Proposals for Reforms in Standards of Conduct for Investment Advisers and Broker-Dealers, at the S.E.C. and DOL; Questions on Tax Deferral; and ... Should FINRA Be Disbanded?

ALL POSTS PRIOR TO 2021 HAVE NOT BEEN REVIEWED NOR APPROVED BY ANY FIRM OR INSTITUTION, AND REFLECT ONLY THE PERSONAL VIEWS OF THE AUTHOR.

Thoughts on Regulatory and Other Reforms in 2021 and Beyond

By Ron A. Rhoades

A prior version of this article was originally published at Advisor Perspectives.

This is a time of much political and economic upheaval. Yet, it is also a time in which possibilities arise for meaningful change at the U.S. Securities and Exchange Commission (“S.E.C.”). 

Just this year we have seen the S.E.C. finalize its interpretation of the Advisers Act fiduciary duties and the implementation of Regulation Best Interest. And we have seen the Department of Labor propose rules that would gut the fiduciary standard found under ERISA. No doubt these are disturbing developments, as the influence of broker-dealers and insurance companies over these government agencies has reached new heights. Cherished principles and established legal precedents have fallen to the whims of those who seek to accommodate Wall Street, under the false mantra of consumer choice, rather than protecting individual investors. Recent rulemakings also deter the proper functioning of our capital markets, making them less efficient in allocating of capital. As regulators accommodate excessive intermediation, less capital is available, substantially dampening U.S. economic growth over the long term.

I suggest a series of questions that policy makers should be asking regarding financial services and other reforms, as we hopefully move forward toward emerging from this pandemic.

Thoughts on the current status of the fiduciary standard

Some six decades ago, Fred Schwed, Jr. wrote his classic book, Where Are the Customers’ Yachts? Yet, just a few years ago, when taking a group of my college students on a visit to a large broker-dealer firm, I found myself in offices near the top floors of a magnificently tall building overlooking the Hudson from lower Manhattan. As I looked down and saw the many yachts parked in the adjacent harbor, the host of our visit approached and proudly proclaimed that they belonged to many of the brokers who worked there. 

In more than 60 years, little has changed.

We are at a crossroads in terms of the application of the fiduciary standard to the delivery of financial and investment advice. Many insights have been developed over the past decades regarding what the fiduciary standard is all about. Yet, much work remains to be done.

We have seen regulators in recent years try to adapt the fiduciary standard of conduct to the current business models of Wall Street and the insurance companies. But, predictably, their efforts have failed. You cannot chip away at the fiduciary standard – just a few chips, and the fiduciary standard loses its structure, and collapses into a pile of goo.

There is a simple truth – no person can serve two masters. You cannot be a trusted adviser, bound by a fiduciary duty of loyalty to your client, and also push proprietary or expensive products. The roles of seller’s representative, also known as a product distributor, and purchaser’s representative, also known as a fiduciary, are simply incompatible.

Nor is the fiduciary standard observed properly by mere disclosure when a conflict of interest is present. Disclosures are ineffective, as confirmed by a large body of jurisprudence as well as by more recent academic research into the behavioral biases that both consumers and advisors possess. We also know this from our own collective practical experience as financial advisors … consumers do not often read disclosures, and those few who do simply do not understand the complexities of the modern capital markets. Because of the ineffectiveness of disclosures, the law imposes upon those who provide financial and investment advice, in relationships where trust and confidence exists, tough requirements to be an expert – in other words, adhere to the fiduciary duty of due care. And advisors are likewise bound to the distinctive requirement to act in the “best interests” of the client – in other words, with a fiduciary duty of loyalty.

So, the law imposes the requirement that, when a conflict of interest is present, the client must provide informed consent to be harmed. Unlike other situations in which fiduciary duties exist, where structures exist to prevent harm, as confirmed by extensive academic research – the greater the fees and costs of an investment product, the lower the returns, especially over the long term, all other things being equal. The result is that the existence of a conflict of interest in the delivery of investment advice – at least where the adviser receives additional compensation for a recommendation of one security or product over another –harms the investor. 

Fiduciaries must, therefore, undertake a cost-benefit analysis when applying their expertise in the selection of investment products. Higher cost products are not easily justified. Nor is the differential compensation that often flows from pushing proprietary or expensive products. Why? Because no client would ever provide informed consent to an investment destined to produce lower returns. Judges will never accept the proposition that clients are so gratuitous toward their financial advisers.

Additionally, the law concludes that the treatment of the client would not be substantively fair. These legal principles – informed consent and substantive fairness – substantially limit the application of waiver and estoppel to fiduciary relationships.

It is inevitable that, in applying the “best interests” fiduciary standard of conduct, most conflicts of interest must be avoided. In other words, many of the conflicts of interest in financial services - at least those that generate higher fees for the fiduciary (via higher fees and costs associated with the product selected), are not subject to waiver.

And, to avoid the intense scrutiny of a fiduciary standard, the compensation provided to the advisor should be reasonable and should not vary based upon the product recommendation made.

The fiduciary standard operates as a limitation of choice. It serves to eliminate bad choices and promotes the best investment choices. In so doing, the fiduciary standard counters opportunism and greed.

How should we adapt financial services to the fiduciary standard?

Let me know turn to suggest topics for further exploration in public policy circles.

A bona fide fiduciary standard of conduct is tough to adhere to in financial services. We need to design regulatory structures that better fit the fiduciary standard, rather than seek to adapt the fiduciary standard to fit current conflict-ridden business structures.

To this end, it is worthwhile to ask a great many questions, as we look toward the future.

·       What grant of authority did the S.E.C. possess to change the English language? The term “best interests” has been utilized in over 900 judicial decisions in the United States – as an expression of the fiduciary duty of loyalty. The S.E.C.’s Regulation Best Interest, which by the S.E.C.’s own admission is not a fiduciary standard of conduct, misleads consumers. To promote oneself as acting in one’s best interest – in essence as a fiduciary, while not being a trusted advisor and merely acting as a product salesperson – is tantamount to fraud.

 

·       How can we – and how fast can we – correct the SEC’s flawed interpretation of the fiduciary standard under the Advisers Act? How can we point out that estoppel and waiver possess very limited application to fiduciary-client relationships?

 

·       Can we return to the principle that, once a fiduciary relationship is established with a client, the fiduciary duties apply to all aspects of that business relationship? There should neither be a “taking off” of the fiduciary hat nor “switching hats,” particularly by dual registrants.

 

·       In what universe is ERISA’s strong trust-law based fiduciary standard, and ERISA’s prohibited transaction rules, reduced to a disclosure-only regime, as the DOL’s recent (proposed) rule would authorize? Where did the DOL get the authority to simply ignore the Congressional mandates for the grant of this proposed class exemption and reduce the interpretation of ERISA’s strong fiduciary standard to be the same as the non-fiduciary standard found in Regulation Best Interest?

 

·       We must ask – Should all financial and investment advisers be bound by a bona fide fiduciary standard of conduct? The State of Massachusetts has taken this approach, excepting only insurance agents, as have some other countries. If this were done, monumental changes would be needed in the securities and insurance industries. To provide truly objective fiduciary advice, one might mandate via law or legislation that fiduciaries must be separate and apart from product manufacturers and product distributors. This would dismantle many of the structures that have evolved in broker-dealer and RIA firms associated with mutual fund companies and other product providers. Would such a sea change be justified? Are the benefits of a bona fide fiduciary standard to our society and economy so profound that we can justify the elimination of many of the business structures that exist, in firms both large and small?

 

·       Should we not insist, at the very minimum, that brokers not disguise the nature of the merchandizing services through the use of titles that denote relationships of trust and confidence? And should we not further insist that the “solely incidental” exemption from the application of the Advisers Act be modified, so that when a relationship of trust and confidence is formed between a broker and his or her customer, the broker becomes subject to the requirements of the Advisers Act?

 

·       Or should we take a different regulatory approach? Should we instead seek to distinguish fiduciaries from non-fiduciary advisors? In other words, should we, through carefully crafted and mandated disclosure forms, provide consumers with the status of their advisor? Consumers might be informed, for example, that they are dealing with a trusted fiduciary upon whom they can rely. Or it could be made clear to the consumer that they are dealing with a “restricted advisor” – one who is not a fiduciary, upon whose reliance cannot be placed, and who may offer proprietary products? We need to explore the MiFID regulatory structure put in place in Europe, which imposes similar disclosures, and ascertain the extent of its effectiveness. And we should look to recent reforms put in place in the United Kingdom, Australia, New Zealand, Japan, and other countries for inspiration, and to ascertain the effectiveness of such regulatory efforts.

 

·       In order to develop a federal body of law and to better protect investor rights, should Congress enact a private right of action for breach of the fiduciary standard, whether occurring by an investment adviser or a broker?

Reducing conflicts of interest in all areas of financial aervices

There are many more specific regulatory actions that should be considered to reduce conflicts of interest in financial services, regardless of the application of the fiduciary standard:

·       For example, Bernie Madoff first developed the practice of payment for order flow. Should we not recognize that payment for order flow is fundamentally a challenge to the duty of best execution?

 

·       Should we acknowledge that many 12b-1 fees are simply advisory fees in drag? Since 12b-1 fees have no real benefit to mutual fund shareholders, should they be eliminated? The original purpose of 12b-1 fees has been lost in history, and 12b-1 fees can easily result in unreasonable compensation over time, as well as consumer confusion.

 

·       Commissions and 12b-1 fees should not be incentivized by tax law. Should tax law be reformed so that commissions are not added to the cost basis of a security? And should 12b-1 fees be treated as taxable distributions to the owner of the mutual fund shares?

 

·       Should we ban all sales contests, in which any rewards are provided for selling more of any financial products or meeting sales quotas?

 

·       Should we ban payment for shelf space, as well as asset manager’s payment for educational sessions at industry conferences, payment of marketing support dollars, and other “hidden” forms of compensation? Shouldn’t all investment and insurance products compete on their merits, rather than on the basis of how much compensation is paid to the product’s distributor?

 

·       I question why any investment adviser should generate revenue for themselves from the cash holdings of the client. Should not the client’s cash be invested in the best vehicles? Should not conflicts of interest arising from cash holdings be avoided?

 

·       When will regulators realize that the high fees and costs in conflict-ridden sales models are negatively affecting the retirement security of tens of millions of Americans? As retirement nest eggs are smaller, so is the availability of capital to provide fuel for new and existing businesses to form and grow. Given that fees and costs have a monumental adverse effect when compounded over time, when will regulators realize that the adoption of the fiduciary standard will usher in a far better future for the U.S. economy?

 

·       Lastly, clients of both investment advisers and brokers believe that their investment nest eggs are managed under a prudent person standard, even if such clients cannot articulate that standard. Should we provide, at a minimum, for full disclosure the duty of care owed? For example, should both investment advisers and brokers be mandated to disclose to their clients and customers whether investment recommendations are undertaken pursuant to the tough prudent investor rule, or the moderately impactful “reasonable basis” standard applicable to investment advisers when not dealing with ERISA-covered accounts, or the very weak “suitability” standard (whether it is called a “Reg BI” standard or not)?

Should FINRA be disbanded?

Our policymakers should also examine, closely, the ineffectiveness of FINRA in its regulation of the conduct of brokers:

·       In 1941, FINRA acknowledged, in its newsletter, that brokers can possess a fiduciary duty to their customers when a relationship of trust and confidence is present. But this acknowledgement is still not reflected, nearly 80 years later, in FINRA’s rules. Senator Maloney believed that NASD, which has become FINRA, would raise the standards of conduct of brokers to professional levels. Yet, at every turn FINRA has opposed raising standards of conduct. I ask … Is it not time to admit that FINRA’s model of self-regulation is a gross failure? Is it not time to disband FINRA and move market conduct regulation back to the S.E.C. and to the states? Or are we going to endure another eight decades where the standards of conduct for brokers make very little progress?

 

·       By what construct does one ever believe that independent, objective arbitration can be secured when such arbitration is under the control of an industry’s association? Abuses have and will continue to occur. And the perception of most individual investors is that FINRA arbitration is inherently unfair. Should not FINRA arbitration be moved to a separate and completely independent entity?

 

·       Or should, at a minimum, Congress mandate a disclosure, akin to what is seen on cigarette packages, such as: “FINRA represents a significant risk to your financial health”?

Reforming retirement plans 

·       Why do we have so many types of defined-contribution and defined-benefit plans, each with their own legal and tax rules? Why not just have one version of each? And why can’t the government provide a single plan document that can be easily adopted by any plan sponsor?

 

·       Should corporations be prohibited from issuing dividends or engaging in stock buy-backs when the funding of their pension plans falls below 90%? Are actuaries using appropriate data, such as reasonable estimates of the expected returns of asset classes (that often vary tremendously over 15-year periods, reflecting current asset class valuations and the reversion to the mean phenomenon)?

 

·       Should more appropriate limits be placed on the funding of certain defined-benefit qualified plans as well as nonqualified retirement plans, when such plans are designed to benefit the owners of closely held firms? Why should highly compensated owners or executives of small firms be permitted to defer $200,000 or more of income each year?

 

·       In an era of employee movement from one company to another, should not employer contributions to retirement plans immediately vest?

 

·       Also, why can’t we simplify the limits of employer and employee contributions to avoid the necessity in many plans of anti-discrimination testing?

 

·       Should we not limit the contributions made under defined-benefit plans where the bulk of the benefits go to the owner of the business entity?

 

·       At a minimum, can we expand the options for employer matches for SIMPLE IRA plans in order to incentivize employee contributions at greater levels? A 3% match to a 3% employee contribution is an insufficient level of savings for retirement purposes. Can we provide for one-for-one and one-for-two matches for employee contributions up to 12% of the employee’s pay?

 

·       The exemption of governmental 403(b) plans from ERISA’s requirements has wreaked havoc upon the retirement dreams of teachers, in particular. Congress needs to address this issue promptly.

 

·       Should legislation be enacted in which plan sponsors are relieved from liability under ERISA for decisions relating to the selection of the investments for the plan, provided that they engage an investment adviser and the investment adviser possesses sufficient liability insurance coverage?

 

·       In an era in which many Americans possess inadequate savings for retirement, should tontines be permitted, and if so, should they be organized as trusts? Should they be governed by ERISA?

 

·       We continue to see major abuses in the areas of annuities and the sale of cash-value life insurance for retirement purposes. Should Congress re-visit the regulation of both fixed and fixed-index annuities and classify them as securities?

 

·       And should Congress revisit the safe harbor provided to plan sponsors for annuity products, recognizing that the decision to annuitize is a major decision that should benefit from fiduciary advice, a cost-benefit comparison of annuity products available in the marketplace, and due attention paid to the financial strength of the issuer?

On the regulation of life insurance and annuities

·       Should Congress repeal the tax-deferral provisions which benefit nonqualified annuities, at least where annuitization has not occurred?

 

·       Should Congress require that withdrawals and loans from cash-value life insurance result in taxation of any gains within those policies?

 

·       Congress may also need to address annuity and life insurance disclosures as required by state law. Should it be made clear that such disclosures do not prevent other disclosures from taking place, such as those required by a fiduciary in order to fulfill the fiduciary’s obligations to her or his clients?

 

·       And should Congress mandate that no state law may prohibit the rebate to the client of commissions on the sale of insurance products, in order that fiduciaries who are also licensed insurance agents can avoid the conflicts of interest that arise from commission-based compensation?

 

·       Should Congress also mandate, as state insurance regulators have failed so often to do, that the compensation paid to insurance agents from the sale of life insurance and annuity products be fully disclosed to the customer, in advance?

Initial public offerings 

·       How can we make initial public offerings of securities more efficient? There are great disparities in the pricing of these offerings, often negatively affecting the amount of capital raised by issuers. The extraordinary hype of many securities offerings often results in detrimental impacts on individual investors.

 

·       Does the existence of syndicates for initial public offerings result in less competition among investment banks, in terms of the pricing of IPOs?

 

·       In this era of multi-national companies with often dozens of different divisions, how can the financial disclosures in prospectuses and annual reports be more transparent, so that investors can better assess the operations of these companies and their future prospects?

 

·       At the same time, should the frequency of such disclosures be reduced, to align better with regulation in other capital markets around the world, and to reduce corporate costs?

 

·       How is crowd-funding working? Is it efficiently allocating capital? Or are excessive frauds taking place, and if so, are the remedies adequate to deter fraud and for investors to recover?

Investment company reforms

·       In light of the structural impediments to arm's-length bargaining between a mutual fund and its investment adviser, how should Congress modify the Investment Company Act to better ensure that a fund’s board of directors exercise its fiduciary duties to the fund shareholders far more robustly than is currently seen?

 

·       Should not any compensation received by investment advisers from investment companies, relating to securities lending activities, be part of the management fee? Where did anyone ever get the idea that securities lending revenue deserves to be “shared” with the investment adviser to a fund?

 

·       Many bank-affiliated mutual funds have much higher administrative cost structures, with payments of such costs often made to bank subsidiaries. This issue deserves greater scrutiny.

 

·       Why shouldn’t portfolio turnover reflect the average of asset sales and purchases within the fund, rather than the lower of the two? And should not transaction costs within funds, as well as certain opportunity costs, be better disclosed if not estimated?

 

·       I question whether investment advisers to investment companies should ever share in the securities lending revenue they generate. Their compensation for these activities should be part of their management fee, and as a result fully transparent.

Questions to pose on tax reform 

·       More broadly, in an era of huge federal budget deficits, and the federal debt approaching 150% of GDP (with the actual federal debt, including unfunded future liabilities, much higher), can we justify the tax breaks from Roth accounts? Can we justify any tax-deferral vehicles, including qualified retirement plans and IRAs, given the loss of revenue?:

 

·       Given the fact that our private retirement systems have failed to provide retirement security for tens of millions of Americans, should we explore reforms that involve mandated withholdings for individual retirement accounts?

 

·       When will Congress close the carried interest loophole? Does this not incentivize, unfairly, the movement away from publicly traded corporations to private equity? And does this also not unfairly incentivize high-fee hedge funds?

 

·       Can we close the loophole for exchange-traded funds, in which they avoid capital gains taxation? Should we not, at a minimum, impose average cost realization of capital gains upon the ETF when securities are delivered in kind? The current tax treatment of ETFs substantially disfavors traditional mutual funds.

 

·       Instead of lower taxation of capital gains, should we instead tax gains as ordinary income, but provide an adjustment to cost basis to reflect the rise of the consumer price index? These systems could be established with current technology.

 

·       Should we move away from itemized deductions for home mortgage interest and state and local taxes? These deductions only benefit higher-income Americans. By eliminating these deductions, could we further expand the standard deduction, especially since itemized deductions greatly favor those in higher income tax brackets?

 

·       While lowering the corporate tax rate a few years ago made American companies more profitable as well as more competitive with respect to other countries, much more could have been accomplished. Many of the special tax deductions for various industries could have been eliminated at the same time, and each and every one of these should be revisited.

 

·       Would it be more competitive for U.S. corporations, particularly with respect to exports, if we moved to a value-added tax?

 

·       We should examine whether the massive complexity of the Qualified Business Interest Deduction for pass-through entities is necessary; I cannot believe that I pay a lower income tax rate on much of my income in my practice than the tax rate paid by my lower-compensated friends receiving salaries.

 

·       Related thereto, should policymakers incentivize the payment of dividends to other corporations and to individual shareholders, by permitting a full dividends-paid deduction? Would reforming this also result in more efficient allocations of capital in our economy?

 

·       Should we incentivize charitable gifting in better ways, such as by returning to an above-the-line deduction for gifts to charities? Should we incentivize, in particular, gifts to endowment funds that are designed to provide benefits in perpetuity? U.S. economic stability can be enhanced, and the growth of government to meet the needs of its citizens can be reduced and reversed, if we return to the principle that we should collectively save into community trusts to provide for those in legitimate need, especially in times of crisis. Increased savings to provide for future needs is a much better solution to ensuring American progress than is deficit spending.

 

·       Should the trustees of the Social Security trust funds be permitted to invest a portion of the funds in a broadly diversified basket of equities, as has occurred successfully in Australia and in some other countries?

 

·       Our Social Security and Medicare trust funds have long needed reform. Each passing year has made these reforms more consequential to individual Americans. Rather than continue to punt this problem to future generations, we must undertake reforms that will involve further increases in the retirement age, as well as greater contributions from wage earners, especially higher-wage earners.

Examining regulatory burden 

·       We need to examine every regulatory burden imposed upon public corporations and financial services firms. Is each burden – whether it be of disclosure, maintenance of systems or practices – justified? How do our regulatory burdens contrast with those of other countries?

 

·       We must acknowledge that government is designed to be limited in its resources, and that those resources must be applied to deter, detect and correct inappropriate or poor business practices that are likely to cause the most harm. Government cannot be the solution to every problem.

 

·       Finally, we need to get to the point where fiduciary advisers are treated as true professionals. Yes, inspection for asset verification – in other words, for proper custody of client’s assets – should be both robust and frequent. But we must ask – Why can’t independent investment advisers be otherwise treated in a similar manner as CPAs and attorneys? Why must examiners camp out in advisers’ offices, for weeks at a time? Cannot the limited resources of our securities regulators be utilized better?

My vision for the future

I have a vision of a future where all financial and investment advisers are fiduciaries, trusted by the public, and where the demand for financial advice soars, as trust in financial advisors grows. All Americans can receive, through some means, the trusted and expert advice they so sorely need. Trusted experts can receive professional-level compensation for their valued services. Investment and product manufacturers can compete on the basis of the overall quality of their offerings, not by providing economic incentives to product distributors through varied means that is often not discerned by investors.

I have a vision where the world of individual and business-entity federal income taxation is simpler and fairer. Important decisions as to investments made by individuals, and the use of capital by corporations, will not be skewed by tax considerations. Those with very high incomes won’t effectively pay lower tax rates than those with substantially less incomes.

I have a vision of the future where greater savings occurs, and each individual American’s investment portfolio reach higher levels, in order to better provide for individual Americans’ retirement and other financial needs. For greater capital will, especially compounded over time, will bring forth much stronger U.S. economic growth over the long run.

I have a vision where politicians are subject to term limits, so that they will serve the people and always vote their conscience, rather than be worried about their re-election prospects. No corporations nor organizations should undertake contributions to any political cause, and a fixed dollar limit should exist for each individual, each year, as to the total amount they may choose to contribute to any political candidates and causes. To move forward as a country, and to solve our most pressing problems, we must remove the distortions in public policy caused by the infusion of money into politics.

There remains much work to be done in advancing the fiduciary cause and in pressing common-sense solutions to the many structural problems in government, law and tax policies that hamper the growth of the U.S. economy and its fairness in allocating resources to all of our fellow citizens. This is important work. We are dealing with other’s people money, their lifelong financial needs, and their hopes and dreams.

Ron A. Rhoades, JD, CFP® is director of the personal financial planning program and associate professor of finance at the Gordon Ford College of Business, Western Kentucky University.

The foregoing remarks represent only my own views, and are not necessarily those of any institution, organization, nor firm with whom I may be associated, nor of any gang, cult, or motley collection of individuals with whom I have ever been associated or have been kicked out of.