Over
and over again, opponents of the fiduciary standard (whether imposed by the DOL
or the SEC) herald their cry of "Don't Limit Investor Choice." For example,
the National Association of Plan Advisors (NAPA), whose members include some
very large broker-dealer firms, insurance companies, and asset managers /
product manufacturers (among others), recently opined that the DOL’s fiduciary
rulemaking would keep “many Americans from working with the trusted advisor of
their choice, even in the critical decision regarding rollovers from their 401k
and 403(b) plans.” Yet, is this
statement - “don’t limit choice” – a legitimate argument?
I
submit the following observations:
(1) There
are two types of relationships under the law – arms-length (sales)
relationship, and advisory (fiduciary) relationships.
(2) Fiduciary
status results in the highest standards imposed by the law.
(3) Brokers
complain that, having moved into the realm of advisory relationships, and now
holding themselves out as trusted advisors, they should nevertheless not be
held to the fiduciary standards which attach to such trusted advisor – client relationships.
(4)
Despite the fact that the United States firmly embraces capitalism, even Adam
Smith acknowledged that the imposition of professional duties would be required
at times as a constraint upon greed, including the enactment of professional
standards of conduct.
(5) The
solution to the problems of today is imposing fiduciary standards upon all
those who – regardless of the nature of their registration – provide advice to consumers. Consumers may still
choose to deal with product sellers – but they will be armed (hopefully) with
clear, concise instructions that they are in an arms-length relationship, not
entitled to “rely” upon any statements provided by the (non-fiduciary) broker.
Moreover, brokers must not utilize titles, nor other marketing tactics, in
which they hold themselves out as advisors.
I conclude that "choice" will not be limited. But, a continuation of fraud and misrepresentation, which so often occurs today, will be avoided.
(1) DISTINGUISHING ARMS-LENGTH
(SALES) RELATIONSHIPS VS.
FIDUCIARY (ADVISORY) RELATIONSHIPS
It is
first interesting to note that NAPFA uses the phrase “trusted advisor” – this
is itself is telling of the type of misrepresentations which occur by many brokers
today, as these salespersons promote themselves as “trusted advisors” and
achieve relationships of trust and confidence with their clients.
ARMS-LENGTH SALES
RELATIONSHIPS
PRODUCT MANUFACTURERS
(providers of mutual funds, ETFs, variable
annuities, etc.)
hire and pay
SALES REPRESENTATIVES
(brokerage firms and their registered
representatives)
to sell to
CUSTOMERS
The
customers are entitled to rely on the “good faith” of the broker, dealer, or
seller (i.e., no actual misrepresentations or fraud concerning the product may
occur, delivery must occur in good faith), modified somewhat by the requirement
that any product sold must be “suitable” to the customer’s needs (which relates
mainly to product-specific risks, not to the fees, costs, or tax consequences
of the product). There is no requirement to recommend the best product
available.
For example,
a car salesman could recommend the sale of a Yugo, even though a similar model Toyota
would be better. And, in the realm of financial services, salesmen often
recommend poor products, because the manufacturers of such products pay higher
compensation to the sales representatives (brokers) in order to incentivize the
sale of inferior products.
The
customers are in a position of arms-length with respect to the sales
representatives (brokers). In such a sales relationship, caveat emptor applies – i.e., the customer must be diligent, is not
entitled to rely upon the broker for advice. The customer must protect herself
or himself from undue harm, for non-fiduciaries who contract with their
customers can engage in “conduct permissible in a workaday world for those
acting at arm's length.” Meinhard v
Salmon, 249 NY 458, 464 (N.Y. 1928).
While the
vast majority of relationships in commerce today are arms-length relationships,
the growing import of the fiduciary relationship, as specialization in society
increasingly occurs, should not be overlooked.
FIDUCIARY
ADVISORY RELATIONSHIPS
CLIENT
Seeks out a trusted advisor for
guidance.
Requires expert advice to navigate the
complexities of the modern financial world.
Engages
and pays
PURCHASER’S REPRESENTATIVE
A fiduciary advisor who is bound to
represent
the best interests of the client at all times.
Armed with expert knowledge, steps into the
shoes of the client. Possessing
broad fiduciary
duties of due care, loyalty, and utmost good
faith toward the client.
Who
screens and advises upon
INVESTMENT PRODUCTS
In other words, securities
providers.
Increased competition exists to
develop
better products and more choices,
due to
the presence of knowledgeable
advisors
acting as representatives of the purchaser.
In
contrast to arms-length relationships, the law imposes upon one party to some
relationships the status of a fiduciary.
This form of relationship is called the “fiduciary relationship” or
“fiducial relationship.” One upon whom
fiduciary duties are imposed is known as the “fiduciary” and is said to possess
“fiduciary status.”
(2) UNDERSTANDING THE FIDUCIARY
PRINCIPLE: THE HIGHEST STANDARD
IMPOSED BY LAW
The
fiduciary standard of conduct is consistently described by the courts as the “highest
standard of duty imposed by law.” See,
generally BLACK'S LAW DICTIONARY 523 (7th ed. 1999) ("A duty of utmost
good faith, trust, confidence, and candor owed by a fiduciary (such as a lawyer
or corporate officer) to the beneficiary (such as a lawyer's client or a
shareholder); a duty to act with the highest degree of honesty and loyalty
toward another person and in the best interests of the other person (such as
the duty that one partner owes to another."); also see F.D.I.C. v. Stahl, 854 F.Supp. 1565, 1571 (S.D. Fla.,
1994) (“Fiduciary duty, the highest standard of duty implied by law, is the
duty to act for someone else's benefit, while subordinating one's personal
interest to that of the other person); and
see Perez v. Pappas, 98 Wash.2d 835, 659 P.2d 475, 479 (1983) (“Under
Washington law, it is well established that ‘the attorney-client relationship
is a fiduciary one as a matter of law and thus the attorney owes the highest
duty to the client.’”), cited by
Bertelsen v. Harris, 537 F.3d 1047 (9th Cir., 2008); also see Donovan v. Bierwirth, 680 F. 2d 262, 272, n.8 (2nd Cir.,
1982) (fiduciary duties are the “highest known to law”).
Justice
Philip Talmadge of the State of Washington Supreme Court summarized the core
aspects of current fiduciary relationships:
A fiduciary
relationship is a relationship of trust, which necessarily involves
vulnerability for the party reposing trust in another. One's guard is down. One
is trusting another to take actions on one's behalf. Under such circumstances,
to violate a trust is to violate grossly 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. One can
call this the fiduciary principle.
Von Noy v. State Farm Mutual Automobile
Insurance Company, 2001 WA 80 (WA, 2001) (J. Talmadge, concurring opinion).
This
much higher standard of conduct flows from the requirement of the fiduciary “to
adopt the principal’s goals, objectives, or ends.” Georgakopoulos, Nicholas L.,
Meinhard v. Salmon and the Economics
of Honor (April 1998). Available at SSRN: http://ssrn.com/abstract=81788 or
DOI: 10.2139/ssrn.81788.
This duty
to adopt the client’s ends as one’s own “is what makes fiduciary law unique and
separates fiduciaries from other service providers.” Meinhard v. Salmon, 164 N.E. 545 (N.Y. 1928). “Justice Cardozo
held that a nonmanaging partner could share in a deal that the owner of the
property the partnership managed had offered to the managing partner although
the deal would begin after the termination of the partnership's 20-year term
and included significant property beyond what the partnership had managed.
Meinhard provides a workable definition of fiduciary duties as requiring the
obligated party to act with the ‘finest loyalty’ to the owner's interests.” Ribstein,
Larry E., “The Structure of the Fiduciary Relationship” (January 4, 2003). U
Illinois Law & Economics Research Paper No. LE03-003. Available at SSRN:
http://ssrn.com/abstract=397641 or DOI:
10.2139/ssrn.397641
As
Professor Arther Laby more recently further explained:
Some even use the
phrase ‘alter ego’ to reference the fiduciary norm. This personalizes the duty in a particular
way. The fiduciary must appropriate the objectives, goals, or ends of another
and then act on the basis of what the fiduciary believes will accomplish them –
a happy marriage of the principal’s ends and the fiduciary’s expertise. The
fiduciary does not eliminate its own legal personality, rather it must consider
the principal’s delegation of authority to the fiduciary from the perspective
of fidelity to the principal’s objectives as the fiduciary understands them.
Laby,
Arthur B., “The Fiduciary Obligation as the Adoption of Ends,” Buffalo L. Rev
99, 135 (2008), available at available at: http://ssrn.com/abstract=1124722.
(3) BROKERS PROVIDING "ADVICE"
HAVE LONG BEEN HELD TO BE FIDUCIARIES
Despite
the fact that brokers (i.e., registered representatives of broker-dealer firms)
possess an exemption from registration (if their advice is “solely incidental”
and if “no special compensation is received”) as an investment adviser (upon
whom fiduciary status is imposed by the Advisors Act, as consistently
interpreted since its enactment in 1940), brokers can become fiduciaries under
a variety of legal theories. One of these is if they possess a relationship of
trust and confidence with their customer. In other words, the Investment Advisers
Act of 1940, while providing a limited exception from the application of its
registration requirements for brokers, did not negate the potential status of
brokers as fiduciaries under state common law.
The
SEC’s March 1, 2013 release acknowledges that brokers and their registered
representatives may possess a fiduciary duty under state common law: “A
broker-dealer may have a fiduciary duty under certain circumstances. This duty
may arise under state common law, which varies by state. Generally, courts have
found that broker-dealers that exercise discretion or control over customer
assets, or have a relationship of trust
and confidence with their customers, are found to owe customers a fiduciary
duty similar to that of investment advisers.” [Emphasis added.] See also
January 2011 SEC Staff Study, at pp.10-11. “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.
Moreover, broker- dealers are subject to statutory, Commission and SRO
requirements that are designed to promote business conduct that protects
customers from abusive practices, including practices that may be unethical but
may not necessarily be fraudulent.” It should be noted that the views expressed
in the Study were those of the staff and do not necessarily reflect the views
of the Commission or the individual Commissioners. See also A Joint Report of the SEC and the CFTC on Harmonization
of Regulation (Oct. 2009), available at http://www.sec.gov/news/press/2009/cftcjointreport101609.pdf,
stating: “While the statutes and regulations do not uniformly impose fiduciary
obligations on a [broker-dealer (BD)], a BD may have a fiduciary duty under
certain circumstances, at times under state common law, which varies by state.
Generally, BDs that exercise discretion or control over customer assets, or
have a relationship of trust and confidence with their customers, are found to
owe customers a fiduciary duty similar to that of investment advisers … State
common law imposes fiduciary duties upon persons who make decisions regarding
the assets of others. This law generally
holds that a futures professional owes a fiduciary duty to a customer if it is
offering personal financial advice.” Id. at pp.9-10. [Emphasis added.]
Courts
have held that a fiduciary relationship, resulting from a relationship based
upon trust and confidence, need not be created by contract. It may arise out of any relationship where
both parties understand that a special trust or confidence has been
reposed. “A fiduciary relation does not
depend on some technical relation created by or defined in law. It may exist
under a variety of circumstances and does exist in cases where there has been a
special confidence reposed in one who, in equity and good conscience, is bound
to act in good faith and with due regard to the interests of the one reposing
the confidence.” In re Clarkeies Market, L.L.C., 322 B.R. 487, 495 (Bankr. N.H.,
2005). Stated differently, once a relation between two parties is established,
“its classification as fiduciary and its legal consequences are primarily
determined by the law rather than the parties. Thus, unlike a party to a
contract, a person may find himself in a fiduciary relation without ever having
intended to assume fiduciary obligations. The courts will look to whether the
arrangement formed by the parties meets the criteria for classification as
fiduciary, not whether the parties intended the legal consequences of such a
relation.” Tamar Frankel, “Fiduciary Law,” 71 Calif. L. Rev. 795, 817 (1983).
These more
recent pronouncements only buttress what was already well known back early in
the 20th Century and in the 1940’s.
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.
John R.
Dos Passos, A Treatise on the Law of Stock-Brokers and Stock Exchanges, The
Banks Law Publishing Co., 2ND Edition (1905), Vol. 1, at p. 180-1.
By the
early 1930’s, the fiduciary duties of brokers (as opposed to dealers) were
widely known. As summarized by Cheryl Goss Weiss, in contrasting the duties of
a 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.
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).
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. 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.”).
Early on the SEC also opined on the status of brokers as
fiduciaries. The SEC opined in its Seventh Annual Report: “The preceding case [Hope & Co.] is one of a series of
cases involving revocation of registration ordered by the Commission during the
year in which fraud, arisirig out of an abuse of a fiduciary duty, has been
alleged. Other cases were: In the Matter of Commonwealth Securities,
Inc.; In the Matter of Securities
Distributors Corporation; In the
Matter of Equitable Securities Company of Illinois; and In the Matter of Geo. W. Byron &: Co.
In some of these cases, including Commonwealth
Securities, Inc. and Securities
Distributors Corporation, the registered broker or dealer had attempted to avoid fiduciary responsibility by use of
words on the confirmation intend to
indicate that in the particular transaction
it had not acted in a fiduciary capacity, but, in such cases, the Commission held that the form of
confirmation could not alter the
fiduciary character of the relationship where this was clearly established from the other facts and circumstances
surrounding the transaction. The case
of Geo. W. Byron &: Co. involved
transactions in which the firm acted
as agent for both parties to the transaction
and accepted commissions from each without the other's knowledge and consent, which constituted an abuse
of thc fiduciary responsibility to
which an agent is subject. In the Matter
of Securities Distributors Corporation involved failure of a securities
firm, while acting as a fiduciary, to
disclose information in its possession which the customer would wish to have in deciding whether to enter into the transaction. In the Matter of Equitable Securities Company oj Illinois involved
a fiduciary obligation arising from a relation of trust and confidence between
the customer and the securities company. In the decision in In the Matter of Hope & Company the
Commission held:
‘A broker-dealer
exercising supervision over a discretionary account is; Of course, an agent and
under the principles already discussed these transactions constitute a
violation of the statutory provisions cited …’
and further held:
‘A broker is an
agent and it is, of course, a general principle of law that an agent may not,
in the absence of consent of the person whom he purports to represent, deal
with such person as a principal. This is so irrespective of any injury or loss
to the principal. It follows that when a broker-dealer represents to a customer
that he is effecting a transaction as broker, and, without the knowledge or
consent of the customer buys from or sell to the customer as a principal, he is
making a misrepresentation of a material fact and is engaging in a fraudulent
practice which violates Section 17(a) of the Securities Act, Section 15(c) of
the Securities Exchange Act and Rule X-15Cl-2 thereunder.’
In this opinion the Commission quoted the following statement
of the law by the Supreme Judicial Court of Massachusetts in Hall v. Paine [224 Mass. 62, 112 N. E.
153.]:
‘A broker's
obligation to his principal requires him to secure the highest price
obtainable, while his self-interest prompts him to buy at the lowest possible
price … The law does not trust human nature to be exposed to the temptations
likely: to arise out of such antagonistic duty and influence. This rule applies
even though the sale may be at auction and in fact free from any actual
attempts to overreach or secure personal advantage, and where the full market
price has been paid and no harm resulted * * *’”
Seventh Annual
Report of the Securities and Exchange Commission, Fiscal Year Ended June 30,
1941, at p. 158.
In its 1940 Annual Report, the U.S. Securities and Exchange
Commission noted: “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.
The SEC also “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
also summarized a court decision finding that the furnishing of investment
advice by a broker was a “fiduciary function.”
The SEC stated: “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.” – from the 1942 SEC Annual Report, p. 15,
referring to In the Matter of Willlam J. Stelmack Corporation, Securities Exchange Act Releases 2992 and 3254. See also Arleen
W. Hughes, Exch. Act Rel. No. 4048,
27 S.E.C. 629 (Feb. 18, 1948) (Commission Opinion), aff’d sub nom. Hughes v. SEC, 174 F.2d 969 (D.C. Cir. 1949)
(broker-dealer is fiduciary where she created relationship of trust and
confidence with her customers).
Even
FINRA, the broker-dealer regulatory association, whose members include
broker-dealers, acknowledged that brokers would be fiducaiaries in specific
situations, early on in the history of FINRA (formerly the National Association
of Securities Dealers, or NASD). In a very early opinion issued by the NASD, it
was 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.” –
from The Bulletin, published by the
National Association of Securities Dealers, Volume I, Number 2 (June 22, 1940).
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.’” - from N.A.S.D.
News, published by the National Association of Securities Dealers, Volume
II, Number 1 (Oct. 1, 1941).
NASD also noted that a dealer in securities was not a
fiduciary, but rather a merchant, stating: “A member when acting as a dealer or
principal in a transaction with a customer is acting essentially as a merchant,
buying or selling securities for himeself, for his own account, and like all
merchants, hoping to make a profit of the difference between the price at which
he buys or has bought for himself and the price at which he sells for himself. A
member when acting as a dealer or principal is thus not subject to the common
law principles of agency which apply to a broker, but a dealer must at all
times make it clear to his customer that he is acting as a dealer or principal,
if that is the fact.” –
from The Bulletin, published by the
National Association of Securities Dealers, Volume I, Number 2 (June 22, 1940).
[Emphasis added.]
Despite
the depth of this early authority, brokers have consistently argued against the
imposition of fiduciary status, even though they provide personalized
investment advice. And FINRA, in a glaring omission from the early 1940’s to
today, has never acknowledged in its rules of conduct for its members that
brokers, as a result of their agency, owe broad fiduciary duties of due care,
loyalty, and utmost good faith when the broker and/or its registered
representative is in a relationship of trust and confidence with the client.
Over
the past four decades, following the repeal of fixed commissions for trading in
stocks, and with the assistance of ill-advised positions advanced by the U.S.
Securities and Exchange Commission, brokers (i.e., registered representatives
of broker-dealer firms) have held themselves out as “trusted advisors” through
the use of titles denoting their role as an advisor, through marketing
confirming such impressions, through giving ongoing advice in the selection of
managers, through “special compensation” received in the form of 12b-1 fees, and
by other means. They have successfully blurred the distinction between
non-fiduciary product salespeople and fiduciary trusted advisors, to the
detriment of consumers of advisory services.
It is
against this backdrop, in which brokers have moved even further toward advisory
relationships, and now hold themselves out as “financial consultants” and “financial
advisors” and “wealth managers” (and many other terms which infer status as a
trusted expert), and in which brokers have steadfastedly refused to accept the
restrictions which come from fiduciary status, that the DOL’s rule-making is
taking place. The DOL seeks to negate, at least with respect to the defined contribution accounts and IRA accounts over which it possesses jurisdiction, the rampant misrepresentations which occur today, and in so doing to more clearly distinguish "product sales" from "advice."
(4) SHOULD UNRESTRICTED CHOICE
ALWAYS BE AVAILABLE?
WHAT WOULD ADAM SMITH SAY?
The "don't limit consumer choice" has somewhat of a populist nature to it. Americans value their "freedoms" - and they treasure capitalism.
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.
Restraints
upon conduct are necessary for all actors in our society, if capitalism to
function. Some actors, such as those in relationships of trust and confidence
with their clients, must accept further restrictions, beyond the boundaries of
good faith required in all commercial relationships. Even Adam Smith, the
founder of modern capitalism: “Our continual observations upon the conduct of
others insensibly lead us to form to ourselves certain general rules concerning
what is fit and proper either to be done or to be avoided.” Adam Smith, THE
THEORY OF MORAL SENTIMENTS 109 (1759).
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 th e 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 seen, “Smith embraces both the great society and the
judicious hand of the paternalistic state.” 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.)
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, he would observe 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 those who provide investment advice.
(5) THE SOLUTION: DISTINGUISHING
“ADVICE” FROM SALES; HOLDING
ALL “ADVISORS” TO FIDUCIARY STANDARDS;
THE “SELLER’S EXEMPTION”
Michael
Kitces, a renowned industry commentator, best expressed the sentiment that what
proponents of the fiduciary standard desire is not that everyone become
a fiduciary, but rather that everyone who
provides investment advice become a fiduciary:
[T]he only kind of
advice is fiduciary advice, delivered in the best interests of the person
receiving the advice. Merriam-Webster defines the act of advising as "to
give (someone) a recommendation about what should be done" (emphasis
mine); in other words, telling the person what should be done that's in their interests is the very essence of
what advice is, in the first place! On the other hand, the suitability standard
is about offering a product for sale that is suitable - or at least, not
unsuitable - given the client's circumstances. The latter, simply put, is not a
standard for advice; it's not actually about advice at all, but simply determining
whether a product being sold is so unsuitable that it's unconscionable to allow
it to be bought at all. Advice, as Merriam-Webster makes clear, it about
telling someone what actually should be done, not merely what would be
"not unsuitable" to buy …
Accordingly, the real
debate is not about whether consumers should have a choice between fiduciary or
suitability; the real choice is between working with an advisor who delivers
advice and working with a salesperson who
sells a product. Notably, the latter is not intended in a derogatory or
pejorative manner; it is simply to make the distinction between someone who
offers bona fide advice - which, by definition, is in the interests of the
person receiving the advice to get a recommendation about what should be done -
versus someone who offers a product for sale, which is implicitly in the
interests of the person or company offering the product for sale but should
only be offered when it is not unsuitable to do so.
Why is this
distinction of advice versus sales more important than fiduciary versus
suitability? Because, cast in the context of advice versus sales, the solutions
quickly become more readily apparently. The goal of fiduciary advisors should
not be to subject everyone to the fiduciary standard; it should be to subject
everyone offering advice to the
fiduciary standard. If you don't want to be treated as a fiduciary, that's
fine; just don't offer advice, and don't hold yourself out as offering advice.
People who offer securities or insurance products for sale eliminate the words
"financial advisor" or "financial consultant" from their
business cards, and simply hold themselves out for doing what they do:
registered representative, stockbroker, or insurance agent. Those who offer
advice hold themselves out as advisors, and subject themselves to the
appropriate standard.
Should we
fail to make the distinction – between advisors and salespeople – the ramifications
for consumers will continue to be untold amounts of harm. As observed by
Professor Langevoort:
[W]hen faced with
complex, difficult and affect-laden choices (and hence a strong anticipation of
regret should those choices be wrong), many investors seek to shift
responsibility for the investments to others. This is an opportunity – the core of the full-service brokerage business
– to use trust-based selling techniques, offering advice that customers
sometimes too readily accept. Once trust is induced, the ability to sell vastly
more complicated, multi-attribute investment products goes up. Complex products
that have become widespread in the retail sector, like equity index annuities,
can only be sold by intensive, time-consuming sales effort. As a result the
sales fees (and embedded incentives) are very large, creating the temptation to
oversell. In the mutual fund area, the
broker channel – once again, driven by generous incentives - sells funds
aggressively. Recent empirical research suggests that buyers purchase funds in
this channel at much higher cost but performance on average is no better, and
often worse, than readily available no-load funds …
‘[U]ltimately, this
is where we see the clearest gap between advisers and brokers. An adviser is
presumably expected to recommend the best available securities for the desired
portfolio, taking costs into account. By contrast, a broker has no well-defined
obligation to offer the best available securities—just suitable ones with no
hidden risks or fees. Within these norms, the broker is free to push what is in
inventory, or what is otherwise most profitable to sell, even if there may be
other, less costly investments that would satisfy the customers risk/return
preferences just as well or better.”
Donald
C. Langevoort, “The SEC, Retail Investors, and the Institutionalization of the
Securities Markets” (Jan. 2009).
IN CONCLUSION – THE "SELLER'S
EXAMPTION AND THE FALLACY
OF THE “CHOICE” ARGUMENT
While
we do not yet know the actual content of the U.S. Department of Labor’s
re-proposed regulation, it is apparent from public comments by its authors that the regulation will provide a “seller’s
exemption.” In essence, consumers will possess the choices they previously
possessed. The argument that the regulation will “limit consumer choice” is a
fallacy.
The “seller’s exception” is logical. This provides the "choice" for consumers. In essence, consumers may still choose to deal with product sellers – but they will be armed (hopefully) with clear, concise instructions that they are in an arms-length relationship with the broker and that they are not entitled to “rely” upon any statements provided by the (non-fiduciary) broker. The consumer will know, we hope, that she or he must protect himself or herself, and that any recommendations received from the (non-fiducairy) salesperson must be scrutinized carefully.
But what should NOT be a choice present is the ability to mislead consumers - by providing advisory services, and/or holding out as an advisor (through the use of titles or otherwise) - and then hiding behind the veil of suitability when something goes wrong.
It is my hope that the regulation will specify that brokers must not utilize titles, nor other marketing tactics, in which they hold themselves out as advisors, in order to utilize this seller’s exemption. For it is a fundamental truth that “to provide biased advice, with the aura of advice in the customer’s best interest, is fraud.” [Angel, James J. and McCabe, Douglas M., Ethical Standards for Stockbrokers: Fiduciary or Suitability? (September 30, 2010), at p.23. Available at SSRN: http://ssrn.com/abstract=1686756.]
What should be different under the DOL’s re-proposed “Definition of Fiduciary” rule
(at least, I hope, having not seen the text of the rule itself) is a return to
when fiduciary standards were imposed upon all relationships of trust and
confidence, where advice as to the
purchase of securities by clients occurs. Only in this respect will “choice” be
restricted – i.e., bad product sales recommendations
can no longer masquerade as trusted advice.
Perhaps
National Association of Plan Advisors (NAPA), which espouses that “many
Americans” would be prevented “from working with the trusted advisor of their choice,” should examine their own
messaging. For it is obvious that NAPA desires, for some of its broker-dealer
and insurance company members – the continuation not of choice, but of consumer
fraud, by permitting sales activities under the low suitability standard of conduct to continue to occur within relationships
of trust and confidence, when it is altogether proper that the higher fiduciary standard of conduct should be applied.
However, in essence, under the DOL's re-proposed regulation, consumer
choice will continue. Consumers will be able to rely upon trusted advisors, or they may choose to work with product sellers. Only now, the
distinction between the two will become clearer.
The argument of those opposed to the imposition of fiduciary standards - that this regulation will constrain consumer choice - is a fallacy.
