THE FOLLOWING DOCUMENT WAS PRESENTED TO STAFF OF THE U.S. CONGRESS IN JULY 2013, IN OPPOSITION TO EFFORTS IN CONGRESS TO STALL RULE-MAKING BY THE U.S. DEPT. OF LABOR AND THE U.S. SECURITIES AND EXCHANGE COMMISSION ON THE FIDUCIARY STANDARD.
COMMON SENSE 2013
ADDRESSED TO
POLICYMAKERS
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
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.
INTRODUCTION.
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
ê ê
Salesperson Fiduciary
(Advisor)
ê ê
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.
IN CONCLUSION.
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).
[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.
[viii] Georgarakos, Dimitris and
Inderst, Roman, Financial Advice and Stock Market Participation (February 14,
2011). ECB Working Paper No. 1296. Available at SSRN: http://ssrn.com/abstract=1761486.
[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).
[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.”
(Sell, p.27).
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).
[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.
