Wednesday, May 22, 2013

Why American Business Should Support the Bona Fide Fiduciary Standard of Conduct for Investment Advice

American business is the engine which drives forth the growth of our economy, and delivers prosperity for all. An important component of the fuel for this engine is monetary capital. Yet, this monetary capital is not efficiently delivered to the engine of business … it’s as if the engine is stuck using an outdated, clogged carburetor, in the form of substantial intermediation costs by current investment banking practices.

More importantly, the transmission system of our economic vehicle is failing, leading to far less progress in our path toward personal and U.S. economic growth. The transmission system is large, heavy and unwieldy; its sheer weight slows down our vehicle. It unnecessarily diverts much of the power delivered by the engine to Wall Street, rather than deliver it to the investors (our fellow Americans) who provide the monetary capital.

The ramifications of this inefficient vehicle are many, and they are severe. The cost of capital to business is much higher than it should be, due to the significant intermediation costs of Wall Street in raising capital. And, because Wall Street currently diverts away from investors 35% or more of the profits generated by American publicly traded companies, often through high fees and other hidden fees and costs, investors receive far less a proportion of the returns of the capital markets.

This all leads to a high level of individual investor distrust in our system of financial services and in our capital markets. In fact, many individual investors, upset after discovering the high intermediation costs present, flee the capital markets altogether. As a result, the capital markets are further deprived of the capital which fuels American business and economic expansion, and the cost of capital is again raised. Indeed, as higher levels of distrust of financial services continue, the long-term viability of adequate capital formation is threatened.

Even more severe are the long-term impacts of high intermediation costs imposed by Wall Street firms on investors themselves. Individual investors, now largely charged with saving and investing for their own financial futures through 401(k) and other defined contribution retirement plans and IRA accounts, reap far less a portion of the returns of the capital markets than they should. These substantially lower returns from the capital invested, due to Wall Street’s diversion of profits, result in lower reinvestment of the returns by individual investors; this in tern also leads to even lower levels of capital formation for American business.

As individual Americans’ retirement security is not adequately provided through their own investment portfolios, saddled with such high intermediation costs, burdens will shift to governments – federal, state and local – to provide for the essential needs of our senior citizens in future years. These burdens will likely become extraordinary, resulting in far greater government expenditures on social services than would otherwise be necessary. As a consequence, higher tax rates become inevitable, for both American business and individual citizens alike.

In essence, American business has become Wall Street’s servant, rather than its master. The excessive rents extracted at multiple levels by Wall Street firms fuels excessive bonuses paid, in large part, to young investment bankers. Wall Street also drains some of the best talent away from productive businesses, as well. Consequently, Wall Street has become a huge drain on American business and the U.S. economy, as it derives excessive rents at the expense of corporations and individuals. The financial services sector, rather than providing the grease for American's economic engine, instead has become a very thick sludge.

There is but one solution to this crisis. The compelling answer to the problem presented by Wall Street’s excessive growth and consumption of a 35% or greater share of the profits of American business lies in the application of the bona fide fiduciary standard of conduct to all providers of personalized investment advice. Simply put, this broad-based fiduciary standard requires only that financial advisors act in the best interests of their clients.

Yet, Wall Street strongly opposes efforts by the U.S. Department of Labor (Employee Benefits Security Administration) and the U.S. Securities and Exchange Commission to apply a bona fide fiduciary standard to the delivery of investment advice to retirement plan sponsors (business owners), retirement plan participants (employees), and to all Americans. Worse yet, Wall Street and its proxies – brokerage firms, insurance companies, and securities industry organizations which oppose the fiduciary standard – seek to have a “new federal fiduciary standard” adopted which is not a true fiduciary standard at all, and which would permit Wall Street to continue to extract excessive rents from the U.S. economy.

By way of explanation, Wall Street will “accept” more disclosures – provided, of course, they are as general as possible and, as to details, only provided upon request of the client. Yet, a bona fide fiduciary standard of conduct requires much more. While disclosure is important, under a bona fide fiduciary standard of conduct conflicts of interest must be either avoided or, if not avoided, properly managed. And the proper management of a conflict of interest requires not just disclosure of the conflict, but also affirmative disclosure of all of the ramifications of that conflict of interest in a manner designed to ensure client understanding and to secure client consent. Even then, the client must not be harmed (for no truly informed client would ever consent to harm), and the transaction must be substantively fair to the client. Wall Street resists these requirements with a passion, for it knows it would be unable to extract excessive rents, as it does currently, if a bona fide fiduciary standard is applied.

In summary, the bona fide fiduciary standard of conduct is good for all Americans. More importantly, it is good for, and strongly needed by, American business. The application of a true fiduciary standard will assist to restore the much-needed trust in our capital markets, so necessary to foster capital formation and resulting economic growth. Application of the fiduciary standard will result in a much larger and more appropriate share of the returns of the capital markets flowing – not to Wall Street – but instead to investors.

The fiduciary standard of conduct, if applied correctly, will enhance the retirement security of our fellow Americans, reducing future burdens on governments, leading to lower tax rates in future years and greater prosperity for all.

The proper application of the fiduciary standard to the delivery of investment advice, as is now being considered by the DOL and SEC, provides an historic opportunity for American business to speak up, demand adoption and implementation of the bona fide fiduciary standard. In this manner, American business will foster its own future growth, and greater future prosperity for business, our fellow Americans, and for America itself.

I call upon American business leaders to speak up, and let policymakers in Washington, D.C. and beyond know of their concerns for adequacy of future capital formation and economic growth. Unite to restore faith in our capital markets. Resolve to rid our economy of the sludge which slows it down so much, in favor of a more efficient engine and transmission which will propel American business to greater prosperity.

Ron A. Rhoades, JD, CFP(r) is an Asst. Prof. of Business at Alfred State College. To follow this blog, please follow him on Twitter (@140ltd) or link to him via LinkedIn. Please direct any questions to Thank you.

1 comment:

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