Friday, May 5, 2017

A Message to Morgan Stanley About Its (Lack of a Fiduciary) Culture

I'd like to step out of character and briefly comment on a story that's been circulating recently - Morgan Stanley's decisions to drop sales of Vanguard funds (as new holdings). The reason suggested by commentators? Because Vanguard does not make payments for shelf space (i.e., revenue sharing). In other words, Morgan Stanley will make more money selling funds that do make payments for shelf space. (Of course, Morgan Stanley is not alone - many broker-dealer firms engage in the same practices.)

In a related story, it was reported that Morgan Stanley would pay their financial advisors less if they recommend Vanguard funds.

Assuming such reporting is true, then I would just like to opine ....
  • Payment for shelf space is an insidious practice. It creates a huge conflict of interest for the firm, and its advisors. Such arrangements should not be permitted to exist under a fiduciary standard, for no benefit accrues to the client. Payments for shelf space have to come from somewhere; they often result from management fees in the mutual funds (which management fees are kept higher than they need to be, by the presence of revenue sharing arrangements). And, the academic research is compelling ... higher-cost funds result in less returns to investors, all other things being equal.
    • (Other insidious practices that will become extinct someday: 12b-1 fees; soft dollar compensation.)
  • The conflicts of interest resulting from pursuit of higher fees to the firm from proprietary products or from products which pay revenue sharing cannot (the vast, vast majority of the time) be defended under the DOL's Impartial Conduct Standards. The 237 words of the Impartial Conduct Standards, elegantly written, should serve as a guide for true fiduciary conduct.
  • Under the DOL's Impartial Conduct Standards, the firm and its advisors must adhere to the prudent investor rule. One of the major aspects of that rule is to not waste client assets. This drives fiduciary advisers to seek out the lowest-cost fund or ETF in each asset class (all other things being equal). If a higher-cost fund is recommended, justification for the expenditure of the client's hard-earned wealth must exist. Not just mere justification - but justification that will stand up in court or in arbitration (with the burden of proof rightfully falling on the adviser and firm, when a conflict of interest exists).
  • Is dropping low-cost funds from a platform, in order to favor funds that pay a firm revenue sharing, a breach of the firm's fiduciary obligation under the Impartial Conduct Standards (and ERISA, generally)? That remains to be seen.
    • Probably not, at least under BICE. (And perhaps Morgan Stanley's actions are indicative of how BICE can be manipulated, through structuring what is available to clients. I have always expressed the view that BICE should be viewed as a transitional measure. If BICE indeeds becomes operational, it should be sunset after a few years, lest tomfoolery take place to use BICE to escape the application of the fiduciary principle.)
    • Suffice it to say, however, that it is clear that the spirit of the fiduciary principle is violated, in my view, at the minimum.
To operate as a fiduciary, your compensation arrangement with the client should be level, and agreed to in advance.

Then, as a fiduciary adviser, with your compensation set, you should search out the marketplace for the very best products available to the client. If those happen to be Vanguard funds, you should seek to have them available to your clients - if not directly on your firm's platform, then perhaps directly via Vanguard.

For a fiduciary is required to be an expert, and to exercise due diligence. And to use this high level of professional due care for the benefit of the client. And neither the firm nor the adviser should, under any circumstances, seek to take advantage of the client.

To Morgan Stanley, I convey these messages:
  • If these news reports are true, and if dropping Vanguard funds was the result of the motivations commentators have suggested - I suggest this. Reverse your decision.
  • Stop ... stop ... stop ... creating perverse incentives for your financial advisers to sell proprietary or other funds that pay the firm more, over lower-cost funds.
  • Otherwise, many of your good advisers, who want to do the best for their clients, and who want to be expert, diligent stewards of their client's hard-earned wealth, will eventually depart your firm.
  • Sure, many other advisers, who don't desire to work in a fiduciary culture, and who are willing to take on the added liability (and severe reputational risk) that results from working in a conflict-ridden environment, will likely stay with your firm.
  • Under a conflict-ridden culture, the legal claims will continue. And the litigation costs will continue. And ... oh yes, good new advisers won't be attracted to your firm. It's a dismal path your firm is on, over the long term. Short-term profits may abound, but long-term the firm has a poor future ahead of it.
  • If your advisers act as fiduciaries, don't compel them to also act as product-sellers. The two roles are simply incompatible. To paraphrase many a jurist, "a man cannot wear two hats at the same time."
To Morgan Stanley, I also state:
  • Change your decision-making. Or change your leadership.
  • For the instillation of a true fiduciary culture is driven from the top, always. And strong leadership embracing a bona fide fiduciary standard will be required to move your firm forward, not backwards.
  • If Morgan Stanley's current leadership can't embrace the changes in the industry, and if they fail to understand that the firm's market share will only shrink if its conflict-ridden business model continues to exist, then perhaps its Board of Directors should think about a change ... before Morgan Stanley's ship cannot be turned, and it either capsizes or diminishes in size to become a toy boat in a broad fiduciary sea.
To all dual registrant firms ... don't try to circumvent the fiduciary principle. In an era where greater transparency is required, and fiduciary practice models continue to win in the marketplace (either with or without the aid of regulatory initiatives), it is incumbent upon your firm to go "all in." Learn what is required under a bona fide fiduciary standard of conduct. Then structure your firm, and your services to clients, and the products offered on your platform, accordingly.


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