, Calif. "I'm not sure you can do that."
PROBLEM: CONFLICTS OF INTERESTCredit-rating agencies, including Moody's and Standard & Poor's, failed to detect flaws in mortgage bonds and other debt. Some risky securities that had the highest rating, AAA, dropped to junk.
Solution: U.S. lawmakers in both the House and Senate are pushing for improved disclosure. They want to require raters to release details about how they are paid. To make risks clearer to investors, they want issuers to provide information about the underlying assets of a bond. In Europe, rating agencies will soon have to register with regulators and reveal the methodologies behind their credit decisions. Independent board members will also have to scrutinize ratings on the Continent.
Change: The proposed changes may improve the quality of bond ratings, but they don't address a central issue: Credit agencies are paid to rate bonds by the companies that issue them. Bond investors may have to live with that. "We've taken the position that you've got to kind of ignore the rating agencies entirely...and just go do the credit work yourselves," says Mackin Pulsifer of Fiduciary Trust, a money manager for wealthy individuals.
PROBLEM: TOXIC BONDSGovernments sold investments that imploded. Jefferson County, Ala., issued munis linked to exotic financial instruments to build sewers. The borrower defaulted and the county's bondholders got burned.
Solution: Lawmakers worry that small municipalities don't have the resources to vet exotic investments. Under the House bill and the Senate proposal, financial advisers to muni issuers would have to register with the SEC and follow a new set of rules for dealing with municipalities.
Change: The plan may decrease the likelihood that a municipality runs into financial trouble and could help protect investors from a bond blowup. But the new rules won't prevent all the problems that have plagued the muni market—or local government. In Jefferson County, a former official involved in the sewer debt deal was found guilty in late October of accepting bribes.
PROBLEM: BIASED ADVICEStockbrokers who collected fat commissions sometimes acted like financial advisers. There's a legal distinction: Advisers must put their clients' interests first, brokers only have to market "suitable" investments.
Solution: Brokers providing investment advice to retail investors would also have to act as fiduciaries, putting clients' interests first, if pending legislation passes both the House and the Senate. Brokers who simply execute trades would be exempt. The SEC may also issue rules for "simple and clear" disclosures about a broker's potential conflicts of interest.
Change: Many industry players say the move will improve the quality of investment advice. Higher compliance costs—which could cut into profits—may drive some smaller brokers out of business. "There will be a lot of brokers making a lot less money," says Bob Williams, a broker with Delta Trust Investments in Little Rock. "But I think it's for the best."
PROBLEM: SPECULATIONOil prices spiked to a record high in 2008 as hedge funds and other financial players poured money into the commodity.
Solution: Regulators want to curb speculation, which some blame for the run-up in commodity prices. The U.S. Commodity Futures Trading Commission and the New York Mercantile Exchange, for example, are capping the amount of grain, oil, and other commodity-based derivatives known as futures contracts that a money management firm can buy.
Change: Managers of exchange-traded funds that buy commodities may run afoul of the new limits. To avoid that situation, some firms have preemptively shut down funds or stopped issuing new shares. On Sept. 1, Deutsche Bank announced it would shutter PowerShares DB Crude Oil Double Long, an exchange-traded product geared toward individuals. If more follow suit, small investors may have fewer options to diversify their portfolios.
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