Tuesday, July 8, 2014

431 Days and Counting: Mary Jo White and Her Legacy as the SEC Chair

In July 1934 President Franklin D. Roosevelt appointed Joseph Patrick Kennedy (the father of future President John F. Kennedy) as Chair of the newly created Securities and Exchange Commission (SEC). Despite widespread qualms about the appointment of a business person who had made a personal fortune from financial manipulation, Joseph Kennedy’s tenure proved to be just the start necessary for the new agency. Kennedy knew the business community and understood the business practices he was charged with policing.

Despite serving only a mere 431 days as the SEC’s Chair, Joseph Kennedy’s legacy was substantial. Despite this brief tenure, he had helped create an institution that was flexible, resourceful, and arguably the most respected of all of the government agencies.

The present Chair of the SEC, Mary Jo White, has been on the job for slightly more than 431 days currently. Certainly the task facing her has been formidable, as Mary Jo White focused first on prosecutions of firms and individuals arising out of the financial crisis of 2008-9, as well as mandatory rule-making burdens imposed by the Dodd-Frank Act and the Jobs Act. Much work remains in these areas, and early reviews of Mary Jo White’s effectiveness have been generally positive.

Yet, I wonder ... what Mary Jo White’s legacy will be? Unless re-appointed by a new President, Mary Jo White likely has only two-and-a-half years or so left as Chair of the SEC. Any new rules today must be formulated, proposed, comments received and analyzed, and then finalized – a process than can easily take two years or longer.

Of all of the abuses of Wall Street, perhaps the most insidious is that of Wall Street’s false embrace, through its lobbying organizations, of the “fiduciary standard” for brokers who provide personalized investment advice. Yet, looking through their public statements, one sees that what Wall Street really wants is to be able to hold out as “trusted advisors” while, in reality, disclaiming (and having clients waive) fiduciary protections. Wall Street wants to claim to be "fiduciaries" but then do business as usual and continue to extract exorbitant rents from individual investors.

As I have written previously in this blog, the fiduciary standard operates as a restraint on conduct – i.e., as a restraint on greed. While certain practices might be expressly permitted by Dodd Frank Act under a fiduciary standard applied to brokers (such as commission-based compensation), it must be fully realized that other business practices – such as the receipt of variable compensation through often non-disclosed (or weakly disclosed) revenue-sharing arrangements, payment for order flow, soft dollars, and 12b-1 fees – create for the fiduciary a nearly insurmountable burden in adhering to a bona fide fiduciary standard. This is because so much academic research has demonstrated that: (1) higher fees and costs are strongly correlated to lower returns for investors; and (2) disclosures are ineffective as a means of consumer protection, and indeed create “perverse effects.”

In essence, mere disclosure of a conflict of interest does not adhere to one's fiduciary obligation of trust; much more is required in order to keep the client's best interests paramount.

In other words, no person can serve two masters. As a fiduciary, you either serve the best interests of the client, or you do not. You agree with the client in advance on reasonable compensation, and then you recommend the best products available. As a fiduciary, you don't push a product upon a client who trusts you, just so you or your brokerage firm can make more money.

Indeed, the SEC has long noted the problems arising from the various compensation schemes of brokers and the many conflicts of interest arising therefrom, once opining:  “[T]he merchandising emphasis of the securities business in general, and its system of compensation in particular, frequently impose a severe strain on the legal and ethical restraints.” 1963 SEC “Special Study of the Securities Markets.” See also Arleen W. Hughes, Exch. Act Rel. No. 4048, 27 S.E.C. 629 (Feb. 18, 1948)

The SEC has not always taken such a light hand with brokers, when they moved into providing individualized advice to individual consumers. Early on the SEC acknowledged brokers were often fiduciaries to their clients, and cautioned brokers to not “disguise” themselves as trusted advisors (as they so often do now). The SEC stated:

If the transaction is in reality an arm's-length transaction between the securities house and its customer, then the securities house is not subject to ‘fiduciary duty.’ However, the necessity for a transaction to be really at arm's-length in order to escape fiduciary obligations, has been well stated by the United States. Court of Appeals for the District of Columbia in a recently decided case: ‘[T]he old line should be held fast which marks off the obligation of confidence and conscience from the temptation induced by self-interest. He who would deal at arm's length must stand at arm's length. And he must do so openly as an adversary, not disguised as confidant and protector. He cannot commingle his trusteeship with merchandizing on his own account….’

Seventh Annual Report of the Securities and Exchange Commission, Fiscal Year Ended June 30, 1941, at p. 158, citing Earll v. Picken (1940) 113 F. 2d 150.

In the same report, the SEC also alluded to a specific case involving brokerage activities, which arose to the level of “investment counsel” and hence a fiduciary relationship:

In the Stelmack case the evidence showed that the firm obtained lists of holdings from certain customers and then sent to these customers analyses of their securities with recommendations listing securities to be retained, to be disposed of, and to be acquired … The [U.S. Securities and Exchange] Commission held that the conduct of the customers in soliciting the advice of the firm, their obvious expectation that it would act in their best interests, their reliance on its recommendations, and the conduct of the firm in making its advice and services available to them and in soliciting their confidence, pointed strongly to an agency relationship and that the very function of furnishing investment counsel constitutes a fiduciary function.”

Seventh Annual Report of the Securities and Exchange Commission, Fiscal Year Ended June 30, 1941, at p. 158.

Two decades later the SEC repeated its warning to brokers – that they would be considered fiduciaries where customers relied upon them for personalized investment advice:

[The SEC] 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 … [BD 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.

1963 SEC Study, citing various SEC Releases.

The SEC has transgressed in recent decades. As I have previously written about in this blog, as the result of a series of decisions stretching back to 1975, the SEC now permits brokers to hold out to the public as being in a relationship of trust and confidence through the use of titles such as “financial consultant” and “wealth manager.” The SEC has permitted dual registrants to disclaim their core fiduciary obligations through inappropriate language found in their Form ADV and in client services agreements. It has not applied the duty of care to the selection of investment managers, relying instead upon the weak suitability standard (which should only apply to transaction execution by brokers, without more). It has permitted anti-competitive 12b-1 fees (“advisory fees in drag”) – often 1% in Class C mutual funds with no opportunity for client negotiation – to be utilized (despite judicial opinions which note the confines of the term “special compensation” in applying the broker-dealer exclusion to the requirement for registration from the Advisers Act). The SEC has even defined the term "solely incidental" out of existence. The SEC has also permitted broker-dealer firms both big and small (and, more recently, even FINRA) to use the term “best interests” - without cautioning that such term denotes a fiduciary relationship and, outside of such a relationship, misleads investors. And the SEC has inappropriately permitted “switching of hats” and “dual hat” wearing by dual registrants, contrary to the common law which informs the federal fiduciary standard that fiduciary is applied to relationships, and not accounts.

In essence, the SEC has permitted brokers – when providing personalized investment advice – to ignore the fiduciary standard (whether or not deemed applicable by the SEC). It has permitted those brokers in relationships of trust and confidence with their clients to subordinate the interests of their customers to the brokerage firms' own interests. The SEC has permitted brokers to enter into relationships of trust with their customers, and then – over and over again – betray that trust.

All of this has led to great detriment of investors, in this ever-more-complicated world of financial services. In my reviews over the past fifteen years of hundreds and hundreds of the investment portfolios of customers of broker-dealer firms, I nearly always find total fees and costs of 2% or much higher – and I would estimate that the average is 2.5% to 3%. (This is more than twice the average total fees and costs seen in portfolios managed by true fiduciary investment advisers, who avoid most conflicts of interest.)

All of this is just confirmation of the often-cited statistics that the financial services industry today ... instead of serving as grease for American’s economy, is but a sludge as it extracts 30% to 40% of the profits generated by operating businesses. Of course, such extraction of rents ruins the financial futures of millions of Americans today, endangering their retirement and their ability to provide for their own future needs. If instead, we were to protect our fellow Americans from excessive investment fees and costs, Americans would be able to provide for themselves far better in their retirement years, thereby lessening the burdens on federal, state and local governments, as well as the burdens on charitable  organizations.

How do governments react, in the fact of such SEC inaction? One need look no further than the recent federal government’s proposal for “myRA” accounts, or the very recent development by 17 state governments that are now considering their own form of investment accounts for workers. Where Wall Street cannot be trusted (and falsely opines that small investors cannot be served under a fiduciary standard, despite the fact that numerous registered investment advisers are doing just that today), the government seeks its own solution – one that disintermediates nearly all financial intermediaries and increases the size of government itself.

Despite the authority granted to the SEC four years ago by the Dodd-Frank Act, the SEC has stood idly by and has not yet proposed fiduciary rules. While Mary Jo White has indicated that she desires a “direction” for fiduciary rule-making by the end of 2014, rumors from Washington, D.C. have indicated that a “direction” for fiduciary rule-making won’t occur until at least mid-2015. I would suggest that this is far too late, not only for individual investors everywhere, but also for Chair Mary Jo White to secure for investors the protections of a bona fide fiduciary standard, for all those who receive personalized investment advice.

Over 431 days have already passed in Mary Jo White’s tenure as SEC Chair. Only several months remain for her to begin, in earnest, the process of implementing a true, bona fide fiduciary standard that American consumers deserve and that the American economy so desperately needs.

Let us hope that Chair Mary Jo White will act to effect, correctly and firmly, a bona fide fiduciary standard under the authority granted to the SEC by Section 913 of the Dodd-Frank Act. Let us hope that, when she proceeds, she ignores Wall Street’s call for an ineffective “new federal fiduciary standard” based upon disclosures alone, and instead embraces the true federal fiduciary standard which keeps paramount, at all times, the best interests of our fellow Americans.

Let us hope that Chair Mary Jo White will secure for herself a historic legacy as she seeks to right the SEC ship, and in so doing restores the SEC’s prestige as a government agency. Let us hope that Chair Mary Jo White does not become just another in a long line of SEC Chairs that favors the interests of Wall Street over the interests of Main Street.

The time for action is now. Let us hope that, decades from now, Chair Mary Jo White becomes looked upon as favorably as the first SEC Chair, Joseph Kennedy. Let us hope.

Ron A. Rhoades, JD, CFP(r), serves as Chair of The Committee for the Fiduciary Standard. He is Asst. Prof. and Chair of the Financial Planning Program at Alfred State College, Alfred, NY. He may be reached at: RhoadeRA@AlfredState.edu. Readers are invited to follow his tweets on Twitter (@140ltd) and to link with him via LinkedIn, to stay abreast of future postings.

1 comment:

  1. Excellent commentary. Unfortunately, I believe the SEC showed its true focus in the FPA vs. SEC case. Chairwoman White will either become legendary for adopting a uniform fiduciary standard by re-establishing the SEC as the investors' advocate, as set out at the SEC's web site or giving in to her own conflict of interests, her use of the SEC's revolving door and her return to a high paying position with a Wall Street law firm, and refusing to adopt a uniform fiduciary standard. I think Vegas would give odds favoring the latter.

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