COMMON SENSE 2013
ON THE FOLLOWING INTERESTING
S U B J E C T S.
I. Distinguishing between Fiduciary and Non-Fiduciary Relationships.
II. Thoughts on the Present State of Affairs for American Consumers.
III. The Application of Fiduciary Standards is Consistent with Adam Smith’s Capitalism.
IV. The Application of Fiduciary Standards is Pro-Small Business, Pro-Economic Growth, & Will Nudge Income Tax Rates Lower
V. The U.S. Department of Labor’s Rulemaking Should Not Be Delayed.
VI. The U.S. Securities and Exchange Commission’s Rulemaking Necessarily Follows.
VII. Repudiating Several Myths Promoted by Wall Street in Opposition to These Rulemaking Efforts.
“If men were angels, no government would be necessary.”
- James Madison
UNITED STATES OF AMERICA;
Printed and Distributed in Washington, D.C.
July 4, 2013
BY THE COMMITTEE FOR THE FIDUCIARY STANDARD
BY THE COMMITTEE FOR THE FIDUCIARY STANDARD
P R E F A C E
Through prudent, principles-based regulation and the proper application of the fiduciary standard upon providers of personalized investment advice to retail investors and retirement plan sponsors:
· Greater trust in financial advisors will result, and individuals will deploy a greater portion of their savings to the capital markets;
· As greater capital formation occurs, the cost of capital is lowered for U.S. business;
· Greater and lower-cost capital formation thereby provides the fuel for greater future U.S. economic growth and prosperity;
· With their financial futures better secured through lower-cost, more prudent investments, individuals accumulate far more for their retirement needs;
· As a result, burdens are lifted from government to provide for many senior citizens; and
· This leads to lesser government expenditures and, over the long term, lower income tax rates for both business and individuals.
Additionally, recent judicial decisions reveal that owners of small and large businesses remain at substantial risk when they receive advice, as retirement plan sponsors, from non-fiduciary “retirement plan consultants.”
In summary, the application of the fiduciary standard of conduct promotes small and large business capital formation, fosters U.S. economic growth, and will reduce income tax rates for both business and individual Americans in future years.
The application of the fiduciary standard protects small business owners from liability as retirement plan sponsors, and it ensures greater financial and retirement security for all Americans.
America faces a highly uncertain future. Many economic challenges lie ahead for our country. As government’s ability to provide for the financial and health care needs of retirees dwindles, our fellow Americans largely possess inadequate retirement security, a situation compounded by the excessive rents taken from retirement plan, IRA and other investment accounts by Wall Street firms. But such need not occur.
The U.S. Department of Labor (DOL), through the Employee Benefits Security Administration’s re-proposed rule, “Definition of Fiduciary,” is an important component of a greater answer to these economic and financial challenges. The proper application of ERISA’s strict “sole interests” fiduciary standard to all providers of advice to plan sponsors and plan participants, and IRA account owners, reflects a long-needed reform in reaction to radical changes occurring in retirement plans.
The U.S. Securities and Exchange Commission has been authorized by the U.S. Congress to adopt regulations imposing the Advisers Act’s “best interests” fiduciary standard upon brokers who render personalized investment advice to retail investors. In so doing, the SEC will simply follow principles of law which have been applied under state common law for over a century to brokers and their registered representatives.
Many arguments have been advanced to slow down or stop the proper application of fiduciary standards. As will be shown herein, these arguments run counter to sound economic principles, are often spurious in nature, or attempt to preserve conflict-ridden, expensive investment product sales practices.
The economic benefits of the proper application of the fiduciary standard are far too great to ignore – both for individual Americans and for all of America itself .
I. Distinguishing Between Fiduciary and Non-Fiduciary Relationships.
There are two types of relationships between product and service providers and their customers or clients under the law. The first form of relationship is an “arms-length” relationship. This type applies to the vast majority of service provider – customer engagements. In these relationships, the doctrine of “caveat emptor” generally applies, although this doctrine is always subject to the requirement of commercial good faith. Additionally, this doctrine may be modified through the imposition of specific rules or doctrines by law, such as the low requirement of “suitability” imposed upon registered representatives of broker-dealer firms (i.e., brokers).
The second type of relationship is a fiduciary relationship. This involves a relationship of trust, which necessarily involves vulnerability for the party who is reposing trust in another. In such situations one’s guard is down; i.e., one is trusting another to take actions on one's behalf. Under such circumstances, to violate a trust is to infringe grossly upon the expectations of the person reposing the trust. Because of this, the law creates a special status for fiduciaries, imposing duties of loyalty, care, and full disclosure upon them. Hence the law creates the “fiduciary relationship,” which requires the fiduciary to carry on with their dealings with the client (a.k.a. “entrustor”) at a level far above ordinary, or even “high,” commercial standards of conduct.
The Sales Relationship The Trusted Advisor Relationship
Product Manufacturers Client
Salesperson Fiduciary (Advisor)
Customer Product Manufacturers
II. Thoughts on the Present State of Affairs for American
Consumers of Financial Services and Products
We have a problem in America. The world is far more complex for individual investors today than it was just a generation ago. There exist a broader variety of investment products, including many types of pooled and/or hybrid products, employing a broad range of strategies.
This explosion of financial products has hampered the ability of plan sponsors and individual investors to sort through the many thousands of investment products to find those very few which best fit within the retirement plan or individual investor’s portfolios. Furthermore, as such investment vehicles have proliferated, plan sponsors and individual investors are challenged to discern an investment product’s true “total fees and costs,” investment characteristics, tax consequences, and risks. Simply put, retirement plan sponsors and their participants are at a vast disadvantage.
Information Asymmetry is Vast and will Never Disappear. Disparities in the availability of information, or its quality, or its understanding, lead to advantages by those endowed with the ability to decipher, discern and apply the information correctly. It must be recognized that efforts to enhance financial literacy, while always worthwhile and important, will never transform the ordinary American into a wholly knowledgeable consumer of financial products and services, just as we cannot expect the average American to perform brain surgery.
Given the sophisticated nature of modern financial markets and complex array of investment products, it is not just the uneducated that are placed at a substantial disadvantage – it is nearly all Americans. Hence, other means are necessary to negate advantages brought on by information asymmetry.
If Disclosures Alone were Sufficient, there would be no Need for the Fiduciary Standard of Conduct. Substantial academic research has revealed that disclosure is not effective as a means of dealing with the vast information asymmetry present in the world of financial services. Indeed, as the sophistication of our capital markets had increased, so has the knowledge gap between individual consumers and financial advisors.
Additionally, academic research now reveals that disclosures, while important, can lead to perverse results – i.e., worse advice is provided if the advisor, following disclosure, feels unconstrained by the application of the fiduciary standard of conduct.
The Need to Embrace Fiduciary Principles for Certain Actors. Because of the vast information asymmetry, and due to the many behavioral biases consumers possess which deter them from effectively spending the time and effort to read and understand mandated disclosures, there exists a great need for financial and investment advice. In such situations, our fellow citizens place trust and confidence in their personal financial advisor. It is right and just in such circumstances that broad fiduciary duties be applied to these financial intermediaries.
The absence of appropriate high ethical standards for all providers of personal financial advice, whether to plan sponsors, plan participants, IRA account owners, or others, is a glaring current gap in the financial services regulatory structure.
The Need to Ensure Distinctions between the Types of Financial Intermediaries. Individual consumers should be empowered to more easily identify the difference between the financial advice role (to which fiduciary status should attach) and the product marketing role (an arms-length relationship, to which only far lesser obligations, such as ensuring suitability, apply). Currently these roles are closely intertwined, and it is exceedingly difficult for consumers to distinguish between them (in part because the product marketer type of intermediary possesses no incentive to make that distinction clear). Our regulators possess the authority and the ability to ensure that consumers are not misled by the use of titles and designations, and they should ensure that all those who hold themselves out as trusted advisors – or who actually provide advisory services – are bound to act in the interests of their clients under the fiduciary standard of conduct.
III. The Application of Fiduciary Standards is
Consistent with Adam Smith’s Capitalism.
Adam Smith’s “Opportunism.” The undeniable truth is that capitalism runs on opportunism. In his landmark work, The Wealth of Nations, Adam Smith described an economic system based upon self-interest. This system, which later became known as capitalism, is described in this famous passage:
It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.
(Smith, p. 14, Modern Library edition, 1937).
As Adam Smith pointed out, capitalism has its positive effects. Actions based upon self-interest often lead to positive forces which benefit others or society at large. As capital is formed into an enterprise, jobs are created. Innovation is spurred forward, often leading to greater efficiencies in our society and enhancement of standards of living. As Adam Smith also noted, a person in the pursuit of his own interest “frequently promotes that of the society more effectually than when he really intends to promote it.” (Smith, p. 423)
Taken to excess, however, the self-interest which is so essential to capitalism can lead to opportunism, defined by Webster’s as the “practice of taking advantage of opportunities or circumstances often with little regard for principles or consequences.” A stronger word exists when consequences to others are ignored - “greed.” We might define “greed” in this context as the selfish desire for the pursuit of wealth in a manner which risks significant harm to others or to society at large. Whether through actions intentional or neglectful, when ignorance of material adverse consequences occurs, the term “greed” is rightfully applied.
Gordon Gekko in the film Wall Street, who famously declared that “Greed, for lack of a better word, is good,” got it wrong. Opportunism itself – acting in pursuit of one’s self-interest - does not always lead to greed. Rather, it is only when the pursuit of wealth causes significant undue harm to others does such activity arise to the level of greed, and in such circumstances the rise of greed is not “good.”
What Would Adam Smith Say Today? Even Adam Smith knew that constraints upon greed were required. While Adam Smith saw virtue in competition, he also recognized the dangers of the abuse of economic power in his warnings about combinations of merchants and large mercantilist corporations.
Adam Smith also recognized the necessity of professional standards of conduct, for he suggested qualifications “by instituting some sort of probation, even in the higher and more difficult sciences, to be undergone by every person before he was permitted to exercise any liberal profession, or before he could be received as a candidate for any honourable office or profit.” (Smith, p. 748, see also pp. 734-35.) As one commentator noted, “Smith embraces both the great society and the judicious hand of the paternalistic state.”[i]
In essence, long before many of the professions became separate, specialized callings, Adam Smith advanced the concepts of high conduct standards for those entrusted with other people’s money.
What would Adam Smith, if he were alive 250 years later, observe regarding the modern forces in our economy? He would likely opine, given the economic forces that led to the recent Great Recession, that unfettered capitalism can have many ill effects.
Indeed, Adam Smith would likely observe today that, for all of its virtues, capitalism has not recently been a very pretty sight. And he would likely proscribe many cures – including prudential regulation through the application of fiduciary principles of conduct upon providers of personalized investment advice to businessmen (retirement plan sponsors) and to individual American investors.
IV. The Application of Fiduciary Standards is
Pro-Small Business, Pro-Economic Growth,
& Will Nudge Income Tax Rates Lower
American business is the robust engine that drives the growth of our economy and delivers prosperity for all. An important component of the fuel for this engine is monetary capital.
However, the transmission system of our economic vehicle is failing, leading to far less progress in our path toward personal and U.S. economic growth. This transmission system is large, heavy and unwieldy; its sheer weight slows down our vehicle’s progress. Through costly investment products and hidden fees and costs, this transmission system unnecessarily diverts much of the power delivered by American business’ economic 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, with its faulty transmission, are both numerous and severe. The cost of capital to business is much higher than it should be, due to the exorbitant intermediation costs Wall Street imposes via the diversion of the returns of capital away from individual investors.
In fact, Wall Street currently diverts away from investors a third or more of the profits generated by American publicly traded companies. As Simon Johnson, former chief economist of the International Monetary Fund, in his seminal May 2009 article “The Quiet Coup,” observed: "From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits … In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent."[ii] More recently the financial services sector’s bite into corporate profits has been estimated at one-third or higher.[iii]
Investor Distrust = Less Capital
The siphoning of profits by Wall Street, away from the hands of individual investors, has led 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 finally discovering the high intermediation costs present, flee the capital markets altogether. (Many more would flee if they discovered all of the fees and costs they were paying, and realized the substantial effect such had on the growth or preservations of their nest eggs.) The effects of greed in the financial services industry can be profound and extremely harmful to America and its citizens. Participation in the capital markets fails when consumers deal with financial intermediaries who cannot be trusted.
As a result of the growth of investor distrust in financial intermediaries, the capital markets are further deprived of the capital that fuels American business and economic expansion, and the cost of capital rises yet again. Indeed, as high levels of distrust of financial services continue,[iv] the long-term viability of adequate capital formation within the United States is threatened, leading to greater reliance on infusions of capital from abroad. In essence, by not investing ourselves in our own economy, we are selling our bonds, corporate and other assets to investors abroad.[v]
Less Capital Formation = Reduced Economic Growth
It is well documented that public trust is positively correlated with economic growth.[vi]
Moreover, public trust is also correlated with participation by individual investors in the stock market.[vii] This is especially true for individual investors with low financial capabilities – those who in our society are in most need of financial advice; policies that affect trust in financial advice seem to be particularly effective for these investors.[viii]
The lack of trust in our financial system has potential long-range and severe adverse consequences for our capital markets and our economy. As stated by Prof. Ronald J. Columbo in a recent law review article: “Trust is a critical, if not the critical, ingredient to the success of the capital markets (and of the free market economy in general). As Alan Greenspan once remarked: ‘[O]ur market system depends critically on trust - trust in the word of our colleagues and trust in the word of those with whom we do business.’ From the inception of federal securities legislation in the 1930s, to the Sarbanes-Oxley Act of 2002, to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, it has long been understood that in the face of economic calamity, the restoration and/or preservation of trust – especially investor trust – is paramount in our financial institutions and markets.”[ix]
There is no doubt that “[t]rust is a critically important ingredient in the recipes for a successful economy and a well-functioning financial services industry. Due to scandals ranging in nature from massive incompetence to massive irresponsibility to massive fraud; investor trust is in shorter supply today than just a couple of years ago. This is troubling, and commentators, policymakers, and industry leaders have all recognized the need for trust's restoration ….”[x]
Less Trust = Less Use of Financial Advisors
The issue of investor trust in financial intermediaries does not just concern asset managers and Wall Street’s broker-dealer firms; it affects all investment advisers and financial advisors to individual clients. As Tamar Frankel, a leading scholar on U.S. fiduciary law, once observed: “I doubt whether investors will commit their valuable attention and time to judge the difference between honest and dishonest … financial intermediaries. I doubt whether investors will rely on advisors to make the distinction, once investors lose their trust in the market intermediaries. From the investor’s point of view, it is more efficient to withdraw their savings from the market.”[xi]
Impact on Americans’ Retirement Security
Even more severe are the long-term impacts of the high intermediation costs imposed by Wall Street firms on individual investors themselves. Individual Americans, 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 turn also leads to even lower levels of capital formation for American business.
It must be remembered that, fundamentally, an economy is based upon trust and faith. Continued betrayal of that trust by those who profess to “advise” upon qualified retirement plans and IRA accounts, while doing so under an inherently weak standard of conduct, only serves to destroy the essential trust required for capital formation, thereby undermining the very foundations of our modern economy.
Greater Burdens Placed Upon Governments – and Taxpayers
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, precisely at the time when our governments can ill afford further burdens and cannot solve these burdens through the issuance of debt.
Consequentially, higher tax rates become inevitable, for both American business and individual citizens alike. This in turn will consume an event greater share of the profits of the U.S. economy, leading to further economic stagnation, and perhaps to the permanent decline of America in the 21st Century and beyond.
The Fiscal and Talent Drains by Wall Street
The excessive rents extracted at multiple levels by Wall Street fuels excessive bonuses paid, in large part, to young investment bankers and to the brokers who push often-expensive investment products.
Wall Street also drains some of the best talent away from productive businesses, as well. Far too many of our graduates of math and engineering programs make their way to Wall Street. Other top students pursue finance majors rather than pursue studies in the STEM (science, technology, engineering and math) disciplines. This further distorts the labor market, as shortages of talent in our important information technology and engineering sectors continue. The financial services sector, rather than providing the grease for American's economic engine, instead has become a very thick sludge.
V. The U.S. Department of Labor’s Rulemaking Should Not Be Delayed.
Significant Changes Have Occurred Since 1975 in Retirement Plans and in the Complexity of Financial Products. The regulations issued by the U.S. Department of Labor in the mid-1970’s, applying ERISA, provided significant loopholes to the application of fiduciary status to providers of investment advice to qualified retirement plan sponsors and to plan participants. At the time these regulations were issued, most investments were held in pension plan accounts; 401(k) and 403(b) accounts were still in their infancy. No one in 1975 expected 401(k) and other defined contribution plans, as well as IRAs, to so greatly displace defined benefit plans.
Additionally, since the mid-1970’s there have been significant changes in the retirement plan community, with more complex investment products, transactions and services available to plans and IRA investors in the financial marketplace. At the end of 2012 there existed in the U.S. 16,380 mutual funds, closed-end funds, exchange-traded funds and unit investment trusts.[xii] Other “commingled funds,” variable annuity sub-accounts, REITs and other types of investment vehicles exist which are offered to retirement plan sponsors and IRA account owners. All of the foregoing creates a bewildering array of difficult-to-analyze, complex investment choices for plan sponsors and IRA account owners.
Small and Large Business Owners are at Risk under Current Regulations. Most owners of businesses, both large and small, seek to provide retirement plan accounts to their employees as an employee benefit. Yet, far too often these employers, who serve as plan sponsors (and hence fiduciaries), are besieged by non-fiduciary “advisors” who promote often costly investment products with conflicted advice. As a result, business owners increasingly find themselves liable for following the advice of these non-fiduciary “retirement plan consultants.”
The recent case of Tibble v. Edison, 2013 U.S. App. LEXIS 5663 (U.S. 9th Cir. 2013) provides an illustration. Edison, the employer, sponsored a 401(k) retirement plan for its workforce. After receiving consulting services from a large consulting firm in the retirement benefits industry, the plan sponsor chose mutual funds to include in the plan without considering lower-cost options. These mutual funds provided revenue-sharing payments (via 12b-1 fees) back to the large consulting firm, which served as plan administrator and record-keeper. The Court of Appeals held that the plan sponsor (employer) could not “uncritically adopt investment recommendations” recommended by the consulting firm.
In essence, plan sponsors, lacking the expertise to properly examine available investment options, need to turn to outside advisors. Yet, under current regulations, many of these outside consultants offer investment recommendations under a suitability standard, not the fiduciary standard of conduct. This often-conflicted advice turns out to be – years later – inappropriate, leading to substantial liability to the employer (plan sponsor). However, no liability usually attaches to the non-fiduciary “retirement plan consultant.”
In essence, American business owners are put at risk under the current DOL rules. The DOL’s new “definition of fiduciary” rule re-proposal will correct this situation by requiring that nearly all providers of investment advice to plan sponsors be fiduciaries themselves. This is just common sense … employers acting as plan sponsors and fiduciaries should receive the investment advice they need from other fiduciaries, in order to better ensure the business owners’ adherence to their own fiduciary obligations.
The Authority for the Application of the Fiduciary Definition to IRA Accounts. The U.S. Department of Labor possesses the authority under existing law to apply its new definition of fiduciary to IRA accounts. Section 4975(e)(3) of the Internal Revenue Code of 1986, as amended (Code) provides a similar definition of the term "fiduciary" for purposes of Code section 4975 (IRAs). However, in 1975, shortly after ERISA was enacted, the Department issued a regulation, at 29 CFR 2510.3-21(c), that defines the circumstances under which a person renders “investment advice” to an employee benefit plan within the meaning of section 3(21)(A)(ii) of ERISA. The Department of Treasury issued a virtually identical regulation, at 26 CFR 54.4975-9(c), that interprets Code section 4975(e)(3). 40 FR 50840 (Oct. 31, 1975). Under section 102 of Reorganization Plan No. 4 of 1978, 5 U.S.C. App. 1 (1996), the authority of the Secretary of the Treasury to interpret section 4975 of the Code was transferred, with certain exceptions not herein relevant, to the Secretary of Labor.
The Need to Apply ERISA’s Fiduciary Standard to Plan Distributions and to IRA Accounts.
We believe that it is essential for the DOL re-proposed regulation to include investment adviser activities that touch the distribution of assets from all forms of employer-sponsored retirement plans. The distribution stage and process is critical in the cycle of plan participant events in that decisions made with respect to the timing and manner of plan distributions will often determine the efficacy of a working lifetime of retirement savings. In short, a plan participant is in an extremely critical position at distribution decision-making time regarding how to take distributions from his or her retirement plan. Decisions made at that time are often effectively irreversible, at least in a practical sense, on account of the fact that tax consequences and transaction costs generally make it impractical even to consider backing up the distribution election.
Most IRA assets today are attributable to rollovers from retirement plans. The statutory definition of fiduciary investment advice is the same for IRAs and retirement plans. The DOL’s proposed regulation will sensibly set forth a single consistent definition, addressing practical differences between the two by tailoring exemptions accordingly.
Given that IRA holders have more choice than most retirement plan participants as to the choice of investment advice provider and investment products, they also require more protection. Unlike plan participants, IRA holders do not have the benefit of a plan fiduciary, usually their employer, to represent their interests in dealing with advisers.
Without the imposition of fiduciary standards upon IRA accounts, there would exist a substantial economic incentive for brokers to drive plan participants away from qualified retirement accounts (if governed by the protections of ERISA’s fiduciary standard) into IRA accounts (if not governed by such protections).
Accordingly, it is essential for the IRA account holder to have the protection of ERISA’s fiduciary duty cloak attaching to the investment adviser who undertakes to guide a participant at the time of a distribution decision and for the investment of IRA account funds.
VI. The U.S. Securities and Exchange Commission’s
Rulemaking Necessarily Follows.
The SEC Has Long Opined that Brokers Providing Personalized Investment Advice Are Fiduciaries – This Is Not New!
The U.S. Securities and Exchange Commission (SEC) repeatedly opined, for much of the 20th Century, that brokers were often fiduciaries. In 1963 The SEC noted that it “has held that where a relationship of trust and confidence has been developed between a broker-dealer and his customer so that the customer relies on his advice, a fiduciary relationship exists, imposing a particular duty to act in the customer’s best interests and to disclose any interest the broker-dealer may have in transactions he effects for his customer … [broker-dealer advertising] may create an atmosphere of trust and confidence, encouraging full reliance on broker-dealers and their registered representatives as professional advisers in situations where such reliance is not merited, and obscuring the merchandising aspects of the retail securities business … Where the relationship between the customer and broker is such that the former relies in whole or in part on the advice and recommendations of the latter, the salesman is, in effect, an investment adviser, and some of the aspects of a fiduciary relationship arise between the parties.”[xiii]
Pre-1940: Brokers Were Fiduciaries When
Providing Personalized Investment Advice.
At the beginning of the 20th Century, in “the United States the business of buying and selling stocks and other securities [was] generally transacted by Brokers for a commission agreed upon or regulated by the usages of a stock exchange.”[xiv] Indicative of the known distinctions between brokers and dealers, an early Indiana law provided for the licensing of brokers but not for “persons dealing in stocks, etc., on their own account.”[xv]
During the early part of the 20th Century, stockbrokers were known to possess duties akin to those of trustees, including the duty of utmost good faith and the avoidance of receipt of hidden forms of compensation. As stated in the 1905 edition of an early treatise:
He is a Broker because he has no interest in the transaction, except to the extent of his commissions; he is a pledgee, in that he holds the stock, etc. as security for the repayment of the money he advances in its purchase; so he is a trustee, for the law charges him with the utmost honesty and good faith in his transactions; and whatever benefit arises therefrom enures to the cestui que trust.[xvi]
By the early 1930’s, the fiduciary duties of brokers (as opposed to dealers[xvii]) were widely known. As summarized by Cheryl Goss Weiss, in contrasting the duties of an broker vis-à-vis a dealer:
By the early twentieth century, the body of common law governing brokers as agents was well developed. The broker, acting as an agent, was held to a fiduciary standard and was prohibited from self-dealing, acting for conflicting interests, bucketing orders, trading against customer orders, obtaining secret profits, and hypothecating customers' securities in excessive amounts -- all familiar concepts under modern securities law. Under common law, however, a broker acting as principal for his own account, such as a dealer or other vendor, was by definition not an agent and owed no fiduciary duty to the customer. The parties, acting principal to principal as buyer and seller, were regarded as being in an adverse contractual relationship in which agency principles did not apply.[xviii] [Emphasis added.]
The fact that stockbrokers were known to be fiduciaries at an early time in the history of the securities industry (when acting as brokers and not acting as dealers) should not come as a surprise. To a degree it is simply an extension of the laws of agency. One might then surmise that, if the broker provides personalized investment advice, then a logical extension of the principles of agency dictates that the fiduciary duties of the agent also extend to those advisory functions, as the scope of the agency has been thus expanded.[xix]
While agency law provides one basis for the imposition of broad fiduciary duties upon brokers, early court cases confirmed the existence of broad fiduciary duties upon brokers in situations where brokers possessed relationships of trust and confidence with their clients. For example, in the 1934 case of Birch v. Arnold,[xx] in a case which did not appear to involve the exercise of discretion by a broker, the relationship between a client and her stockbroker was found to be a fiduciary one, as it was a relationship based upon trust and confidence. As the court stated:
She had great confidence in his honesty, business ability, skill and experience in investments, and his general business capacity; that she trusted him; that he had influence with her in advising her as to investments; that she was ignorant of the commercial value of the securities he talked to her about; and that she had come to believe that he was very friendly with her and interested in helping her. He expected and invited her to have absolute confidence in him, and gave her to understand that she might safely apply to him for advice and counsel as to investments … She unquestionably had it in her power to give orders to the defendants which the defendants would have had to obey. In fact, however, every investment and every sale she made was made by her in reliance on the statements and advice of Arnold and she really exercised no independent judgment whatever. She relied wholly on him.[xxi] [Emphasis added.]
In this case the Massachusetts Supreme Court held that, in these circumstances, facts “conclusively show that the relationship was one of trust and confidence”[xxii] and therefore the broker could not make a secret profit from the transactions for which the advice was provided.
In another early (1938) case the broker’s customer, “untrained in business – she had been a domestic servant for years – was susceptible to the defendant's influence, trusted him implicitly ….” The court stated: “We are persuaded from the facts of the case that a trust relationship existed between the parties … The [broker] argues that he was not a trustee but a broker only. This argument finds little to support it in the testimony. He assumed the role of financial guide and the law imposed upon him the duty to deal fairly with the complainant even to the point of subordinating his own interest to hers. This he did not do. He risked the money she entrusted to him in making a market for hazardous securities. He failed to inform her of material facts affecting her interest regarding the securities purchased. He consciously violated his agreement to maintain her income, and all the while profited personally at the complainant's expense. Even as agent he could not gain advantage for himself to the detriment of his principal.”[xxiii] [Emphasis added.]
Hence, while under the Securities Exchange Act of 1934 and FINRA rules, broker-dealers are not subject to an explicit fiduciary standard, in private litigation between customers and brokers and in some arbitrations fiduciary standards are applied when a relationship of trust and confidence is found. As noted in a recent law review article, “Notwithstanding the absence of an explicit fiduciary standard, broker-dealers are subject to substantially similar requirements when they act as more than mere order takers for their customers’ transactions.”[xxiv] This appears in accord with the original intent of Franklin D. Roosevelt and the United State Congress: “Roosevelt and Congress used the 1934 Exchange Act to raise the standard of professional conduct in the securities industry from the standardless principle of caveat emptor to a ‘clearer understanding of the ancient truth’ that brokers managing ‘other people's money’ should be subject to professional trustee duties.”[xxv]
Post-1940 Authorities: Brokers Providing Personalized Investment Advice are Fiduciaries.
The fact that broker-dealers may, when providing more than trade execution services to individual investors, possess broad fiduciary duties was confirmed by the SEC Staff Study on Investment Advisers and Broker-Dealers (As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act) (Jan. 2011), which stated: “Broker-dealers that do business with the public generally must become members of FINRA. Under the antifraud provisions of the federal securities laws and SRO rules, including SRO rules relating to just and equitable principles of trade and high standards of commercial honor, broker-dealers are required to deal fairly with their customers. While broker-dealers are generally not subject to a fiduciary duty under the federal securities laws, courts have found broker-dealers to have a fiduciary duty under certain circumstances … This duty may arise under state common law, which varies by state. Generally, broker-dealers that exercise discretion or control over customer assets, or have a relationship of trust and confidence with their customers, owe customers a fiduciary duty similar to that of investment advisers.”[xxvi]
What about the effect of the Investment Advisers Act of 1940 (“Advisers Act”)? At the time of its enactment it was designed to apply to investment counsel, a relatively new type of professional whom was paid directly by the customers for his or her advice. It required investment counsel (i.e., investment advisers) to register with the SEC. Moreover, Section 206 of the Advisers Act imposed a fiduciary duty upon investment advisers. [The imposition of the fiduciary standard by the Advisers Act was well- known at the time of its enactment; the U.S. Supreme Court’s 1963 SEC vs. Capital Gains decision only confirmed this long-held view.]
Brokers were exempted from the registration requirements of the Advisers Act, provided that their investment advice remained “solely incidental” to the brokerage transactions and they received no “special compensation.” But here’s the key – the Advisers Act never stated that brokers providing personalized investment advice (whether “solely incidental” or otherwise) were not fiduciaries. The law applicable to brokers remained the same.
Indeed, even after the passage of the Investment Advisers Act, the National Association of Securities Dealers (NASD, now known as FINRA), confirmed the existence of high, fiduciary standards of conduct for brokers in the very early days of FINRA’s existence. In 1940, in only the second newsletter for its members issued by NASD, it unequivocally pronounced that brokers were fiduciaries: “Essentially, a broker or agent is a fiduciary and he thus stands in a position of trust and confidence with respect to his customer or principal. He must at all times, therefore, think and act as a fiduciary. He owest his customer or principal complete obedience, complete loyalty, and the exercise of his unbiased interest. The law will not permit a broker or agent to put himself in a position where he can be influenced by any considerations other than those to the best interests of his customer or principal … A broker may not in any way, nor in any amount, make a secret profit … his commission, if any, for services rendered … under the Rules of the Association must be a fair commission under all the relevant circumstances.”[xxvii]
A little more than a year later, in discussing the decisions of two cases, the NASD wrote that it was “worth quoting” statements from the opinions: “In relation to the question of the capacity in which a broker-dealer acts, the opinion quotes from the Restatement of the law of Agency: ‘The understanding that one is to act primarily for the benefit of another is often the determinative feature in distinguishing the agency relationship from others. *** The name which the parties give the relationship is not determinative.’ And again: ‘An agency may, of course, arise out of correspondence and a course of conduct between the parties, despite a subsequent allegation that the parties acted as principals.’”[xxviii]
The Dodd-Frank Act: An Elegant Return to Fiduciary Principles.
Through the enactment of the Dodd-Frank Act, the U.S. Congress has rightfully authorized the U.S. Securities and Exchange Commission to consider the application of fiduciary standards of conduct upon broker-dealer firms and their registered representatives who provide personalized investment advice to retail consumers. In essence, the U.S. Congress has enabled the SEC to conform brokerage practices involving the delivery of personalized investment advice, which have evolved over the course of the last few decades, to fiduciary principles that have been applied by the SEC and the courts throughout the past century.
The need for brokers to adapt their business practices arises because brokers have changed the nature of their business to provide personalized investment advice and to form relationships of trust and confidence with their customers. During the course of the 20th Century brokers have shifted from the role of merchandizer, in which they used the terms “registered representative” or “sales representative” to describe themselves, to the role of trusted advisor using titles[xxix] denoting relationships of trust and confidence and employing trust-based sales techniques.[xxx] Having transformed their businesses to incorporate the delivery of financial[xxxi] and investment advice, broker-dealers should be willing to assume the fiduciary duties and obligations which adhere as a result.
SEC’s Coordination with the Department of Labor.
The DOL and SEC have stated that they are coordinating their efforts, including sharing economic analysis regarding the potential application of the fiduciary standard of conduct.
Given that the DOL’s “sole interests” fiduciary standard is stricter, it seems altogether proper that the DOL proceed to enact rules first. In this manner, the SEC can more fully examine the impact of whether, and how, to apply fiduciary standards under a “best interests” standard. The SEC will be afforded to opportunity to observe the manner in which firms adapt to ERISA’s strict “sole interests” fiduciary standard, in order to ensure its own contemplative rule-making.
VII. Repudiating Several Myths Promoted by Wall Street
in Opposition to These Rulemaking Efforts.
Myth #1: Commissions are not Prohibited by the Application of Fiduciary Standards.
The receipt of a commission, as was the typical manner in which brokers were compensated for much of the 20th Century, is not prohibited by imposition of fiduciary status.
While other countries (notably Australia and the United Kingdom) have recently chosen to substantially limit the circumstances in which commissions can be received by financial services providers, Congress has not expressly provided authority to either the DOL or to the SEC to eliminate commission-based compensation.
However, difficulties can arise under the fiduciary standard when compensation varies, or is differential, with the advice being given. In other words, if a fiduciary advisor recommends an investment product which pays a higher commission than another similar product available to that fiduciary, then a heavy burden is placed on the fiduciary to justify this type of self-dealing activity.
Under the fiduciary standard, providers of advice to retirement plan sponsors and their participants can continue to charge commissions. Commission-based compensation is not, in and by itself, contrary to fiduciary principles. However, a cautious broker would ensure that the commissions received by the broker do not vary with the advice being given and is fully disclosed and agreed-to-in-advance by the client. Moreover, the fiduciary should ensure that the total compensation received by the advisor is reasonable for the services provided.
The DOL has expressly stated that it does not propose to eliminate commission-based fee arrangements. Moreover, the DOL has stated that it will consider exemptions for certain revenue-sharing arrangements which are beneficial to plan participants and IRA account owners. The Dodd-Frank Act expressly instructs the SEC to permit commission-based compensation under the fiduciary standard.
Myth #2: “The Application of the Fiduciary Standard will Result in Higher Fees and Costs for our Fellow Americans”
Many times the broker-dealer industry has opined that commissioned-based accounts, rather than advisory accounts, are less costly to consumers. They argue that the application of the fiduciary standard will raise fees and costs, which in turn will be borne by investors. In reality, the exact opposite effect occurs – i.e., fees and costs are dramatically lowered.
Unlike (typically non-fiduciary) registered representatives of broker-dealer firms and insurance agents of insurance companies, fiduciary advisors possess the duty to ensure that the total fees and costs associated with any investment product, and with the receipt of investment advice, remain reasonable.
Studies proffered by opponents to the fiduciary standard often assume a 1% annual advisory fee is imposed; yet, most participants in retirement plans enjoy fees which are far lower. These studies also ignore many of the hidden fees and costs of investment products. Only fiduciary advisors must consider such “hidden fees and costs” when undertaking due diligence prior to recommending an investment product to a client. Even if a 1% annual advisory fee is imposed, it has been the experience of many fiduciary advisors that the total fees and costs paid by clients of fiduciaries are 30% to 70% lower than the total fees and costs borne by customers of brokers under the lower suitability standard.
Additionally, these studies ignore the growing provision of financial and investment advice, even to small accounts, for a very low (often 0.25% or less) advisory fee (in which low-cost passive mutual funds and/or index funds and/or ETFs are recommended). Also, nearly 41% of fiduciary investment advisers offer fixed fee arrangements to their clients, and nearly 28% offer hourly fees to their clients.[xxxii]
Moreover, the studies offered by opponents to DOL rule-making efforts ignore the fact that 401(k), 403(b) and other qualified retirement plan accounts enjoy economies of scale. As retirement plan sponsors select, with the aid of fiduciary advisors, available investment options, and the services to be provided to plan participants, they can ensure very low levels of fees and costs for all plan participants. In the realm of fiduciary retirement plan advisors, annual fees are being driven ever-lower, and even flat fee and hourly fee business models are emerging to serve business owners (plan sponsors) both large and small.
Additionally, it should be noted that the application of the fiduciary standard does not prohibit commission-based compensation. For some investors, especially those who do not expect to engage in frequent trading, a commission-based account may be in their best interests. The rulemaking authority granted to the SEC in Section 913 of the Dodd-Frank Act recognizes as much by providing that “[t]he receipt of compensation based on commission or other standard compensation for the sale of securities shall not, in and of itself, be considered a violation of” the standard of conduct applicable.
Ensuring reasonableness of fees and costs is important. Substantial academic research compels the conclusion that the higher the fees and costs associated with an investment product, the lower the returns for the investor.
Applying the fiduciary standard will greatly lower the extraction of excessive rents which occurs under the low suitability standard applicable to non-fiduciary providers of investment advice.
Myth #3: Small Investors Cannot Be Served Under the Fiduciary Standard.
In a recent interview, a lawyer representing Wall Street firms cautioned that applying a fiduciary duty to brokers who sell IRAs could force them out of the market and leave investors without guidance. The lawyer stated: “We’re not trying to tilt the playing field … The objective is to provide the best information possible so that [plan] participants can make the best decision. But if there is fiduciary liability associated with the provision of information to participants, that information will dry up, which is exactly the opposite of what the GAO is recommending.”[xxxiii]
Wall Street’s ongoing threat to abandon small investors has been made before. For example, in 2005 SIFMA argued that should discretionary brokerage accounts be subjected to the fiduciary requirements imposed by the Advisers Act, such a change “would likely work to the disadvantage of customers, who, as a result, could face increased costs or who choose to lose their chosen forms of brokerage accounts to the extent their broker-dealer determined not to continue to provide these forms of accounts rather than effect such conversion.”[xxxiv] Yet, after the application of the fiduciary standard to discretionary accounts, and to all fee-based accounts (following the 2007 court decision which overturned the SEC’s authorization of fee-based brokerage accounts), there was no exodus from the marketplace. Instead, most discretionary and fee-based brokerage accounts were converted to advisory accounts, and most brokers and their registered representatives added registrations to also be investment advisers and investment adviser representatives. Indeed, in early 2011 SEC staff noted: “As of mid-October 2010, approximately 88% of investment adviser representatives were also registered representatives of a FINRA registered broker-dealer.”[xxxv]
Wall Street's hollow threats and attempts at obfuscation also ignore fundamental economic principles. In 1970, Nobel-Prize winning economist George A. Akerloff, in his classic thesis, The Market for "Lemons": Quality Uncertainty and the Market Mechanism, The Quarterly Journal of Economics, Vol. 84, No. 3 (Aug., 1970) demonstrated how in situations of asymmetric information (where the seller has information about product quality unavailable to the buyer, such as is nearly always the case in the complex world of investments), "dishonest dealings tend to drive honest dealings out of the market." As George Akerloff explained: “[T]he presence of people who wish to pawn bad wares as good wares tends to drive out the legitimate business. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.” Akerloff at p. 495.
In other words, as long as Wall Street is able to siphon excessive rents from investors, through conflict-ridden sales practices resulting in higher costs for individual investors (and lower returns), the business model Wall Street seeks to preserve will continue to attract bad actors. It's only human nature. "Join our firm and your compensation potential is virtually unlimited" is Wall Street's "promise" - ignoring of course the requirement that each new employee is required to sell expensive products without regard to whether the product is in the customer’s best interests.
What will happen if the fiduciary standard is applied to the delivery of advice to all plan sponsors, plan participants, and individual investors in IRA and other accounts, through potential DOL and SEC rulemaking? Economic principles and common-sense logic indicate that three dramatic developments will occur.
First, once individual investors know that they can trust the words coming out of the mouths of their financial advisors, the demand for financial advice will soar. Currently far too many individuals distrust Wall Street, and - given their inability to discern between high-quality, fiduciary advisors and low-quality, non-fiduciary advisors - they simply choose to stay away from all advisors. In essence, the adverse smell of non-fiduciary advisors infects the entire landscape of financial advisors today; this smell will disappear if the fiduciary standard is properly applied.
Second, we will see a surge in the availability (supply) of fiduciary-bound financial and investment advice. More and more students and career-changers will be attracted to a true profession in which they sit on the same side of the table as the client and assist the client in achieving their hopes and dreams. These advisors receive not just professional compensation from providing expert, trusted advice, but they also receive the immense joy from assisting their fellow Americans in a manner consistent with fiduciary obligations.
Third, the quality and quantity of advice will also soar. Currently Wall Street's legions are primarily "asset gatherers" and product salespersons. Much of the training provided is on how to sell - i.e., to close the deal. Fiduciary financial advisors, on the other hand, bound by fiduciary standards, are required to exercise due care in all aspects of the advice they provide. Clients will receive better budgeting advice, increased levels of savings, and better investment advice as increased due diligence is required of all advisors.
I can hear those on Wall Street bemoan such logic ... "Surely, you jest," they would say. "No advisor can afford to serve small clients, without selling expensive products to them!" Yet, we ask, what is the compensation paid on a Class A mutual fund, for a client who has only $20,000 to invest? 5.75%, plus a small (0.25% or less, typically) trailing 12b-1 fee (in theory, in perpetuity) - in addition to possible payment for shelf space, soft dollars, and other forms of hidden compensation. In this example, a Wall Street firm (and its representative) would receive a $1,150 sales load, plus more fees (0.25% a year, plus possible other payments) over time. There are many, many hourly-based and flat fee fiduciary advisors who would provide a greater level of financial advice for the same or lower fees. Moreover, within the fiduciary investment adviser community there has been an explosion of investment advisory platforms in which small accounts are served for very low fixed fees, low percentage fees, or low hourly fees.
Let us permit fiduciary advisors to be paid professional-level compensation, for truly expert advice which is in the client's best interest. Wall Street may be unable to extract enough rents for its current high-rent-extraction business model to survive under the fiduciary standard, but there are plenty of independent, objective, trusted professionals who will take Wall Street's place, and who will do a far better job for the individual investor in the process while receiving professional-level compensation.
What is Wall Street really stating? “We can't fleece small investors if a fiduciary standard is applied.” Stated differently, Wall Street is actually advocating as follows: “Our business model is only highly profitable for us if we can push expensive products and other wares under the weak 'suitability' standard, which permits us to recommend the highest-cost products for our client, even if our customers are substantially disadvantaged by same.”
Adopting a strong and uniform fiduciary standard of conduct will also make all fees and costs, as well as compensation, more transparent. Such transparency is not fully required under the suitability standard at present. The effect of such transparency is a greater ability by consumers to compare product fees and costs, and methods and amounts of compensation, leading to more effective competition in the marketplace.
Wall Street repeatedly warns that applying the fiduciary standard would leave small investors without the ability to access advice. Yet, there is no credible evidence to back up such a position. In fact, the reverse is true – with the application of the fiduciary standard more and better advice will result for plan participants and IRA and other brokerage account owners.
Myth #4: Applying the Fiduciary Standard Will Unduly Limit “Choice” for Plan Sponsors and Investors.
In his February 3, 2011 comment letter to EBSA, SIFMA CEO Timothy Ryan, Jr. asserted: “The proposed regulation will limit access to markets, investment products and service providers. Limited availability and decreased competition will result in higher costs and spreads and adversely impact market efficiency. Service providers and counterparties that choose to continue to provide services to, and trade with, plans and IRAs will incur a multitude of new costs, much of which will be passed on to clients.” Specifically, SIFMA further noted: “Investment options will be curtailed. Plans will be prohibited from engaging in swaps, restricted in their use of custody, lending, cash management, and futures strategies, and limited in their access to alternatives.”
The “limited choice” argument refuses to properly recognize the positive effect of the application of the fiduciary standard of conduct. The fiduciary standard, in essence, does constrain the actions of those providing advisory services and it may prohibit recommending certain products or services to a client. This is because the fiduciary standard operates as a restraint on self-serving conduct. The fiduciary standard constrains greed.
However, there is nothing in the adoption of a strong fiduciary standard that necessarily results in any restriction in access to corporate or municipal bonds, or to participation in public offerings, for retail customers. In a fiduciary relationship, full disclosure to the client must occur of the compensation received by the fiduciary, and of any other conflict of interest that may be present. Also, the fiduciary recommending a principal trade must conclude that the principal trade is in the clients’ best interests, as may well be the case in specific situations. These requirements do not negate the ability to engage in principal trades with clients, when it is appropriate for the client.
Myth #5: The Fiduciary Standard Could “Disrupt Capital Markets” or “Adversely Affect the Economy.”
In fact, the reverse is true. The current system of costly securities underwriting and investment product sales, operating largely under a suitability standard, results in distortions in the capital markets system. Economists generally believe that the current financial structure results in wholesale misappropriations of needed capital.[xxxvi]
Evidence of the harm upon the U.S. economy caused by the low “suitability” standard is quite apparent. For example, witness the flow of investor’s funds into heavily hyped mortgage-backed securities in recent years, leading in large part to the most recent economic “Great Recession.” If most individual investors were represented by fiduciary investment advisers, rather than served by broker-dealers selling manufactured products out of their own inventories, no doubt the risks of such mortgage-backed securities would have earlier become more well-known. Fiduciary investment advisers possess a duty to discern risks of the investment products they recommend. The 2008-9 Great Recession may have been alleviated, if not averted in its entirety, had fiduciary standards been applied by the DOL and the SEC to the delivery of all personalized investment advice during the past decade.
Moreover, due in large part to the substantial distrust by individual investors of those registered representatives and insurance agents who pose as “financial consultants” and “financial advisors,” less capital is available presently to fuel economic growth. It is well documented that public trust is positively correlated with economic growth.[xxxvii]
It must be remembered that, fundamentally, an economy is based upon trust and faith. Continued betrayal of that trust by those who profess to “advise” upon qualified retirement plans, IRAs and other accounts, while doing so under a non-fiduciary standard, only serves to destroy the essential trust required for capital formation, thereby undermining the very foundations of our modern economy.
The “Retail Investor Protection Act” (RIPA) and its cost‐benefit provisions would improperly constrain the SEC’s ability to do what Congress asked it to do by authorizing rulemaking under Section 913 of the Dodd‐Frank Act. Section 913 commanded the SEC to consider whether broker‐dealers, like investment advisers, should be subject to a “best interest of the customer” standard when providing personalized investment advice to retail customers. The Act would substantially impede the SEC’s ability to analyze this option.
[And now, Senator Hatch's proposal would gut the DOL's rule-making processes and delay rule-making efforts by both the SEC and the DOL.]
The interagency coordination of rulemaking provision set forth by RIPA appears to reflect an ultimate goal of preventing the Department of Labor from moving forward with a fiduciary proposal that may impose more stringent requirements than SEC rules may impose. However, it is ERISA itself, created by the U.S. Congress, which mandates more stringent requirements for retirement plan investments. It is altogether logical and appropriate that the DOL proceed to propose its rule first, given the higher “sole interests” fiduciary standard imposed by ERISA; this will permit the SEC to give proper and due consideration to the potential application of the fiduciary standard to all other types of brokerage accounts, with greater ability by the SEC to provide guidance to those advisers and brokers who provide personalized investment advice.
The application of the fiduciary standard to the delivery of personalized investment advice is nothing new and has existed for over a century. Yet, in recent decades broker-dealer practices have changed. And the landscape of financial products has grown incredibly more complex just as individual Americans have possessed greater responsibility to invest for their retirement and other financial needs.
Substantial benefits flow from the application of the fiduciary standard for our fellow Americans, and America’s future economic prosperity is better assured. Accordingly, we request that Congress permit SEC and DOL rule-making to proceed, and that the RIPA not be enacted.We request this on behalf of small business owners, U.S. taxpayers, and all of our fellow American individual investors. Congress - and the future of the U.S., and your fellow citizens, is in your hands.
[i] Shearmur, Jeremy and Klein, Daniel B. B., “Good Conduct in a Great Society: Adam Smith and the Role of Reputation.” D.B Klein, Reputation: Studies In The Voluntary Elicitation Of Good Conduct, pp. 29-45, University of Michigan Press (1997).
[ii] Simon Johnson’s complete article is available at http://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/307364/?single_page=true. See also Simon Johnson, 2011, 3 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Vintage Press.
[iii] “Finance, which accounts for only about 8% of GDP, reaps about a third of all profits.” Noah Smith, http://noahpinionblog.blogspot.com/2013/02/finance-has-always-been-more-profitable.html. See also James Kwak, Why Is Finance So Big? (Feb. 29, 2012): “Many people have noted that the financial sector has been getting bigger over the past thirty years, whether you look at its share of GDP or of profits. The common defense of the financial sector is that this is a good thing: if finance is becoming a larger part of the economy, that’s because the rest of the economy is demanding financial services, and hence growth in finance helps overall economic growth. But is that true? … the per-unit cost of financial intermediation has been going up for the past few decades: that is, the financial sector is becoming less efficient rather than more.” Available at http://baselinescenario.com/2012/02/29/why-is-finance-so-big/.
[iv] The consulting firm Edelman Berland publishes a “Trust Barometer” each year that surveys various issues dealing with trust in both the U.S. and globally. One question posed is, “How much do you trust businesses in each of the following industries to do what is right?” Globally, the two industries listed at the bottom of the list are “Financial services” and “Banks” - both at 50% in the 2013 survey. 2013 Edelman Trust Barometer Executive Summary, available at http://trust.edelman.com/trust-download/executive-summary/.
[v] “Foreign investors now hold slightly less than 55% of the publicly held and publicly traded U.S. Treasury securities, 26% of corporate bonds, and about 12% of U.S. corporate stocks. The large foreign accumulation of U.S. securities has spurred some observers to argue that this foreign presence in U.S. financial markets increases the risk of a financial crisis, whether as a result of the uncoordinated actions of market participants or by a coordinated withdrawal from U.S. financial markets by foreign investors for economic or political reasons.” James K. Jackson, “Foreign Ownership of U.S. Financial Assets: Implications of a Withdrawal” (Congressional Research Service, April 8, 2013), p.1.
[vi] Putnam, R., 1993, Making Democracy Work: Civic Traditions in Modern Italy, Princeton University Press, Princeton, NJ.; La Porta R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny, 1997, “Trust in Large Organizations,” American Economic Review, 87, 333-338. In an influential paper, Knack and Keefer found that a country's level of trust is indeed correlated with its rate of growth. Knack, S. and Keefer, P. (1996). "Does social capital have an economic payoff?: A cross country investigation," The Quarterly Journal of Economics, vol 112, p.p 1251. See also Zak, P., and S. Knack, 2001, “Trust and Growth,” The Economic Journal, 111, 295-321.
[vii] Guiso, L., P. Sapienza, and L. Zingales, 2007, “Trusting the Stock Market,” Working Paper, University of Chicago.
[ix] Ronald J. Colombo, Trust and the Reform of Securities Regulation, 35 Del. J. Corp. L. 829 (2010).
[x] Id. at 875. Prof. Colombo further observed: “Increased regulation of broker-dealers is likely to do little harm, as it is unclear whether sufficient room for high-quality, affective/generalized trust exists here in the first place. And if, in the twenty- first century, the brokerage industry relies upon primarily cognitive and specific trust (due to increased movement toward the discount-broker business model), such increased regulation could be beneficial.” Id. at 876. Prof. Colombo explained the concept of cognitive trust: “Reliance and voluntary exposure to vulnerability stemming from cognitive trust is not based upon emotions or norms, but rather ‘upon a cost-benefit analysis of the act of trusting someone.’ For this reason, Williamson rejects even calling such reliance ‘trust.’ To him, such reliance is a form of calculativeness, which serves to economize on the scarcity of one's mental energies and time. The potential vulnerabilities accepted are not due to ‘trust,’ but to rational risk management - to the fact that ‘the expected gain from placing oneself at risk to another is positive.’” Id. at 836.
[xi] Tamar Frankel, “Regulation and Investors’ Trust In The Securities Markets,” 68 Brook. L. Rev. 439, 448 (2002).
[xiii] 1963 SEC Special Study on the Securities Markets, citing various SEC Releases.
[xiv] John R. Dos Passos, A Treatise of the Law of Stock-Brokers and Stock-Exchanges (Banks Law Publishing Co., 1905), Vol. 1, at p. 173.
[xv] Id., at Vol. 1, p.176, citing Banta v. Chicago, 172 Ill. 201.
[xvi] Id. at at Vol. 1, pp. 180-1.
[xvii] As was well-known in the early case law: "The principle is undeniable that an agent to sell cannot sell to himself, for the obvious reason that the relations of agent and purchaser are inconsistent, and such a transaction will be set aside without proof of fraud.” Porter v. Wormser , 94 N. Y. 431, 447 (1884). The Investment Advisers Act of 1940 provided a specific exception to this legal principle for investment advisers who engaged in principle trades, but requiring as a safeguard in-advance disclosures and the consent of the client.
[xviii] Cheryl Goss Weiss, A Review of the Historic Foundations of Broker-Dealer Liability for Breach of Fiduciary Duty, 23 J. CORP. L. 65, 66 (1997) (providing a summary of the historical development of brokers and dealers before the ’33 and ’34 securities acts).
[xix] See RESTATEMENT (THIRD) OF AGENCY § 1.01 cmt. e (2006) (“Any agent has power over the principal’s interests to a greater or lesser degree. This determines the scope in which fiduciary duty operates.”).
[xx] Birch v. Arnold, 88 Mass. 125; 192 N.E. 591; 1934 Mass. LEXIS 1249 (Mass. 1934).
[xxii] Birch v. Arnold, citing Reed v. A. E. Little Co., 256 Mass. 442, 152 N.E. 918, and Wendt v. Fischer, 243 N.Y. 439, 443, 444, 154 N.E. 303.
[xxiii] Norris v. Beyer, 124 N.J. Eq. 284; 1 A.2d 460 (1938).
[xxiv] Hazen, Thomas Lee, Stock Broker Fiduciary Duties and the Impact of the Dodd-Frank Act. North Carolina Banking Institute, Vol. 15, 2011; UNC Legal Studies Research Paper No. 1767564. Available at SSRN: http://ssrn.com/abstract=1767564. See also Rhoades, Ron A., “Shhh!!! Brokers Are (Already) Fiduciaries ... Part 1: The Early Days,” available at http://scholarfp.blogspot.com/2013/04/shhh-brokers-are-already-fiduciaries.html
[xxv] Matthew P. Allen, A Lesson from History, Roosevelt to Obama - The Evolution of Broker-Dealer Regulation: From Self-Regulation, Arbitration, and Suitability to Federal Regulation, Litigation, and Fiduciary Duty, Entrepreneurial Bus. Law. J. (2010), at p. 20, citing Steven A. Ramirez, The Professional Obligations ofSecurities Brokers Under Federal Law: An Antidote for Bubbles?, 70 U. Cin. L. Rev. 527 (2002), at p. 534 (quoting H.R. Rep. No. 73-85, at 1-2 (1933)).
[xxvi] SEC Staff Study (Jan. 2011) at pp. iv, 51. See also Arleen W. Hughes, Exchange Act Release No. 4048 (Feb. 18, 1948) (Commission Opinion), aff’d sub nom. Hughes v. SEC, 174 F.2d 969 (D.C. Cir. 1949) (“Release 4048”) (noting that fiduciary requirements generally are not imposed upon broker-dealers who render investment advice as an incident to their brokerage unless they have placed themselves in a position of trust and confidence).
[xxvii] The Bulletin, published by the National Association of Securities Dealers, Volume I, Number 2 (June 22, 1940).
[xxviii] N.A.S.D. News, published by the National Association of Securities Dealers, Volume II, Number 1 (Oct. 1, 1941).
[xxix] In recent years massive marketing campaigns by Wall Street firms have touted their “objective advice” from “financial consultants” who attended their client’s soccer games and made so many believe that the “advice” received would result in the ability to afford that second home on the beach. Even long-respected firms like Goldman Sachs have been perceived, at least at times and by some, to “throw clients under the bus” [see http://theweekinethics.wordpress.com/2012/03/22/the-week-in-ethics-goldman-sachs-2012-problem-with-culture/], apparently in violation of their adopted Code of Business Conduct and Ethics in which the firm commits “to conduct our business in accordance with … the highest ethical standards.”
Slowly the clients of broker-dealer firms have realized the harm to which they have been subjected. Not quickly, and not all the time, of course. “[I]ndividuals continue to trust beyond the point where evidence points to the contrary. Eventually, however, the accumulated weight of evidence turns them towards distrust, which is equally reinforcing.” Anand, Kartik, Gai, Prasanna and Marsili, Matteo, Financial Crises and the Evaporation of Trust (November 16, 2009). Available at SSRN: http://ssrn.com/abstract=1507196.
In recent years the media has increasingly noted that, however disguised they might be by the use of titles, “financial consultants” and “wealth managers” are seldom in a “fiduciary relationship” with their customers, even though most customers believe they can “trust” their advisor. Many studies confirm consumer confusion.
In essence, the use of common titles, and the high fees received by those operating under a conflict-ridden standard of conduct, which in turn funds marketing efforts which suggest a relationship of trust with those advisors who operate under the old product-sales business model, results in the inability by consumers to distinguish higher-quality advisors.
[xxx] Someone forgot to tell financial advisors that the use of trust-based sales techniques results in the application of fiduciary standards of conduct. In the latter half of the 20th Century, sales techniques evolved, as did salespersons’ view of themselves. Codes of ethics were developed, high-pressure sales techniques sometimes disavowed, and needs-based selling became a new paradigm. This evolved into “trust-based selling” and substantial changes in the sales process, with trust as a focus. In the past few years, “many authors have recognized that in the ‘relational era’ there have been radical changes in sales-force activities and sales management practices. In brief, salesmen are expected to become value creators, customer partners and sales team managers, market analysts and planners, and to rapidly shift from a hard selling to a smart selling approach … trust is a focal construct in the analysis of relationship marketing.” Paulo Guenzi, “Sales-Force Activities and Customer Trust.” [Citations omitted.]
Where do we stand today? In the 2nd edition of the textbook, Sell (Cengage Learning, 2012), Professors Ingram, LaForge et. al. state that trust, when used as a sales technique, answers these questions:
“1. Do you know what you are talking about? – competence; expertise
2. Will you recommend what is best for me? – customer orientation
3. Are you truthful? – honesty; candor
4. Can you and your company back up your promises? – dependability
5. Will you safeguard confidential information that I share with you? – customer orientation; dependability.”
In looking closely at this list, it appears that questions 1, 3 and 5 are closely associated with the fiduciary duty of due care. Question 2 is close to the proposition of “acting in the client’s best interests” – one of the major aspects of the fiduciary duty of loyalty. And Question 3, acting with honesty and candor, translate into the fiduciary duty of utmost good faith.
Somewhere along the way, the academics and practice consultants have often omitted to tell the financial advisors that “trust-based selling,” designed to achieve a relationship of trust and confidence, results in fiduciary status attaching. This is true regardless of how the financial advisor is licensed or regulated (whether as a registered representative of a broker-dealer firm, investment adviser representative of a registered investment adviser firm, dual registrant, or even life insurance agent.
[xxxi] The use of financial planning services as a means to sell securities in order to generate profits by brokers was criticized early on by the SEC:
[R]egistrant … engaged in a scheme to defraud customers who utilized registrant's financial planning services in the purchase and sale of securities … holding themselves out as financial planners who would exercise their talents to make the best choices for their clients from all available securities, when in fact their efforts were directed at liquidating clients' portfolios and utilizing the proceeds and their clients' other assets to purchase securities which would yield respondents the greatest profits, in some instances in complete disregard of their clients' stated investment objectives … [they] induced customers, who were generally inexperienced and unsophisticated, to believe that their best interests would be served by following the investment program designed for them by respondents. In fact, such programs were designed to sell securities that would provide the greatest gain to respondents, rather than to promote the customers' interests ….
In the Matter of Haight & Company, Inc. (Feb. 19, 1972)
[xxxii] Investment Adviser Association and National Regulatory Services, Evolution Revolution 2012—A Profile of the Investment Adviser Profession (2012), at p.20.
[xxxiii] Mark Schoeff, Jr., "GAO: Workers hurt when rolling over 401(k) plans to IRAs" (InvestmentNews, April 3, 2013).
[xxxiv] Comment letter dated Feb. 7, 2005, from SIFMA to U.S. Securities and Exchange Commission, available at http://www.sec.gov/rules/proposed/s72599/sia020705.pdf.
[xxxv] SEC Staff Report, Study on Investment Advisers and Broker-Dealers as Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (January 2011), at p.12.
[xxxvi] “[T]he concept of efficient unregulated trading markets is fundamentally flawed. At its core, it is based on an incorrect measure of efficiency which leads analysts to look in the wrong places when measuring ‘frictions’ embedded in market structures and behaviors. Efficiency is almost uniformly measured by referencing the cost of individual transactions. But the principal social value of financial markets is not to assure the lowest transaction costs for market participants. Rather, it is to facilitate the efficient deployment of funds held by investors (and entities that pool these funds) to productive uses. In other words, markets are efficient if the cost to the entity putting capital to work productively is as close as possible to the price demanded by the entity that seeks a return on its investment. All of the difference between the two is attributable to the plumbing that connects capital sources to capital uses, known as ‘intermediation.’ The ‘economic rents’ extracted by intermediaries must be as low as possible to compensate them for performing the essential intermediation service if the system is to work efficiently.
Almost universally, this concept is lost in the discussion of financial markets. Efficiency is expressed in terms of the cost of a securities or derivatives transaction. This measures how well the markets work for traders. But it is only one element of the cost of intermediation between capital sources and uses. For reasons ranging from ideology to analytic sloth, the possibility that a market with low transaction costs can also be one in which intermediation costs are inefficiently high is ignored in public debate and academic analysis.
Properly measured, the financial markets have become less efficient in the era of deregulation even though advances in information technology and quantitative analysis should have caused the opposite result under the common understanding of the markets. It is evident that massive sums are extracted from the capital intermediation process causing the financial sector share of the economy to grow at the expense of the productive manufacturing and service sectors and public finance. This trend must be reversed if the US economy is to prosper and compete successfully in the world markets.”
Wallace E. Turberville, Cracks in the Pipeline Part One: Restoring Efficiency to Wall Street and Value to Main Street (2012), available at http://www.demos.org/publication/cracks-pipeline-restoring-efficiency-wall-street-and-value-main-street. [Emphasis added.]
[xxxvii] See text at pp. 7-10 and accompanying notes.