Tuesday, March 12, 2019

SEC Chair Jay Clayton is Wrong: The Advisers Act Requires Much More Than Just Disclosure of a Conflict of Interest

It has been confirmed to me that SEC Chair Clayton and/or others at the SEC have been stating recently that:

  • The Advisers Act's fiduciary standard of conduct only requires disclosure, when a conflict of interest exists.
  • Proposed Reg BI, which would impose a "best interests" obligation on broker-dealers and their registered representatives (which, the SEC acknowledges, only imposes an obligation of disclosure when a conflict of interest exists), would essentially raise the standard for broker-dealers to near the same standard of conduct as exists for investment advisers.
WE MUST PUSH BACK ON THIS.

Realize that the SEC ignores its own precedent, and centuries of law, with these actions. SEC Chair Clayton seeks to redefine the English language. His actions will only weaken the law, foster distrust of financial advisers, and deter capital formation (as trust is essential to same, and high intermediation costs interfere with capital accumulation), which in turn will weaken the U.S. economy in the long term.

Also realize that Reg BI arose from a proposal by SIFMA and FSI (broker-dealer lobbying organizations), the SEC Chair Clayton (who represented broker-dealers in his law practice) has embraced. But it is a grave threat to the financial security of individual Americans, and does not impose any substantial restrictions on the conduct of brokers.”


The SEC’s current view of the fiduciary standard is NOT the same as the view it had prior to the current Administration.
  • The current SEC Chair seeks to water down the fiduciary standard to a meaningless disclosure standard.
Think about it … if disclosure was all that were required under a fiduciary standard, then there would be no need for a fiduciary standard!
  • Laws and regulations imposing disclosure obligations would be all that is required. No fiduciary duties would have ever come into existence, under the law.
The law’s imposition of a fiduciary standard recognizes that disclosures are ineffective, especially in advisor-client relationships where a great disparity in knowledge and power exists and public policy so dictates.

The Investment Advisers Act of 1940 was ALWAYS known to apply the fiduciary standard.
  • The SEC stated this in 1941! The language of the Advisers Act was always known to apply the fiduciary standard!
  • While not expressly stated in the Advisers Act, there does not mean that the fiduciary standard, being “implied” from the language of the Advisers Act, is less than a true fiduciary standard.
  • The fiduciary standard was only confirmed to exist by the U.S. Supreme Court in the SEC vs. Capital Gains decision in 1963. It did not arise for investment advisers at that time.
The SEC’s view of Capital Gains is incorrect.
  • The broker-dealer industry (and, acting through its attorneys, who write outlines on fiduciary duties for dual registrant firms), has recently taken the position that the Investment Advisers Act of 1940 only requires disclosure, and nothing more. This is based upon a misreading of SEC vs. Capital Gains. But the U.S. Supreme Court, in that case, stated that it “could go further.” But all the SEC charged, as to a breach of fiduciary duty, was violation of the obligation of disclosure of a conflict of interest. (Which is far easier to prove than other requirements of the fiduciary duty of loyalty, such as whether informed consent was obtained.)
  • “It is arguable -- indeed it was argued by ‘some investment counsel representatives’ who testified before the Commission -- that any ‘trading by investment counselors for their own account in securities in which their clients were interested . . .’ creates a potential conflict of interest which must be eliminated. We need not go that far in this case, since here the Commission seeks only disclosure of a conflict of interests ….”
The SEC has previously taken the position that disclosure is not enough when a conflict of interest is present - much more is required.
  • As stated in an SEC No-Action Letter:  “We do not agree that ‘an investment adviser may have interests in a transaction and that his fiduciary obligation toward his client is discharged so long as the adviser makes complete disclosure of the nature and extent of his interest.’ While section 206(3) of the Investment Advisers Act of 1940 (“Act”) requires disclosure of such interest and the client's consent to enter into the transaction with knowledge of such interest, the adviser's fiduciary duties are not discharged merely by such disclosure and consent. The adviser must have a reasonable belief that the entry of the client into the transaction is in the client's interest.  The facts concerning the adviser's interest, including its level, may bear upon the reasonableness of any belief that he may have that a transaction is in a client's interest or his capacity to make such a judgment.” Rocky Mountain Financial Planning, Inc. (pub. avail. Feb. 28, 1983).
  • It has long been the Commission’s position that the “an investment adviser must not effect transactions in which he has a personal interest in a manner that could result in preferring his own interest to that of his advisory clients.” SEC Rel. No. IA-1092, October 8, 1987, 52 F.R. 38400, citing Kidder, Peabody & Co., Inc., 43 S.E.C. 911, 916 (1968).
The U.S. Supreme Court has previously written about the fiduciary standard, generally, and in particular the fiduciary duty of loyalty:
  • For example, see Justice Douglas’s majority opinion in Pepper v. Litton, 308 U.S. 295, 311 (1939), wherein he stated: “He who is in such a fiduciary position cannot serve himself first and his cestuis second … He cannot use his power for his personal advantage and to the detriment of [the cestuis], no matter how absolute in terms that power may be and no matter how meticulous he is to satisfy technical requirements.  For that power is at all times subject to the equitable limitation that it may not be exercised for the aggrandizement, preference, or advantage of the fiduciary to the exclusion or detriment of the cestuis. Where there is a violation of those principles, equity will undo the wrong or intervene to prevent its consummation … Otherwise, the fiduciary duties … would go for naught: exploitation would become a substitute for justice; and equity would be perverted as an instrument for approving what it was designed to thwart.”
The State Securities Administers Disagree with the SEC, as well.
  • In their Feb. 19, 2019 supplemental comment letter to the SEC, they stated: “What is missing from the [REG BI] proposal and statements by SEC officials is a recognition that disclosure cannot and should not be characterized as sufficient to satisfy an adviser’s fiduciary duty and more especially the adviser’s duty of loyalty. Disclosure of conflicts aside, an adviser’s duty is to act in the best interest of his or her client. The analysis does not and should not stop once the question of whether disclosure of the conflict has been made to the investor.”
It is clear that under state common law the fiduciary standard of conduct requires much more than mere disclosure.
  • It has long been the SEC’s view that the fiduciary duty created by the Advisers Act encompasses state common law fiduciary obligations. Brandt, Kelly & Simmons, LLC, Admin. Proc. File No. 3-11672, 2004 WL 2108661 (SEC Sept. 21, 2004). In fact, a "federal fiduciary standard" only exists to the extent necessary to resolve conflicts among the states or adhere to express legislative dictates.
  • Breach of fiduciary duty claims against investment advisers are typically based upon state common law, as the federal Advisers Act does not possess a private right of action (except in limited circumstances).  Accordingly, maintaining consistency with state common law should be a major factor in how the federal fiduciary standard arising under the Advisers Act is applied. The interpretation of the fiduciary duties arising under the Advisers Act does not preempt,  and should not seek to eclipse, state common law for breach of fiduciary duty by an investment adviser, given the limited remedies afforded to clients under the Advisers Act itself. Rather, the effect should be complementary.
What Does the Fiduciary “Best Interests” Standard Require, When A conflict of Interest is Present?
  1. Full, complete, and affirmative disclosure of the conflict of interest (and its ramifications to the client)
  2. The adviser ensures client understanding of the disclosures made.
  3. The client provides informed consent.
    1. Not mere consent.
    2. No client would ever consent to be harmed!
  4. Even then, the courts further test the transaction – is it substantively fair to the client?

You cannot easily disclaim your fiduciary obligations, nor seek client waiver of same.
  • Concepts of “waiver” and “estoppel” have substantially less application when the fiduciary standard is applied. As a result, generally fiduciaries cannot disclaim away their fiduciary duties, nor may clients waive the core fiduciary duties.
Disclosures are completely ineffective in this area.
The SEC wants brokers and investment advisers to be virtually the same. They are not – they are, and should remain – opposites.
  • Brokers are salespeople. They sell products and securities. They are in arms-length relationships with their customers. Caveat emptor applies. The suitability standard applies, which negates in large part the duty of care most other providers of products and services possess under the law.
  • Investment advisers are fiduciaries. They are paid by the client. They represent the client. They act as the “purchaser’s representative.” They possess strong fidiuciary duties of due care, loyalty, obedience, utmost good faith, and others. They are in a fiduciary-entrustor relationship with the client. They must receive only reasonable compensation (preferably levelized, and agreed-to in advance).
Fees and costs matter. 
  • Brokers generally result in much higher fees and costs for investors, than investment advisers.
  • Compelling and substantial academic evidence leads to the conclusion that the higher the fees and costs, the lower the returns to investors.
  • In my experience, from reviewing hundreds and hundreds of client (and potential client) portfolios, fee-only (fiduciary) investment advisers typically are 30% to 70% less expensive, in terms of total fees and costs investors bear, than “full-service brokers.”
The fiduciary standard acts as a deterrent to, or restriction upon, greed.
  • At its core, the fiduciary standard mandates certain conduct (duty of care) and restricts or prohibits other conduct (duty of loyalty).
  • Public policy strongly supports the application of the fiduciary standard to the delivery of investment advice, as a restraint upon fraud, and for numerous other reasons. See my comment letter.
Small clients CAN BE - and ARE NOW - being served under fee-based (and fiduciary) accounts.
  • Brokers are stating (and the SEC is now repeating) that small clients can't be served except under a broker-dealer commission-based sales model.
  • What the broker-dealer community is really saying: “We can’t serve small investors unless we charge them exorbitant fees.”
  • Note that many, many brokerage firms have minimums - $100,000, $250,000, or greater! Many of the brokers who advocate that "small investors can't be served under a fiduciary standard" are the ones who have these minimums!
  • Investment advisers have been serving small investors for reasonable fees, for many years. Specific examples include:
    • Vanguard Personal Advisor Services - $50,000 minimum.
    • Schwab Intelligent Adviser – a “robo-adviser” (and there are many in this area) that has a $5,000 minimum.
    • Betterment – another robo-adviser, no minimum account size, investment advisory fees of only 0.40% to 0.25%/year
    • Garrett Planning Network – over 300 investment advisers around the country providing comprehensive financial planning advice (including investment advice) for reasonable hourly fees
    • X-Y Planning Network – 750 members and rapidly growing, with most chagrining a monthly subscription fee (some at $80/month, average is about $180/month).
    • And thousands more investment advisers (not in organizations or networks, and who are not robo-advisers) exist that accept small accounts to manage - for flat annual fees, for monthly subscription fees, or for a reasonable percentage of assets under management.
  • As the industry has shifted from about 10% fee-based accounts 20 years ago, to about 50% fee-based accounts (and 50% commission-based) currently, and with the aid of technology that streamlines operations, I anticipate investment advisory fees to continue to trend downward, and more and more investment advisers to work with small clients.
  • Fee-based advice is often much more comprehensive than commission-based advice. Look at this situation. A client is sold a $24,000 mutual fund (Class A shares) by a broker, which has a 5.75% commission. That is $1,380 in compensation paid to the broker – for a simple sale. I know many financial advisors who will prepare a full-blown financial plan for that amount – including recommendations to invest in low-cost Vanguard funds or ETFs (which, unlike the Class A shares sold by the broker, don’t carry the burden of 0.25% annual 12b-1 fees, which is nearly always additional compensation to the broker, in most instances, and often continue indefinitely while adding no benefit to the customer / fund shareholder!)
In my view, SEC Chair Jay Clayton will go down in history as the worst SEC Chair ever. He is pushing the SEC to water down the fiduciary standard, redefine "best interests" as something other than the fiduciary duty of loyalty, and who advances the positions that so many broker-dealers desire - i.e., to be "trusted advisors" without being truly held accountable for the advice that they provide.

How should we react to this travesty?

    A. VISIT OR WRITE YOUR MEMBER OF CONGRESS and YOUR SENATOR. Visit her/him when she/he returns to the district. Or fax a letter to the Member or Senator, or mail one. (Feel free to copy from this post.)

    B. Submit a comment letter to the SEC. Yes, it is past time. But you can still indicate your outrage.

We have a chance of stopping the SEC, if you act now.

Just as importantly, your actions today will also set the stage for correcting the SEC's actions, when we get a new SEC Chair ... and Jay Clayton returns to being an attorney for Wall Street firms.

And your actions will demonstrate to Members of Congress and Senators how important this issue is. Not only to our profession. But to our neighbors and friends, and their future financial security. To the level of trust possessed by consumers in financial advisors.

For betrayal of trust (as will happen under the illusion of "best interests" that Reg BI fosters) will in turn lead investors to flee the capital markets, thereby deterring capital formation. This issue is important for the future growth of the U.S. economy.

Act today. MAKE YOUR VOICE KNOWN.

Thank you.
Bear

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