"Something is rotten" in China: Wall Street's Higher Standard of Care -- China Boss update 5.26.23
Update
What happened.
It was bound to happen. Over-hyping China stocks has been costing retail investors too many billions for too long, and is now too outlandish to ignore.
“Something is rotten in the Chinese economy, but don’t expect Wall Street analysts to tell you about it,” Ruchir Sharma wrote last week in the Financial Times.
“There has never been a bigger disconnect, in my experience, between some of the rosier investment bank views on China and the dim reality on the ground . . . Wall Street forecasts are now even more optimistic than Beijing’s unreachable growth target,” the chair of Rockefeller International said.
Why it matters.
Wall Street has a higher standard of care
On June 5, 2019, the Securities and Exchange Commission (SEC) adopted Regulation Best Interest (Reg BI) giving a “general obligation,” which requires that an investment broker, or broker dealer (BD), “comply with four component obligations”: the disclosure obligation, the care obligation, the conflict of interest obligation and the compliance obligation.”
The investment broker must also “act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.”
Under the 2019 obligation, brokers are not required to make conflict-free recommendations. They were, instead, compelled to “take steps to reduce the effect of (and, in some cases, eliminate) conflicts that would create an incentive to place the BD’s interests ahead of those of the retail customer when making a recommendation, and to make a recommendation in the customer’s best interest even where conflicts continue to exist.”
When the law was first passed, there was some confusion about what, precisely, the “best interest” standard required.
However, in recent months the SEC “issued a series of guidance bringing the regulation into sharper focus,” especially with regard to brokers’ obligation of care, according to Bloomberg law reporter Matthew Bultman.
Bultman, Bloomberg Law:
The SEC’s guidance more closely aligns the duties of brokers with the higher “fiduciary” duty that applies to investment advisers, attorneys said. The SEC in April said the tests for the two groups “generally yield substantially similar results” in terms of responsibilities owed to investors.
While the guidance isn’t binding, it signals what SEC staff expect from the industry.
Brokers have an obligation to understand the needs of investors, including their financial situation, and to consider the available alternatives, the SEC said in last month’s guidance. A product’s cost is a factor, the agency said.
Firms should also scrutinize whether a risky or complex product is in the investor’s best interest, and consider whether lower risk alternatives could achieve the same results for clients, the SEC said.
“By calling that out specifically, the staff is indicating that those areas will be a focus both in exams and potentially in enforcement matters to come,” Ropes & Gray LLP attorney Amy Jane Longo said.
(Investment advisors can only advise on the investment in securities, whereas a broker is paid a commission to execute a buy or a sell.)
Deep pockets with deeper conflicts of interest
And that’s where Wall Street’s China “boomy talk” turns foul.
Wall Street’s standard of care applies to the brokerage and its associates, irrespective of the whether the recommended stock is domestic or foreign. That nuance has not gone unnoticed in Washington, and frustration with the SEC for not doing more to protect American investors from the Chinese government has been mounting.
As far back as August 2021, US analysts and elected officials were complaining that “Wall Street firms and regulators [wouldn’t do] what’s necessary to protect Americans from getting fleeced by Beijing.”
Josh Rogin, Washington Post (August 2021):
Wall Street firms have a fiduciary responsibility to protect U.S. investors beyond what’s required by the letter of the law. Also, the SEC, which is supposed to enforce laws passed by Congress to protect U.S. investors, has allowed China’s abuses to fester.
“It’s discouraging to see some Wall Street executives work so hard and be complicit in trying to make sure these Chinese companies have access to American capital,” Sen. Dan Sullivan (R-Alaska) told me in an interview. “For far too long, these Chinese firms have been able to access American capital markets and investors without having to abide by the laws that Americans companies are required to follow.”
Some analysts have recently highlighted the conundrum in Wall Street’s seemingly infinite optimism on China, with investors, themselves, now “questioning the accuracy of the macro data as corporate earnings and guidance remain soft,” as Bloomberg staff noted yesterday.
Oddly enough, The Economist reports that “despite the bullish talk, Wall Street has China reservations.”
The Economist:
While stocks are up and some evidence shows modest inflows to mutual funds, Bloomberg data suggest continued outflows from exchange-traded funds so far this year.
This indicates a certain trepidation among Wall Street’s finest. Even if they do not like to say so in public, worries about Mr Xi and Taiwan prevent them from embracing China.
So what gives?
Bloomberg’s Shuli Ren made a subtle reveal earlier this month that China Boss thinks explains why Wall Street works so hard to push China stock as it simultaneously sells. After Beijing passed an expanded espionage law intended to scare the bejesus out of foreign expert networks, she asked whether insider trading or espionage might more quickly land one on the inside of a Chinese jail.
Ren, Bloomberg:
This is not the first time these consultancies have drawn regulators’ ire. The nature of their business is to give some money managers an information edge over everyone else. They link investors with industry experts, including government officials and management of publicly listed companies, for a hefty fee. In 2011, the US Securities and Exchange Commission examined whether hedge funds traded on inside information received from corporate employees moonlighting as consultants for these networks.
Watch on YouTube.
****
Have a great weekend.
