Wednesday, July 9, 2014

Apply the Fiduciary Standard to Reduce the Number of Regulations, the Size of Government, and the Need for Wall Street Oversight

In the political climate of Washington, several members of the U.S. Congress have urged the U.S. Department of Labor and the U.S. Securities and Exchange Commission, both empowered by law to apply the fiduciary standard, to either slow down or stop their fiduciary rule-making efforts altogether. Often the reason expressed is concerns about the imposition of more government regulation, as well as reservations about the growth of the size of government. Yet, the contrary result is far more likely, as imposing bona fide fiduciary obligations will likely reduce both the number of government regulations and hold down the size of government. It will also foster the marketplace policing Wall Street, itself, thus substantially reducing the likelihood of the abuses which led to the financial crisis of 2008-9. Please permit me to explain.

One must initially understand the culture of true fiduciary advisors. Equipped with an agreement with their clients for reasonable, professional compensation, they utilize their expertise by “stepping into the shoes” of their clients. They act, at all times and without exception, as the representative of their client. They undertake this sacred obligation of trust zealously, with the due care of an expert, and acting with loyalty and utmost good faith at all times. Fiduciary advisors eschew opportunities for further compensation or other self-benefit, acting always to serve their client, and only their client. Fiduciary advisors possess an undivided loyalty to their clients at all times, and without exception.

Despite its overriding simplicity, many of those in Wall Street fail to understand the fiduciary standard of conduct. In my many discussions with Wall Street executives, they approach the issue from the standpoint of whether disclosures of conflicts of interest must occur (knowing all well that disclosures are ineffective as a means of consumer protection). So engrained are they in a sales culture, in which you “eat what you kill,” they cannot conceptualize, in their own minds, the true nature of the fiduciary standard.

In fact, I have observed many a stockbroker (i.e., “broker” or “registered representative of a broker-dealer firm”) depart from that environment to join fee-only fiduciary investment advisory firms, only to be asked to leave several months later. Their mindset was incapable of change, and hence – not able to adhere to the strict ethics of a fiduciary advisor – they were asked to leave.

Perhaps these brokers who then became “failed fiduciaries” should have received a better explanation of the fiduciary standard. In dictum in the 1998 English (U.K.) case of Bristol and West Building Society v. Matthew, Lord Millet undertook what has been described as a “masterful survey” of the fiduciary principle: “A fiduciary is someone who has undertaken to act for and on behalf of another in a particular matter in circumstances which give rise to a relationship of trust and confidence.  The distinguishing obligation of a fiduciary is the obligation of loyalty.  The principle is entitled to the single-minded loyalty of his fiduciary.  This core liability has several facets.  A fiduciary must act in good faith; he must not place himself in a position where his duty and his interest may conflict; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal.  This is not intended to be an exhaustive list, but it is sufficient to indicate the nature of the fiduciary obligations.  They are the defining characteristics of a fiduciary.”

While I admire Lord Millet’s prose, permit me to say it more directly: A fiduciary steps into the shoes of another person and applies all of her or his knowledge and skill to benefit that person as if she or he were that person. This is the essence of the fiduciary relationship.

So how does the application of fiduciary principles translate into a reduced size of government regulations, and a reduced size for government itself, and the policing of Wall Street?

First, the fiduciary standard is a principles-based standard. The fiduciary standard of conduct can be succinctly expressed as either “acting in the best interests of the client” or “acting with due care, loyalty and utmost good faith” (the “triad” of fiduciary duties often recited by U.S. courts. While further elicitations of the standard can be useful as guides to both fiduciary advisors and their clients, they are not absolutely necessary. In other words, unlike the regulatory scheme for non-fiduciary broker-dealers, where there exist a bevy of highly specific conduct rules governing what can and what cannot be done, there exists no compelling need for detailed rules to govern the conduct of fiduciaries.

Indeed, a detailed set of rules attempting to delineate fiduciary principles could prove to be counter-productive. Fraud is infinite, and the fiduciary standard of conduct must be free to combat fraud. Accordingly, the fiduciary standard must be permitted to evolve. While the fiduciary standard of conduct for investment advisers and personal financial planners is generally uniform, fiduciary duties are not static; rather, they must evolve over time to meet the ever-changing business practices of investment advisers and to ensure that fraudulent conduct is successfully circumscribed. Because fraud is by its very nature boundless, the one fiduciary standard of conduct applicable to investment advisers should not be subjected to attempts to define or restrict it legislatively, by means of any particular definition.

Second, less oversight is required of fiduciaries – once the culture is engrained. SEC and FINRA examiners of Wall Street’s broker-dealer firms often camp out for weeks and weeks when conducting regular visits to those firms. Why? As the SEC has long acknowledged, the sales culture and merchandizing aspects of the broker-dealer model, with its tendency to disguise obscure fees and costs where possible and with its many, many conflicts of interest, can easily lead to transgressions of the many conduct rules applicable to broker-dealers. As a result, thousands and thousands of registered representatives of broker-dealers are fined, or brought into arbitration proceedings by their clients, each and every year.

Yet, if a bona fide fiduciary culture is instilled, the need for such stringent government oversight is substantially lessened. For example, attorneys-at-law are fiduciaries, and their exist hundreds of thousands of them. Yet, I am not aware of any state that conducts routine periodic examinations of lawyers. Instead, the existence of the fiduciary culture is embedded through training and tradition within the legal community, and peer pressure exists to adhere to fiduciary principles, resulting in few transgressions. What problems that do emerge are resolved by a relatively small handful of investigative staff employed by the states, as well as through private civil litigation.

I’m not stating that fiduciary investment advisers and brokers (if fiduciary standards are applied by rule to them) do not need any routine examinations. Unlike most attorneys (and CPAs), some investment advisers (as well as nearly all broker-dealers) accept “custody” of their client assets. It is an essential government function to verify that customers’ assets actually exist; frequent inspections of custody arrangements are essential to ensure that small frauds don’t become huge ones. Yet, such inspections need not take weeks, for routine examinations seldom uncover Ponzi schemes and other thefts of client assets. Rather, most frauds involving custody are detected after a complaint from a client or from a concerned employee. A smart examination would spot check high-risk firms frequently, and for all firms would reach out to employees to encourage whistle-blowing for any actual fraud. And such limited, one-day examinations would occur more frequently, in recognition of the fact that most Ponzi schemes and thefts occur due to financial pressure felt by the securities industry participant, starting off small but ballooning over the course of a few years to involve many more victims.

With the imposition of a bona fide fiduciary standard, and substantial education and training around that standard, over the course of time a true fiduciary culture can develop among all providers of personalized investment advice – whether investment advisers or brokers. And with such a culture will come a reduced number of transgressions, and reduced need for examinations and other forms of oversight. In essence, the SEC, FINRA, and state securities administrators, whose collective staffs have grown to number thousands and thousands (not counting the many compliance officers and staff within firms themselves, nor compliance consulting firms), can see a reduced need for examinations under a bona fide fiduciary standard. Our government’s resources, always limited, can be focused on what truly matters in protecting consumers – asset verification and the detection of actual frauds before they grow into Madoff-like billion-dollar frauds.

Third, and perhaps most importantly, the fiduciary standard reduces the risks of rampant abuses by Wall Street. Think about it. What if Wall Street did not consist of six hundred thousand (or more) product peddlers, but instead consisted of hundreds and hundreds of thousands of fiduciary “purchaser’s representatives”? These fiduciary advisors, bound to use their expertise to guard against undue risks to their clients, would carefully scrutinize the many complex products of today. It is likely that the widespread use of mortgage-backed securities consisting of sub-prime mortgages (as Senator Levin expressed in 2010, “sh***y products) would have occurred had such deals been scrutinized by expert fiduciary advisors, instead of being pushed upon unsuspecting investors.

In fact, the securities markets would likely become far more “efficient” as to the pricing of securities. IPOs of common stock, which on average underperform the overall market in the first two years after issue (due to the hype provided by investment banking firms which underwrite the firms), would likely be much more fairly priced. Asset price bubbles would receive far more scrutiny, as they began to occur, as experts better evaluated the available evidence in adherence to their fiduciary duty of due care to protect their clients against undue risks.

Another type of efficiency would occur, over time. Hundreds of thousands of purchaser’s representatives – fiduciary, expert advisors – would place pressure on the Wall Street oligarchy that controls investment underwriting today. Fees and costs in the primary market for securities issuance would decline. Continued disintermediation in the secondary markets would also occur. Consider the excessive costs imposed upon investors by “payment for order flow” (exacerbated by dark pools and high-frequency trading firms) and “revenue-sharing” arrangements today; pressure would be put on brokers and dealers to eliminate, or at least substantially reduce such payments, should expert advisors accompany more of the consumers of securities products today. Of course, that may be exactly what Wall Street fears most, from the application of the fiduciary standard, and hence why Wall Street opposes a bona fide fiduciary standard so ferociously.

In summary, those who desire to see a reduced role for government, a lesser number of regulations, and reduced need for government to oversee Wall Street, should embrace the application of a bona fide fiduciary standard to all providers of personalized investment advice. Applying the fiduciary standard is the ultimate in securing a marketplace solution to Wall Street's continued abuses. Policy makers should recognize this - regardless of their political affiliation.

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