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The Fleecing Equilibrium

I've been looking at the FINRA rules and regulations, thousands of pages of them all cross-referencing each other, footnoting FINRA notices to members (you can find this stuff at, trying to imagine what it would be like if all advisors had to be cognizant of the brokerage industry's rulebook. My conclusion is that most of it is plain commonsense sorts of things and a lot of procedural prescriptions. Things like "No member shall effect any transaction in, or induce the purchase or sale of, any security by means of manipulative, deceptive or other fraudulent device or contrivance" wouldn't be hard at all for the RIA advisors I talk with.

Under "Suitability" you find: "A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile. A customer's investment profile includes, but is not limited to, the customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation." Once again, this is a matter of routine for most advisors, and simple common sense.

Who can argue with that? You read these rules, and you wonder: why would anybody object to having FINRA regulate advisors.

And then it hit me, a sudden bolt of insight that was blinding in its obviousness.

Please take a moment to follow my logic.

First, no organization would fight against a strict fiduciary standard unless its business model was based on fleecing its customers. Indeed, just about the only thing the strict fiduciary standard actually does is prohibit taking advantage of customers, and it does this in the clearest possible language. When all the words and obfuscations and discussions of "regulatory costs and burdens" are seen through, it becomes suddenly clear that anybody who opposes having to live under this standard must be operating under a business model that is threatened by a prohibition against fleecing customers. You can substitute more diplomatic words for "fleecing" if this offends you, but I think "fleecing" has the advantage of being extremely clear about what we're talking about.

Second, we should all recognize something that isn't talked about very often in the fiduciary/regulatory debate: that there are boundaries that are acceptable in our society. It actually isn't in the brokerage industry's best interests to be too brazen about the fleecing activities, because this would suddenly call attention to their sales activities and conflicted revenue model. It is in the brokerage industry's best interests to carefully control the level to which it fleeces its customers, so that it can sustain this activity for the long-term.

Here's an analogy. Everybody knows that when you walk into a car dealership, the dealership sales rep will try to convince you that he simply cannot sell you the car for less than the full profit, plus dealer incentives, plus the inflated value of detailing, plus the profitable extras–period, end of story. And if you are a relatively smart consumer, you will eventually pay less than this amount that the sales rep has tried with all his powers of persuasion to get you to pay. The customer who pays full price has, effectively, been successfully fleeced. But at the same time, if the sales rep sells you a car that doesn't happen to contain an engine, or forgets to tell you that the tires are going to be extra, then he has committed fraud and, most importantly, damaged the reputation of the dealership in a competitive marketplace.

Fleecing, in other words, has to be constrained to a level that doesn't bring on consumer outrage. Annoyance, yes, but not outrage.

Put another way, a little fleecing is profitable. But if you go too far with it, you destroy the franchise, and no profits will ensue.

The first important part of my insight is that it is in the long-term best interests of the brokerage firms to have a regulatory structure in place. Of course they want to set rules for their own behavior–or, more specifically, for the behavior of their brokers. This zealous regard for rules, however, can have nothing whatsoever to do with consumer protection, and everything to do with protection of the franchise.

I think this is worth repeating. Companies that fleece their customers have to set boundaries that don't trigger an outcry of anger from customers everywhere, and they have to impose those boundaries on their employees. You can go this far, but no farther. They create rules that their employees have to follow, and in general the rules are there not to protect the customer, but to protect the company from severe reputational damage, and also to avoid triggering legal action. There is a fine balancing act: you want the rules to give the sales rep enough latitude to generate the maximum possible (fleecing-related) profit, but not enough to cause customers to avoid dealing with you.

Ideally, from a profit standpoint, all of the competitors would agree on a common set of rules, so that people wouldn't be able to play one firm off against another and get less-fleeced here as opposed to there.

Now, to get to the heart of the insight, what I realized when I was looking over FINRA's considerable (and impressive) body of rules is that this equilibrial balance between permitted fleecing and fleecing that is dangerous to the franchise is exactly what I was looking at.

I wasn't looking at a scheme of consumer protection at all. I was looking at the rules that the brokerage firms had created in order to protect themselves from the severe damage that could redound back on them if and when their sales reps stepped outside the boundaries of acceptable fleecing of customers. The rules impressively walked that fine line where they allowed many profitable activities at the expense of the customer, while at the same time controlling the level of outrage the customer would experience as the fleecing activities went on.

These FINRA rules, in other words, codified the internal policies and procedures of the sales-oriented brokerage organizations, which defined what behaviors the sales reps could engage in, and what they must avoid because it would damage the firm. Additionally, there are rules which require the sales reps to go through a lot of processes designed to make it seem to the customer as if he or she is not being fleeced. Gathering a whole lot of customer information before you recommend that annuity is a terrific way of making it look like the annuity recommendation was not foreordained before the customer walked into the office.

But even more cleverly, the FINRA rulebook amalgamates all the internal rules of all the members of the wirehouse cartel, ensuring that none of them will gain a competitive advantage by having their sales reps operate under more consumer-friendly behavioral boundaries.

The key point here is that we have been calling the FINRA regulatory structure a consumer protection vehicle, and pretty much everybody in the debate has fallen into the trap of thinking of it in those terms. But in fact, the FINRA regulations exist to protect the brokerage firms from the worst consequences of their perverse incentive systems. Brokers well understand that their business model is centered around fleecing customers; their jokes give the game away, and sometimes their emails (Fabulous Fab comes to mind) make it clear that they are rewarded for selling what they know to be useless junk, or charging more for asset management activities that are little more than perfunctory assemblages of separate account managers who pay under-the-table revenue sharing fees to the home office.

But what the individual brokers cannot be expected to understand is why, if their job is to fleece customers, they can't just go ahead and commit rampant fraud and pillage and generate the maximum profits implied by the incentive system. It takes a senior executive to understand how delicate is that balance between the amount of fleecing you can get away with and the danger of maximizing short-term profits by simply holding a gun to the head of customers and confiscating their wallets. Somewhere along that spectrum, you find the perfect level of artful fleecing without alienating the customer–and since the sales rep isn't likely to have a fine appreciation of where that boundary lies, and since he is paid based on how much he can pry out of those customer wallets, you have to rein him in with a lot of very strict, very specific rules.

And you have to be ready to denounce him as a "rogue" if he follows the perverse incentives to their logical conclusion and ventures beyond those rules.

And you have to have an arbitration system governed by your own self-created regulatory structure that allows you to avoid having to answer in court for the logical outcome of the perverse incentives you've created multiplied by several hundred thousand brokers who are probably impatient with the rules and cannot understand the point of them.

The bolt of insight tells me that FINRA is, in reality, nothing more than the outsourced compliance department for the brokerage industry. And its other role is to convince people that all these rules that were created to protect the brokerage industry are actually there to protect the consumer.

This is the enormous untruth at the center of the debate over whether FINRA should take over regulation of the financial services industry.

And the enormous truth that lies behind it is visible if you follow that spectrum, from hitting clients over the head with a blackjack (clearly not in the brokerage firm's long-term best interest, alas), to outright fraud (probably still too risky from a reputational risk standpoint but worth testing every once in a while since the consequences have been reduced to a tap on the wrist), to slyly siphoning money out of the customer's wallet with recommendations and sales tactics that would make a car salesman blush (AKA The Revenue Model, god bless it), to a strict, meaningful fiduciary standard where fleecing of any sort is plainly outlawed.

FINRA cannot, and will not, allow the profession to move all the way to that far fiduciary end of the spectrum, which happens to be where genuine customer protection lies. Its mandate is to define and maintain what might be called a "fleecing equilibrium," and everybody involved in the fiduciary debate should clearly recognize that very simple fact as they weigh the consequences of FINRA's regulatory proposals.