A Reply to the CEO of the CFP Board

I appreciate the November 1, 2012 response of the CFP Board’s CEO, Kevin Keller in Financial Planning (http://www.financial-planning.com/blogs/Fiduciary-Standard-Moving-the-Ball-Forward-2681644-1.html?pg=1) to my prior blog post, and I welcome the continued dialogue on these important issues.  I urge all stakeholders affected by this discussion to weigh in with their views.  To this end, and as a means of replying to Mr. Keller’s remarks, I offer this follow-up blog post on this important issue.

INTRODUCTION

As I mentioned previously, I applauded the CFP Board for having moved the ball forward in 2007.  Furthermore, I also state now that I applaud the CFP Board’s educational and testing regimes; over time these have set the standard for the minimal competency levels which should be expected of every person providing personalized individual financial or investment advice.

I have questioned, however, in the context of continued evolution of the profession toward a true profession, whether it is time that the CFP Board’s Standards of Professional Conduct be revised and updated, in order to reflect: (1) the greater understanding of the fiduciary standard of conduct by leaders of the profession, now compared to five years ago; (2) the broad application of the fiduciary standard to brokers and their registered representatives who provide personal financial or investment advice (notwithstanding lack of registration as an RIA); (3) the importance of the fiduciary standard as a means of consumer protection, especially in this modern era where it is well-known that disclosures are largely ineffective as a means of consumer protection when dealing with such complex, intricate matters as financial planning and investments.

ON THE ISSUE OF “FRAUD.”

Mr. Keller questions my statement that failure to hold CFP® certificants to fiduciary status amounts to fraud.  I reply.

First, I note that my previous blog post stated:

“[T]he mere use of the title ‘financial planner’ (and even more so, Certified Financial Planner™” – leads the consumer to believe that advice will be received.

Of course, not just the CFP Board can be singled out on this point.  Many other designations and certifications use terminology such as ‘financial consultant’ or ‘advisor’ within the title.  One must ask … didn’t they know, at the time they created the designation, that holding oneself out as a ‘consultant’ or ‘planner’ or ‘advisor’ (or similar terms) was a significant factor, under state common law, in finding that fiduciary status exists?  And don’t they realize that disguising the certificant or designee as a “confident” – when the certificant or designee is not – amounts to fraud? …

I hope the CFP Board will revise and clarify its Standards of Professional Conduct, and recent interpretations thereof, to recognize that all those who hold themselves out as CFP® certificants should be held to fiduciary status at all times.  To do otherwise is fraud.”

I would first note, as set forth in my recent blog post (but omitted from Mr. Keller’s commentary), that the CFP Board uses advertisements and promotions which either expressly state or imply that a relationship of trust exists between CFP certificants and consumers.  I simply ask that the CFP Board not undertake misrepresentations to consumers.  It is a reality that, under the CFP Board’s own rules, currently not all CFP® certificants place all consumers’ best interests first when providing personalized financial planning or investment advice.  Until and unless the CFP Board actually requires that all CFP® certificants adhere to the fiduciary standard at all times when providing advice to clients, these particular ads should cease.

For some additional examples of the content which is questionable, please refer to the following:

1.             CFP Board Commercial:  “Does your financial advisor see a client? or Cash? Put your needs first. Work with a CFP® Professional.”  [Emphasis added.]  A copy of this commercial located at http://www.youtube.com/watch?v=F2yVP3mEYbw&feature=rellist&playnext=1&list=PL9B1E9E1C26D1A25D.
2.          CFP Board’s “Garden’ Banner Ad” which states: “Is your financial advisor more interested in growing your finances … or taking his cut? … Put your needs first.  Work with a CFP® Professional.”  [Emphasis added.]  For a copy of this and other banner ads, visit http://www.cfp.net/publicawareness/banners.asp.
3.          CFP Board’s written ad containing the phrase, “Americans Need Financial Advice They Can Trust,” which is found at http://www.cfp.net/teamup/toolkit.asp#Ads. [Emphasis added.] 
4.    .    CFP Board’s “Let’s Make a Plan – Talking Points” document states, in part, “As a CFP® professional, I’m here to serve consumers … My CFP® mark distinguishes me among my peers in the financial services industry as it shows that I have voluntarily met rigorous requirements of education, examination and experience and abide by CFP Board’s Standards of Professional Conduct, which includes agreeing to a fiduciary standard of care that places my clients’ interests first.”  [Emphasis added.]  http://www.cfp.net/publicawareness/messages.pdf

Again, since the CFP Board acknowledges that not all those use the certification marks (CFP® or Certified Financial Planner™) adhere to the fiduciary standard when providing financial or investment advice, I remain concerned that the public is misled by some of the content contained in the CFP Board’s promotional campaigns. 

There is significant scholarly and legal and regulatory authority in support for my proposition that if one holds out as a “financial planner” or “Certified Financial Planner™ (“CFP®), without assuming fiduciary status, fraud may well occur.  For example, the following extendeed passage is from a fairly recent article by Professors Angel and McCabe:

“The relationship between a customer and the financial practitioner should govern the nature of their mutual ethical obligations. Where the fundamental nature of the relationship is one in which customer depends on the practitioner to craft solutions for the customer’s financial problems, the ethical standard should be a fiduciary one that the advice is in the best interest of the customer. To do otherwise – to give biased advice with the aura of advice in the customer’s best interest – is fraud. This standard should apply regardless of whether the advice givers call themselves advisors, advisers, brokers, consultants, managers or planners.”

Angel, James J. and McCabe, Douglas M., Ethical Standards for Stockbrokers: Fiduciary or Suitability? (September 30, 2010).  Available at SSRN: http://ssrn.com/abstract=1686756.

Many court decisions also reflect the principle that how one holds himself or herself out is a significant factor in determining whether fiduciary status exists.  For example:

•           In a bankruptcy case involving an insurance agent (Mr. Smith) who filed for bankruptcy and sought to discharge a claim based upon breach of fiduciary duty, the Court stated: “In the present instance [the customers] were parties devoid of any financial sophistication. On the other hand, Mr. Smith claimed to be and, in fact, was a ‘financial advisor’ who certainly possessed a far superior expertise concerning investments than either [of the customers]. Mr. Smith was fully aware of the financial conditions of both considering their age and their situation in life … Even to suggest and recommend, let alone persuade [the customers] to invest their entire retirement assets in such a [Ponzi] scheme, was while not fraudulent, certainly amounted to a breach of the fiduciary duty owed by Mr. Smith to Ms. Wilson and Ms. Judson.” In re Gregory Smith (Bkrpt.Ct. M.D. Fl. 2005).
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•           “In the fall of 1985, plaintiff, having recently divorced and relocated to Columbus, Ohio, sought investment advice from Thomas J. Rosser. At the time, Rosser was a licensed salesman for Great Lakes Securities Company and held himself out as a financial advisor … [T]he evidence established that Rosser was a licensed stockbroker and held himself out as a financial advisor, and that plaintiff was an unsophisticated investor who sought investment advice from Rosser precisely because of his alleged expertise as a broker and investment advisor. Further, Rosser testified that plaintiff had relied upon his experience, knowledge, and expertise in seeking his advice. Therefore, we conclude that plaintiff presented sufficient evidence to establish that she and Rosser were in a fiduciary relationship.”  Mathias v. Rosser, 2002 OH 2531 (OHCA, 2002).
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•         When a bank held out as either an “investment planner,” “financial planner,” or “financial advisor,” the Wisconsin Supreme Court held that a fiduciary duty may arise in such circumstances.  Hatleberg v. Norwest Bank Wisconsin, 2005 WI 109, 700 N.W.2d 15 (WI, 2005).
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•          A dual registrant crossed the line in "holding out" as a financial advisor, and in stating that ongoing advice would be provided, and other representations, and in so doing the dual registrant, who sold a variable annuity, and was found to have formed a relationship of trust and confidence with the customers to which fiduciary status attached. Western Reserve Life Assurance Company of Ohio vs. Graben, No. 2-05-328-CV (Tex. App. 6/28/2007) (Tex. App., 2007).
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• .       Insurance agents who introduced themselves as “investment counselors or enrollers” and who tailored retirement plans for each person depending on the individual’s financial position, and who led the customers to believe that an investment plan was being drafted for each customer according to each customer’s needs, was held by a federal court, apply Iowa state common law, to lead to the possible imposition of fiduciary status.  Cunningham vs. PLI Life Insurance Company, 42 F.Supp.2d 872 (1990)
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•       A U.S. District Court in 1985 held that a fiduciary relationship existed in part because of a defendant's holding out as a financial planner to clients.  CSCC was primarily in the business of real estate syndication, but also in business under the name Creative Financial Planning.  “The developer defendants obtained investment capital from the public by posing as financial planners ... The financial planners typically had a background in either insurance or real estate sales …  As an alleged financial planning company, CSCC, dba Creative Financial Planners, contacted potential investors by conducting Creative Financial Planning seminars open to the public. Utilizing a slick presentation… CSCC attempted to lure investment capital out of savings accounts, home equity, insurance policies, and other conservative investment vehicles and into the speculative real estate ventures it controlled … At the seminars, CSCC offered to draft a ‘Coordinated Financial Plan’ for attendees at little or no charge. Individuals who accepted this offer received recommendations to purchase limited partnership or trust deed interests in CSCC controlled partnerships and project ....” Koehler v. Pulvers, 614 F. Supp. 829 (USDC, Cal, 1985).

Some state statutes also reflect the principle that if one “holds out” as a financial planner, fiduciary status should exist, although it remains unclear as to whether, and how, these statutes are actually enforced.  For example, in Maryland the statutes provide that ones who holds out as a financial planner is deemed to fall within the definition of investment adviser. {“An investment adviser means a person who, for compensation: (i) Engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as a part of a regular business, issues or promulgates analyses or reports concerning securities; or (ii) 1. Provides or offers to provide, directly or indirectly, financial and investment counseling or advice, on a group or individual basis; 2. Gathers information relating to investments, establishes financial goals and objectives, processes and analyzes the information gathered, and recommends a financial plan; or 3. Holds out as an investment adviser in any way, including indicating by advertisement, card, or letterhead, or in any other manner indicates that the person is, a financial or investment ‘planner’, ‘counselor’, ‘consultant’, or any other similar type of adviser or consultant.” Md. Code Ann., Corps. & Ass'ns § 11-101(h). [Emphasis added.]]  Of course, it would be wholly dysfunctional to think that a “certified financial planner™” would be excepted from these statutory requirements, which applies to a “financial planner” – simply because the word “certified” is utilized as a prefix thereto.

Lastly, and perhaps most importantly, I also referred, in my original blog post, to statements made by the SEC, cautioning on the use of advertisements and titles to denote a relationship of trust and confidence when none exists.

For example, in its 1940 Annual Report the U.S. Securities and Exchange Commission stated: “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 “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.

In summary, I don’t believe it is too much to request that the CFP Board not engage in advertising which may mislead the public.  Until such time as all CFP® certificants are held by the CFP Board to fiduciary status at all times when providing personalized investment and/or financial advice, the advertisements of the CFP Board suggesting a relationship of “trust” and that CFP® certificants act in the “best interests” of their clients could, as to some customers of some CFP® certificants®, be misleading.  Hence, these advertisements should be withdrawn (or modified with an appropriate disclaimer).  Right now, as it stands, the CFP Board’s advertisements are not always reflective of the reality of the engagement which actually ensues between the consumer and the “planner.”

Simply put, if the CFP Board promotes all CFP certificants as trusted advisors who put the clients’ best interests first and foremost, then the CFP Board should hold all of its certificants to the fiduciary standard.   If the CFP Board is going to talk the talk, then the CFP Board should walk the walk.

ON THE ISSUE OF “DETERMINING A FIDUCIARY RELATIONSHIP.”

Mr. Keller writes: “Rhoades mistakenly accuses CFP Board of placing a ‘huge emphasis on whether the financial planning engagement touches on more than one subject area.’  In actuality, the degree to which multiple financial planning subject areas are involved is just one of a number of factors the board considers in determining whether a CFP professional is in a fiduciary relationship.”

I find it hard to reconcile Mr. Keller’s statement with both the presentations I have seen (in CFP Board ethics courses in recent years), as well as the following language which I set forth in my previously blog.  This language is taken from the CFP Board’s own Q&A regarding its Standards:

Question 1-14: “How many financial planning subject areas can a CFP® professional address with a client without reaching the level of ‘material elements of financial planning’?”

[Answer.]  “Applying the financial planning process to a single subject area is not likely to be considered financial planning or material elements of financial planning. CFP® professionals who integrate the financial planning process and two or more subject areas may be providing financial planning or material elements of financial planning.”

If Mr. Keller’s statement is more reflective of the current state of the CFP Board’s interpretation, then I urge the CFP Board to revise or withdraw the foregoing language from its Q&A document.

A CALL FOR THE CFP BOARD TO LEAD THE WAY.

I would ask of us all these questions:

 If our professional organizations do not voluntarily hold us to the fiduciary standard of conduct, what right to we have to request that it be imposed by legislators or regulators?  In other words, hHow can we approach policy leaders to insist on statutory or regulatory imposition of bona fide fiduciary standards without adopting the fiduciary standard ourselves?

Just as importantly, should our professional organizations lead us toward a true profession, or should we only seek to achieve such status when forced to by our regulators? 

As we seek to answer these questions, we must realize that the fiduciary standard is one of the hallmarks of a true profession.  Robert Kennedy, in his Sept. 2001 article, “The Professionalization of Work,” noted: “As a practical matter, we are willing to permit professionals a great deal of liberty as long as we believe that we can trust them to place the welfare of those they serve (clients, patients, students, and so on) ahead of their own interests, and to practice competently … This trust is sometimes betrayed by professionals, and the community is rightly skeptical of the power of those with special knowledge. This knowledge can be used to help or to harm, and often we do not discover which it will be until it is too late.”

Professor Kennedy goes on to discuss the service attribute of a true profession, stating: “[T]he true professional also professes service to others. That is, professionals publicly commit themselves to use their special knowledge principally to serve others and not primarily to serve themselves. This does not mean that professionals must be selfless in their practices. Quite the contrary, they may be well compensated in a variety of ways for what they do. However, their first concern in making decisions will always be the benefit to the person served, and only secondarily the consequences to themselves. Furthermore, they place themselves at the service not only of their friends and neighbors, but of strangers as well. They are public persons and so have an obligation to serve those in need, regardless of personal relationship.”

I urge us all to consider this reality, as well.  If CFP® become bound by the fiduciary standard of conduct at all times when providing financial or investment advice, then the demand for the services of CFP® certificants will soar.

I repeat my close from my earlier blog post: "In 2007 a brave group of directors of the Certified Financial Planner Board of Standards, Inc. set aside their individual self-interests and adopted a fiduciary standard of conduct (at least much of the time) for Certified Financial Planners.  Now, more than five years later, it is time for this Board of Directors to complete the task – and in so doing move us toward a true profession of financial planners, all bound together by the highest standards of conduct, mutual admiration, and the respect of the public and public policy makers alike."

I now add that I further hope that the CFP Board’s leaders will not just seek to protect the CFP® mark, as to the number of certificants who utilize the mark. Should some certificants feel compelled to surrender their certification if a bona fide fiduciary standard is adopted for all those who utilize the mark “CFP®,” so be it.  We need to move forward to a true profession, and if this means that the number of CFP® certificants falls briefly, then so be it.

Rest assured, however, of the final result should the CFP Board move forward in the direction I (and many others) have proposed.  Within a short time of adopting a “fiduciary-all-the-time-when-providing-advice” standard for CFP® certificants, the consuming public (in large part due to the media attention such a move will garner, both initially and thereafter) will possess a much greater respect for CFP® certificants and flock in large numbers to seek out their services.  In turn this will lead to a far greater number of new CFP® certificants, in order to meet the substantially increased demand for fiduciary financial advice.

In short, moving forward is good for consumers, and it is likewise good for CFP professionals. Let us give this concept of "moving forward" our increased attention, and deliberate and careful consideration, in the weeks and months ahead.

Respectfully submitted.  Ron A. Rhoades, JD, CFP®

Most Courageous: Phyllis Borzi and her EBSA Team

Here are some questions for you:

• Who has saved investors billions of dollars in unnecessary fees over just the past year? 

• Who, by means of simple regulatory rule changes, compelled disclosure of fees and costs of qualified retirement plans in a meaningful way to both plan sponsors and plan participants, has led to ever-increasing pressure on advisors to plan to select lower-cost mutual funds, thereby securing a better retirement for tens of millions of our fellow citizens?

• Who, despite millions and millions of dollars of lobbying by opponents in the insurance industry and large Wall Street firms, is forging ahead to bring fiduciary duties to nearly all providers of investment advice to qualified retirement plan sponsors, and to participants of retirement plan and IRA accounts?

The answer is Phyllis Borzi, Asst. Secretary of Labor, and her great team at the Employee Benefits Security Administration (EBSA), part of the U.S. Department of Labor (DOL).

In essence, the DOL / EBSA forges ahead, while FINRA continues over decades of mistakes in failing to raise standards, and SEC appears reluctant to face up to Wall Street and apply fiduciary standards to personalized investment advice.

Of course, it is easy to criticize FINRA (f/k/a NASD), whose 1942 adoption of Rules of Conduct lacked the essential ingredient - incorporation of fiduciary duties for the advisory activities of brokers (as exists under the state common law. This is the case even though, back in the early states of federal securities regulation, and now, courts and arbitrators continues to find brokers in relationships of trust and confidence with there clients and hence subject to broad fiduciary duties.

Moreover, FINRA and its member broker-dealer firms have a long history of opposing the essential consumer protections imposed by the fiduciary principle, and which for so long have been known to exist for those who are entrusted to provide personalized investment advice. The Maloney Act of 1938, which for its authors had the goal of raising the securities industry to the highest standards of professionals, is but a dismal failure, due to FINRA.

It is also easy to criticize the SEC, who despite an early history of imposing fiduciary duties upon brokers in relationships of trust and confidence, has so often retreated from its earlier stances. In recent years it has permitted brokers to hold themselves out as trusted advisors (through the use of titles denoting relationships of trust and confidence, and by advertising which obscures the merchandizing efforts of those who sell products). The SEC's most recent release, seeking comment on the application of fiduciary duties to brokers, is indicative of a possible failure in key understandings - now informed by many academic studies - that financial literacy is mostly ineffective, and that disclosures are inadequate (due to many behavioral biases) as a means of consumer protection when such great information asymmetry is present in today's complex financial world.

But you can't criticize the DOL's effort, at least with respect to the EBSA under the leadership of Phyllis Borzi. Despite fierce Wall Street lobbying against her efforts in recent years, she has remained steadfast. Her team has undertaken the altogether necessary steps to re-propose the "Definition of Fiduciary" rule sometime during 2013, backed now by an extensive economic analysis. And this re-proposed rule, if enacted, will be a game-changer. With its potential application to IRA accounts, another $5 trillion of retirement savings will be brought under the fiduciary realm, in addition to the trillions of dollars in qualified retirement plan accounts advised upon currently by those who escape fiduciary duties under the current befuddling and narrow definition of fiduciary (as exists since 1976 ERISA rules were adopted).

How impactful will Phyllis Borzi's re-proposed rule be? Just imagine the powerful force of having individual investors aided by fiduciary "purchaser's representatives." As a result, there will be renewed pressure to lower fees and costs throughout the investment industry. Tens of billions of dollars of more savings for investors, each and every year, resulting (though the miracle of compounding) in a "retirement endowment" for our fellow citizens reaching hundreds of billions of dollars - or even trillions more - than would otherwise be possible.

More importantly, workers will get better advice, and they will be taught to save more, when aided by truly objective financial advisors. As greater and greater amounts are saved for retirement, and the amounts grow better over time through better investment choices, our fellow Americans will become better prepared for their retirement and other financial needs. This is highly important for our nation, as well, for it is self-evident that our federal and state governments are ill-prepared to lend future economic support to an ever-growing number of retirees who, lacking adequate retirement savings, would call upon governments for assistance.

Just as important, with increased saving and better investing will come greater capital formation. The cost of capital will in turn be lowered for companies, both large and small. This will assist in fueling a new explosion of economic growth in our country. Indeed, it is hard to imagine any business owner or executive, large or small, who could not be excited about this re-proposed rule and its positive implications for America's economic growth. (Except, of course, those executives on Wall Street at at insurance companies who currently extract excessive rents from qualified retirement plan and IRA accounts.)

Of course, Phyllis Borzi's efforts, and those of her EBSA team, are not going unnoticed on Wall Street. The powerful force of disintermediation which the application of fiduciary principles will impose on Wall Street and insurance companies will mean that the financial services sector's share of the profits generated in this country, which has once again risen above 30% (and perhaps much higher), will decline to much more reasonable levels. In essence, Wall Street's investment banks and broker-dealers will be hurt, economically. They won't be able to pay out such great bonuses to their executives and employees. They won't consume such a great portion of the wealth of our country. (But who will cry over that, except those who work in the insurance companies and for Wall Street's large broker-dealer firms?)

The forthcoming re-proposal of the "Definition of Fiduciary" rule, despite its huge important to hundreds of millions of Americans, and to the economic future of America itself, will face substantial opposition from Wall Street's legions of lobbyists. These well-paid lobbyists will coddle up to those in Congress, and supply both Senators and Representatives with pre-worded letters written in opposition to the proposed rule (and supply them with campaign cash, as well). With its powerful and monied lobby, Wall Street and the insurance companies will also try desperately to influence the White House, OMB, the Department of the Treasury, and whoever else will listen.

But I am optimistic, despite the huge economic forces lined up against Phyllis Borzi and her team at EBSA. EBSA has done its homework, with a substantial economic analysis supporting the re-proposed rule. The EBSA team members have put their heart and soul into the re-proposed rule. The economic analysis they will provide will, no doubt, clearly demonstrate the huge benefits of the re-proposed rule to tens of millions of Americans. The carefully crafted re-proposed rule will, if adopted, create a new, promising environment for the delivery of investment advice to our fellow Americans under the auspices of ERISA's strict fiduciary standard and prohibited transaction rules.

Hence, Phyllis Borzi's cause is our cause.

• This re-proposed rule should be the cause of every financial advisor who cares about our country's future, and their fellow citizens.
• This re-proposed rule should be the cause of every investment adviser who, despite the disintermediation which will occur, sees this proposed rule as both logical and right for our fellow citizens, and good for America itself.
• This re-proposed rule should be the cause of each and every person who desires to become part of a true profession of financial planners and investment advisers, bound together by a common fiduciary oath to act in the best interests of our clients at all times.
• And (as I hope the media will especially realize), this re-proposed rule should be the cause of our fellow citizens - workers and retirees alike - who so desire a future in which they can rightly place their trust in experts who will help them to achieve their lifetime financial goals.

To Phyllis Borzi and her team, I say: "Go for it!" It will take several months for the actual rule to work its way through OMB and other processes, before it emerges for public view. But please don't let this deter your efforts.

To all financial and investment professionals concerned about progress toward a true profession, to our fellow citizens who care about their own retirement security and about the future of America, I ask that you be prepared to lend your support to Phyllis Borzi's noble cause - applying the fiduciary standard of conduct to all of the investment advice provided to qualified retirement plan sponsors, participants, and IRA account holders, in every corner of this great nation of ours.

More to follow ... on this important issue, in the months ahead.

For updates, follow me on Twitter - @140ltd, or connect with me on LinkedIn or Facebook.

Yours truly, Ron A. Rhoades, JD, CFP(r)

Registered Investment Advisers: A New Paradigm for Regulation and Enforcement

Table of Contents
1. The SEC's Flawed Examination Process
2. A Call for Sound Principles-Based Regulation
3. Professional Involvment in Developing Professional Standards of Conduct
4. The Necessity of Professional Peer Review


1. THE SEC'S FLAWED EXAMINATION PROCESS.

Why are registered investment advisers (RIAs) and their investment adviser representatives (IARs) treated like criminals? Other professionals - attorneys and CPAs for example - don't receive the intense scrutiny during examinations which RIAs receive. Other professionals are not bound to observe a host of rules and regulations which add substantially to the cost of doing business. While there does exist one distinction - i.e., RIAs may possess control over "other people's money," in this post I submit that there are far sounder ways of protecting the public than those currently utilized.

It's easy to criticize the U.S. Securities and Exchange Commission (SEC) and state securities regulators. Over the years they have imposed more and more rules and requirements on registered investment advisers (RIAs) and their investment adviser representatives (IARs). The onsite examinations of small- and mid-size firms often last several days, or several weeks, with a "deficiency letter" following detailing minor transgressions in observing procedures required by the regulators. Very few onsite examinations uncover serious fraud ... rather, theft of client assets is usually uncovered via a complaint from a client or from a disgruntled employee.

I have previously written of the need for the SEC to focus upon actual fraud, in this era of limited funding of government operations. What should an examination look like? First, much of it should be done via an information request, with records electronically delivered to an SEC examiner for a cost-efficient review. The onsite examination should be focused on the detection of actual fraud - i.e., theft or misuse of client assets.

During onsite examinations, SEC and/or state securities examiners should go around to each and every employee of the company, hand out their business cards, and even inform employees of the availability of making an anonymous complaint against the firm. All employees should be required to attest to the fact that theft of clients' funds is not occurring, and that all funds are properly custodied. That's the way to detect fraud!

Of course, most smaller RIA firms don't possess custody of their clients' assets - the client assets are harbored in accounts with a discount broker (custodian). Hence, firms without custody are low-risk. But frequent inspections are still required - in order to verify that no custody actually exists.

In those circumstances where RIA firms take on custody, then a greater onsite review would be required. The essential role of government oversight of RIAs (and Wall Street, generally) is that of asset verification - i.e., ensuring that the client's/customer's assets are in fact there. And firms that take on custody should pay higher fees, due to the necesssity for more intrusive oversight (and the costs thereof).

We must realize that most Ponzi schemes are not "planned" months in advance of their commencement by the perpetrators. Rather, a registered representative or RIA/IAR gets into financial trouble, and he or she begins to "borrow" from client accounts. Slowly the situation balloons, ever-bigger. Self-justification of transgressions becomes the norm. As the fraud grows ever-bigger, most Ponzi artists actually want to get caught.

Hence, frequent inspections of all RIA firms are necessary - to prevent transgressions from escalating into situations where national press reports a multi-million dollar theft. But such examinations do not need to last for many days, or many weeks, in most instances.

By undertaking far more focused examinations, securities examiners can examine all RIA firms far more often. They can ensure that firms accurately report whether they possess custody. They can seek out employees who can whistelblow. They can inspect those RIA firms who possess custody of client assets, with the focus of the inspection on asset verification. In this manner, they would be able to detect frauds before they blossom until large, multi-million dollar (or billion-dollar) frauds. In essence, the securities examiners would be doing the core of their job - protecting the public from thievery. And, by reducing the number of actual frauds, greater consumer confidence will occur in our financial services system.

2.  A CALL FOR SOUND PRINCIPLES-BASED REGULATION

The fiduciary standard imposed upon RIAs and their IARs is beautiful in both its simplicity and its adaptability. Unlike a bevy of rules designed to prevent specific actions (which are often circumvented by new schemes falling outside the specific rules), the fiduciary standard is principles-based regulation.

This does not mean, however, that RIAs should not understand their fiduciary obligations. Guidance is required, and much more so that the simple statement that "RIAs have to act in their clients' best interests." Even the common (in the U.S.) triparte recitation of the fiduciary standard - that it consists of the duty of due care, the duty of loyalty, and the duty of utmost good faith - is insufficient to furnish adequate guidance to RIAs.

What is needed is a more comprehensive set of Standards of Professional Conduct for all individuals who practice as RIAs/IARs. Notice I say all individuals, not firms. Professional regulation does not involve setting standards for firms, but rather for the individual in those firms. In this manner, the development of standards is far more likely to evolve properly, by keeping the standards at the highest level. Otherwise, the economic interests of for-profit firms would, over time, negate the elevation of standards. (This has happened under the Maloney Act and with FINRA - where the creators of the Act desired to raise the standards of broker-dealer firms and their registered representatives to the "highest levels" over time, but due to the protection of the economic interests of its broker-dealer members FINRA has kept the standard to that of the very low standard of "suitability".)

3. PROFESSIONAL INVOLVEMENT IN DEVELOPING STANDARDS OF PROFESSIONAL CONDUCT

From where might we discern a comprehensive set of Standards of Professional Conduct? There are many models to choose from, and sources of information. I tend to favor the American Bar Association's Model Rules of Professional Conduct as an illustrative template. But other existing standards can be looked at, including those found in ISO 22222, the CFP Board's Standards of Professional Conduct, the standards for CPA/PFS, and those of the CFA Institute for its members. Of course, existing state common law, FINRA arbitration decisions, SEC regulations and no-action letters and regulations, and those decisions and rules of other agencies should be consulted during this process.

(For an illustration of just what a principles-based set of professional standards of conduct might look like, view pages 49 ff. of my prior submission to the DOL, located at http://www.dol.gov/ebsa/pdf/1210-AB32-PH029.pdf.)

Who should develop these new Standards of Professional Conduct? The answer is clear ... the professionals themselves. Only those with a thorough knowledge of the profession can envision how proposed rules are likely to be applied. Hence, I call upon the U.S. Securities and Exchange Commission (SEC) and the state securities regulators (through their association, the North American Securities Administrators Association, or NASAA) to form, together with the U.S. Department of Labor (DOL/EBSA), the Commodities Futures Trading Commission (CFTC), and the Municipal Securities Rulemaking Board (MSRB), an Advisory Board for the purpose of establising Standards of Professional Conduct for those individuals who practice as RIAs/IARs.

The members of such an Advisory Board should be wholeheartedly committed to the fiduciary standard of conduct. They should be leaders of the profession. Aided by competent staff, these members should, over a period of time, develop the Standards of Professional Conduct for RIAs. As part of this process, existing regulations requiring RIAs to undertake various actions or maintain certain records should be examined and, where appropriate after applying a cost-benefit analysis, either retained, modified, or discarded.

4.  THE NECESSITY OF PROFESSIONAL PEER REVIEW.

One of the reasons that securities regulators tend to focus on minitae, as well as the adequacy of disclosures, is the fact that enforcement violations relating to inadequacy of procedures, or inadequacy of disclosures, are easy to detect for examiners, many of whom have never worked in the industry.

The lack of experienced professionals being involved in disciplinary actions often leads to harsh results. Many an RIA has spent tens of thousands of dollars (or hundreds of thousands of dollars, or millions of dollars) defending itself against an assertion by a securities examiner, where in the end no violation of the RIA's fiduciary duties has occurred.

Part of the difficulty lies in enforcing the fiduciary duty of due care. We must first decide if it is appropriate for the government to enforce this duty. I personally would opine "yes." Although private rights of action exist for breach of this duty, all professional organizations also take action upon complaints involving the duty of due care.

If we conclude that the fiduciary duty of due care is to be enforced, then peer review is a necessity. Both at the stage where probable cause for a violation is found (or not found), and thereafter during the hearing process. Only fellow professionals, with substantial experience, can responsibily adjudicate the many different types of situations arising under an IARs duty of due care.

Hence, I also call upon our government regulators to augment the current enforcement process with peer review - to aid examiners in determining whether violations exist and in determining the severity of transgressions - when a breach of fiduciary duty is alleged.

IN CONCLUSION.

The time has come for investment advisors (and, more broadly, financial planners) to be regulated under structures befitting their status as professionals. It is time for examinations to focus on the detection of actual fraud, and for professionals to otherwise be treated as such (not as suspects). It is time for professionals to be involved in the development of regulation and oversight procedures, as well as be involved through the necessary step of peer review of their fellow professionals when a potential transgression is noted.

As professionals this will require our time, energy, and perseverence to attain. But, if we are ever to be treated as the professionals we know we are, then it is time to make this transition happen. Why?

• For the betterment of consumers of our professional advice and services. Consumers deserve professional advice provided under true professional standards of conduct.
• For the enhancenment of the trust of consumers in our profession, through proper government oversight (enhanced frequency of more targeted examinations, and peer review). The resulting elevation of trust will no doubt lead to an explosion of demand for professional investment and financial planning advice.
• For you, and for me, to join together in a true profession. To be proud to call our peers fellow members of this profession. To be more knowledgeable, through the developed Professional Standards of Conduct, of the obligations we assume on behalf of our clients under the highest principle set forth in the law - the fiduciary standard.

Thank you.

Ron A. Rhoades, JD, CFP(r)
February 25, 2012

Ron Rhoades is the Curriculum Coordinator for the Financial Planning Program at Alfred State College, Alfred, New York, and a practicing investment adviser representative. He also currently serves as Chair of the Steering Committee of The Committee for the Fiduciary Standard. To contact Ron, please e-mail him at: RhoadeRA@AlfredState.edu.  Thank you.

Changes in the Financial Services Industry and the Rise of the Fiduciary

From 1948 to the early 1980s the financial industry in the U.S. generated from 5 to 15 percent of all U.S. business profits.  In the early 1980s this started to creep higher and higher.  In fact, at one point, early in this 21st Century, financial sector profits reached over 45% of all domestic corporate profits.  While subsequently financial services industry profits declined, and were even negative for a short time, they have returned to levels that seem nonsensical.  In the United States, financial sector profits now have returned to between 30% and 40% of all corporate profits.

As stated in economist Simon Johnson’s seminar article, The Quiet Coup (2009): “From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent.”

How has this occurred?  Why is such a high level of rent extracted from the U.S. economy by the financial services sector?  And will this high level of division of the returns of the capital markets, away from individual investors and to financial services intermediaries, continue?

I would note that the process of capital formation, and investing, from 1950 to the current day, became both more complex and simpler.

There was a time when individual investors relied upon brokerage firms to put together a portfolio of individual stocks.  Brokerage firms and their representatives were hired on the perception as to whether their analysts could “beat the market.”  Advertising campaigns persist to this day which tout stock-picking expertise, although perhaps not of the type seen when everyone in the commercial became silent when the E.F. Hutton broker spoke.

Stock brokerage commissions, once the main source of broker's compensation, were effectively deregulated in 1975.  This began the meteoric rise of pooled investment vehicles.  Broker-dealer firms and their representatives, unable to make high profits from commissions on stock sales, turned to the manufacture and sale of mutual funds and other pools of investment assets.  While extremely high commissions for the sales of mutual funds persisted for a while, eventually limits on commissions were adopted (although they still remain high).  In addition, broker-dealers and product manufacturers adopted means to hide from investors payments by product manufacturers to product distributors, such as by payment of soft dollars, payment for shelf space, and directed brokerage.  These means persist to this day.

In the 1990's, with the continuation of the longest bear market in U.S. stock market history, mutual fund managers began to be worshipped.  Television shows appeared in the 1990’s in which fund managers were routinely interviewed and star fund managers were recognized.  Brokerage firms employed analysts themselves, to pick managers more likely to outperform in the future; these analysts – when they were correct – were likewise promoted by the media as "star analysts."

Concurrent with all of these developments, over the past several decades we have seen the rise of Modern Portfolio Theory (MPT).  With MPT came the realization that diversification was a means of eliminating uncompensated risk.  Subsequently, the Efficient Markets Hypothesis indicated that active investing was a “zero-sum game.”  Subsequent academic studies continue to indicate that, especially over long time periods, passively managed low-cost investment pools outperform (on average) actively managed higher-cost investment pools.  As a result, and especially over the past decade, index funds, assisted by passively managed ETFs, have grown substantially in popularity.  Active management continues to dominate; since there are so many forms of active management it can never be "disproven."  Yet the trend toward passively managed, lower-cost pools of investments continues.

In the late 1970’s defined benefit plans hit their peak in terms of the percentage of employer participation.  Since then, defined contribution plans and individual retirement accounts have over time slowly, but inextricably, replaced defined benefit plans – a trend which continues today.  More and more individual investors became required to manage their own stock portfolios - which previously had been done for many of these individual investors, out of their sight and out of mind, by defined benefit fund managers.

So, looking back, in the mid-1970’s traditional Wall Street firms, lost the fixed and very high, commissions for stock trading.  To replace sources of revenues firms turned to the manufacture, promotion and sale of investment products, mostly of the pooled investment variety.

Yet, under pressure from investors who shied away from proprietary products, over the the last decade many of the large Wall Street firms – but not all – have shed their asset management divisions, selling off their portfolios of proprietary mutual funds.  But many proprietary products remain.

With the continued evolution of technology and competition from discount brokerage firms, profits seen in trading on an agency basis have continued to decline.  To restore profits many Wall Street firms greatly expanded their principal trading operations.  Of course, the expansion of these operations created more severe conflicts of interests, and exposed many firms to new types of risk which they failed, in many cases, to successfully manage.

There is no doubt that, for individual Americans, the financial world became more and more complex.  No longer do most Americans in retirement head to the mailbox for their monthly pension check.  Instead, individual investors possess the solemn responsibility to save, invest, and manage portfolios for the purpose of achieving their lifetime financial goals.

Because there exists such asymmetry in the information between financial product providers and individual investors, in many instances individual investors were sold high-cost investments.  Even today, investment products continue to be sold which possess enormously high rent extraction, driven in large part by huge advertising and promotional budgets of Wall Street’s firms.

Yet, now we appear ready to enter a new age.  Call it the age of the trusted advisor.  It is the age of fiduciary advisor, who represents only the individual investor, and not the product manufacturer.  It is the age where an advisor says, "I will step into your shoes, with my knowledge and expertise.  I will act for you, or advise you, as I would advise myself, in return for a reasonable fee."

In the past few years, it has also become increasingly acknowledged that many types of investments are commodities.  (For a clear example - index funds.)  At financial advisor industry conferences more and more discussion has occurred of the "commoditization" of investments, and forward-thinking financial services bloggers and journalists continue to write articles on this theme.

The result of these trends is disintermediation.  But the dinosaur called Wall Street will not fall down without first thrashing out.  It seeks to preserve the investment product sales model, despite its many conflicts of interest, its high costs of intermediation, and its unexplainable inefficient and high extraction of rents.

Direct sales to consumers continue to expand, such as from discount brokerage firms and low-cost mutual fund complexes.  Much of this occurs because individual investors, often repeatedly burned when dealing with product salespersons only to have their trust betrayed, have eschewed all providers of financial and investment advice.  They simply believe, in some instances, that "investment advice" is not worth paying for, and they guide their own portfolios (aided in many cases by an increasing amount of investment literature - some good, but much of which is awful).

While individual investors possess the power to effect disintermediation, they do not always possess the knowledge to effect that change.  Hence, many more investors remain trapped, by their own ignorance, within the investment product manufacture and sales business model.  Recent studies have revealed that nearly one-third of individual investors believe that their "financial consultant" does not charge them any fees at all, and that they are receiving advice that is being delivered gratuitously.  If only they were so lucky.

Yet knowledgeable investors exist.  Increasingly, and with the assistance (in large part of) independent journalists and others in the media, individual investors are looking for those few financial advisors who possess very few conflicts of interest. (Many are directed to www.NAPFA.org for fee-only financial advisors, and to Garrett Planning Network - whose members often provide hourly-based financial advice.)   In essence, individual investors recognize that, in this complex world, the guidance of a true professional is both needed and desired, and they are willing to pay reasonable compensation for same.  And, with education, these individual investors learn that they will actually save money, often substantially, by having an advisor who assists them to choose lower-cost products.  How much is the net savings to investors, relative to the product-sales (broker-dealer) channel?  30% to 70%, in many cases.  Enough for a comfortable vacation once a year for the client, in most cases.

This brings us to the rise of the fiduciary advisor, and specifically the recent expansion of the registered investment adviser (RIA) community.  In recent years a trend has emerged in which individual investors seek out true fiduciary advisors, leading to this expansion.  This form of remediation is positive, as the costs of remediation are far less than the costs saved from disintermediation (despite unsupported statements by Wall Street firms to the contrary).

Of course, there is resistance to these changes from the old business model of investment manufacture, promotion and sales.  And deception also has increasingly taken place in an effort to preserve the high profits of the product-sales business model.  For example, many financial advisors promote themselves to consumers as “fee-based advisors” while never mentioning that they also sell products for commissions.  Instead of “V.P. Sales” on a business card, the term “financial consultant” has become commonplace for the product salesperson.  Disappointingly, federal securities regulators have failed to address these deceptive sales practices (despite the many warnings against such deceptive sales practices in prior decades from these same regulators).

Who will prevail - the old business model of product manufacturer and its sale through sales brokers?  Or the new business model - in which professional, independent, and trusted advisors use their knowledge to identify lower-cost investment products?

The answer remains unclear, here in early 2013.  Tens of millions of dollars are pouring into Washington, from economic interests determined to preserve the old business model.

But, as I will discuss in a future blog post, there are a courageous few – in Congress and in the halls of government agencies – who seek to aid in the transition to a new “fiduciary society."  They desire their fellow Americans to receive the truly objective, unbiased advice which Americans deserve.  They desire that the returns of the capital markets flow again in greater quantity to individual investors, not Wall Street's intermediaries.  They know that effecting such a transition can fundamentally restore trust in capital formation, leading to a new era of U.S. economic expansion and prosperity for all.  They realize that the imposition of fiduciary status on all financial and investment advisors is good not only for individual Americans, but for America itself.

I'll discuss one such courageous pioneer in my next post.  Stay tuned.

For announcements of new blog posts, follow me on Twitter: @140limited.  Thank you.

Wall Street's Deceptions, Brokers as Fiduciaries, and Investors' Trust Betrayed

WALL STREET HAS BECOME THE “SLUDGE” OF THE MODERN ECONOMY.

As my last blog [http://scholarfp.blogspot.com/2013/01/changes-in-financial-services-industry.html] mentioned, broker-dealer and investment adviser firms often consume 30% or more of the gross returns investors could expect from the capital markets. The financial services industry, as a proportion of the overall U.S. economy, has grown to unforeseen levels. Wall Street, once providing the grease that ran the economy, now provides a sludge, effectively deterring effective capital formation as well as failing to efficiently provide the returns of the capital markets to both institutional and individual investors.

THE RISE OF DECEPTIVE TITLES AND ADVERTISING ON WALL STREET.

In recent years massive marketing campaigns by Wall Street firms have touted their “objective advice” from “financial consultants” who attended their client’s soccer games and made so many believe that the “advice” received would result in the ability to afford that second home on the beach. Wall Street firms tout "wealth management" services, yet often provide, in actuality, the limited services of arms-length product brokers.

The trend has not gone unnoticed. In recent years many courageous journalists have exposed the many conflicts of interests which exist between product salespersons (however disguised they might be by the use of titles) and their clients. They have noted that “financial consultants” and “wealth managers” employed by Wall Street firms are seldom in an acknowledged “fiduciary relationship” with their customers.

Yet, despite the best efforts of many wise and candid financial journalists, the deceptions largely persist. Even though most customers believe they can “trust” their advisor, they are often sold high-cost, tax-inefficient products. These products in turn effect a high cost of intermediation, and drive down the long-term returns of investors - jeopardizing the retirement security of hundreds of millions of Americans.

YET, MANY CLIENTS REALIZE THE HARM

With increasing frequently the customers of Wall Street’s broker-dealer firms and the insurance companies have realized the harm to which they have been subjected. Not always quickly, and not all the time, of course. Even after these customers read articles questioning the objectivity and/or competence of their "financial consultant." Why the slow reaction? “[I]ndividuals continue to trust beyond the point where evidence points to the contrary. Eventually, however, the accumulated weight of evidence turns them towards distrust, which is equally reinforcing.” [Anand, Kartik, Gai, Prasanna and Marsili, Matteo, Financial Crises and the Evaporation of Trust (November 16, 2009). Available at SSRN: http://ssrn.com/abstract=1507196.]

Yet many consumers, already confused as to what obligations are owed to them by their “financial consultants,” are realizing that their trust has often been misplaced.  Increasingly, “Member, FINRA” – a required disclosure in broker-dealer firm advertising - has come to be seen as a consumer warning sign, much like the disclosure “Cigarettes are harmful to your health” found on the side of cigarette packs.

“FEE-ONLY” VS. “FEE-BASED”:  MORE CONSUMER CONFUSION.

As knowledgeable consumers became more aware that true fiduciary advisors, with few conflicts of interest, were available, Wall Street re-doubled its efforts to obfuscate and confuse consumers, in a valiant but ill-advised attempt to preserve its archaic business model.

The past few decades have seen a small but now significant rise in the number of fee-only financial advisors, such as those who are members of the National Association of Personal Financial Advisors, www.napfa.org, and/or those advisors who are members of the Garrett Planning Network, www.garrettplanningnetwork.com).These personal financial advisors eschew all commissions and material third-party compensation paid by product manufacturers (including 12b-1 fees). Instead, they choose to accept reasonable fees paid directly by the clients. In this manner, they avoid many of the conflicts of interest found in Wall Street's large broker-dealer firms. These independent, fee-only and fiduciary financial advisors act solely as the “client’s representative,” researching and then choosing far-lower-cost investments and investment products (and insurance products) for their clients.

Fee-only advisers continue to thrive within their own small universe of clients.  Yet attracting tens of thousands more advisors to the “fee-only” trusted advisor space has been difficult. Why? The reasonable compensation these fee-only advisers receive is insufficient to fund promotional efforts sufficient in quantity to counter the huge marketing budgets of the broker-dealer firms. Wall Street’s marketing machine, fueled by the high diversion of returns from individual investors, is extremely powerful.

For example, in recent years Wall Street’s promotional machine has further confused consumers (and even advisors) by adopting the term “fee-based” to refer to advisors who receive both fees (paid by clients) and commissions (through product sales).  Originally the term “fee-based” referred to fee-based brokerage accounts, which by virtue of a 2007 U.S. Court of Appeals decision were shut down. Following that decision, Wall Street firms embraced using the term "fee-based" to refer to many (if not most) of its dual registrants.

Regulators have failed to step in to warn that the use of “fee-based” to describe an advisor (as opposed to an account), where the advisor was also receiving commission-based compensation, is inherently misleading.  Worse yet, since the term “fee-based advisor” is intended to obfuscate, confuse, and lead to greater business, the necessary intent requisite for actual fraud exists through the use of the term, at least in most instances.  Yet still regulators have refused to clamp down.

In essence, the use of common or similar titles, and the high fees received by those operating under a conflict-ridden standard of conduct (which in turn funds Wall Street's marketing efforts) results in the inability by consumers to distinguish higher-quality advisors from lower-quality advisors. This effect is one Wall Street loves, and of which it takes advantage.

Could regulators stop all of this nonsensical misrepresentation? Yes. However, in recent years we have seen a simple ignorance by the SEC and FINRA of the 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.] 

Yet, such disconnect between regulators and the truth has not always existed.

BROKERS PROVIDING INVESTMENT ADVICE ARE FIDUCIARIES. THEY ALWAYS HAVE BEEN.  SURPRISED?

Decades ago brokers providing investment advice to clients, as opposed to mere trade execution services, were perceived by both the SEC and the NASD (now known as FINRA) to owe broad fiduciary obligations to their clients. In other words, they were required to act in the best interests of their clients, and with a high degree of due care and utmost good faith.

Additionally, many court cases, throughout the 20^th Century and extending into this new era, find brokers to be fiduciaries when providing investment advice to clients.  For example, in 1934 the Supreme Court of Massachusetts stated: “The relations between the plaintiff (consumer) and the defendants (brokers) as found by the master were not those which ordinarily exist between a broker and his customer: the findings conclusively show that the relationship was one of trust and confidence … and that relying upon the good faith of the defendants the plaintiff placed in their hands for investment about $82,000, all the money she possessed. In these circumstances it was the duty of the defendants in investing the plaintiff's money to make full disclosure to her of their interest in the transactions instead of making secret profits for themselves in the purchase of securities with her funds.” Birch v. Arnold, 288 Mass. 125; 192 N.E. 591 (Mass. 1934).

In a more recent case, a dual registrant crossed the line in "holding out" as a financial advisor, and in stating that ongoing advice would be provided, and other representations, and in so doing the dual registrant, who sold a variable annuity, was found to have formed a relationship of trust and confidence with the customers and was held to a fiduciary duty. The decision also states in part: "Obviously, when a person such as Hutton is acting as a financial advisor, that role extends well beyond a simple arms'-length business transaction. An unsophisticated investor is necessarily entrusting his funds to one who is representing that he will place the funds in a suitable investment and manage the funds appropriately for the benefit of his investor/entrustor. The relationship goes well beyond a traditional arms'-length business transaction that provides 'mutual benefit' for both parties." Western Reserve Life Assurance Company of Ohio vs. Graben, No. 2-05-328-CV (Tex. App. 6/28/2007) (Tex. App., 2007).

Even the National Association of Securities Dealers (NASD) (now known as FINRA), in an early pronouncement shortly after its creation, confirmed that brokers were fiduciaries: “Essentially, a broker or agent is a fiduciary and he thus standards 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 ….” – from The Bulletin, published by the National Association of Securities Dealers, Volume I, Number 2 (June 22, 1940).

Additionally, the U.S. Securities and Exchange Commission (SEC), early on in its history, commented in its official report to Congress that the manner in which brokers hold themselves out is often determinative of their fiduciary status. In its 1940 Annual Report, the SEC 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 a 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.

A short time thereafter in its annual report to Congress the SEC 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.” [1942 SEC Annual Report, p. 15, referring to In the Matter of Willlam J. Stelmack Corporation, Securities Exchange Act Releases 2992 and 3254.]

The early principles that a broker providing investment advice was a fiduciary, and that holding out as a trusted advisor should only be undertaken by fiduciaries, were further confirmed and elaborated upon by the SEC in 1963.  In discussing the issue, the SEC noted that it “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 INVESTMENT ADVISERS ACT NEVER NEGATED BROKERS’ FIDUCIARY STATUS.

In those situations in which brokers provide investment counsel (i.e., personalized investment advice), as indicated above the SEC, NASD (now known as FINRA) and the courts early on concluded that fiduciary status attached to the broker.

Yet, in recent years the debate over fiduciary standards has often been characterized by various statements from broker-dealer lobbyists pronouncing brokers to be non-fiduciaries and only bound by suitability standards, while at the same time declaring that investment advisers are fiduciaries.  Yet these statements misconstrue the effect of the Investment Advisers Act of 1940 (“Advisers Act”), at least as to brokers.

It has always clear that investment advisers were fiduciaries under the Advisers Act.  This was widely known at the time of the Advisers Act adoption (as reflected in early SEC decisions and early SEC speeches).  The fact that the Advisers Act imposed fiduciary status upon registered investment advisers and their representatives was only confirmed by the U.S. Supreme Court in its seminal 1963 Capital Gains decision.

Yet nowhere in the Advisers Act did it state that brokers were not fiduciaries. Indeed, as reflected in the early regulator commentary and court decisions discussed above, brokers who provide investment advice and not mere execution of trades are considered fiduciaries – by the courts applying state common law, by the SEC, and also by NASD (n/k/a FINRA).

It has long been held by the courts that a factor in determining whether fiduciary status attaches is the use of a title which connotes trust and influence, such as “financial advisor” or “financial planner.”  However, and while the use of such a title (or designation similar to same) can be a major factor in finding fiduciary status to attach to a broker, it is not necessary for a broker to represent himself or herself as a “financial consultant” or use some other term that represents the broker out as a trusted advisor.  The actual conduct by the broker is what matters most.  Nor are broker’s attempts to disclaim fiduciary status, such as by client execution of a brokerage agreement to that effect, determinative. One cannot disclaim fiduciary status simply by signing an agreement with the customer to such effect, and then provide personalized investment advice (and hence fiduciary advisory services).

For example, in discussing the decisions of two early cases, the NASD said it was “worth quoting” statements from various court 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).

A BETRAYAL OF CLIENTS’ TRUST

Study after study demonstrates of consumers in recent years clearly demonstrate that consumers desire to place their trust in the financial advisors, and have largely done so.  Yet so often, due in part to the misuse of titles and other misrepresentations by brokers, the result has been that this trust has been misplaced and betrayed. The life savings Americans entrust to their financial advisors has failed, in most instances, to earn returns even close to the market indices. Unable to discern all of the fees and costs of the investment products existing, or the risks to which they were exposed by these financial advisors, many investors paid dearly.

Even worse were the “sh**ty” investment products which over the past decade were developed by Wall Street’s investment banks, then sold to consumers (as they often met the low “suitability” test for such a sale to occur). Subsequently many of these investment products “blew up” – destroying the life savings of many individual consumers.

As a result, many Americans have now rightfully regarded the past actions of their “advisers” as fraudulent. In essence, customers of broker-dealer firms feel betrayed. Unfortunately, many consumers also succumb to the incorrect belief that they cannot trust any financial advisor.

As the media continues to report on these travesties, some investors have abandoned the use of financial advisors altogether. Yet individual investors, lacking the skills to navigate the intricacies of the capital markets themselves, and subject to behavioral biases which were not countered with the aid of a knowledgeable and trusted adviser, tend to flee the capital markets following the inevitable periodic price declines in the equities markets. Then, perilously, these same investors return only well after stock market prices had recovered nearly fully – thereby losing out on much of the long-term returns of the capital markets.  Individual investors are seldom trained to undertake due diligence on investments, and are often unaware of the key characteristics of investment products (especially since so many fees and costs are "buried" and not shown in the annual expense ratio of mutual funds and ETFs, and other pooled investment vehicles). Nor do individual investors usually know how the better products may be best utilized to construct a tax-efficient, cost-efficient investment portfolio.

No one said investing – and securing the majority of the gains the capital markets provides – was easy. The vast majority of our fellow Americans need a trusted, guiding hand.

INDIVIDUAL INVESTORS FLEE FROM THE CAPITAL MARKETS

As scandal upon scandal involving Wall Street firms, their brokers and others have been exposed by the media in recent years, many individual investors have fled the capital markets altogether. Subjected to all of the confusing titles and advertising which obscures the truth of many financial advisor-customer relationships, and not knowing who to trust, some individual investors now choose to not participate at all in the process of capital formation. Instead they choose to place their hard-earned accumulated wealth in depository accounts - to their own peril (since such will seldom outpace inflation) and the peril of the U.S. economy.

This should not come as a shock. Participation in the capital markets, especially the equities market, requires a requisite amount of trust. “[S]pecific trust in advice given by financial institutions represents a prominent factor for stock investing, compared to other tangible features of the banking environment.”  [Georgarakos, Dimistris, and Pasini, Giacomo, Trust, Sociability and Stock Market Participation (2009), available at     

http://www.aueb.gr/conferences/Crete2010/Senior/Georgarakos.pdf.]

[See also César Calderón, Alberto Chong, and Arturo Galindo, Structure and Development of Financial Institutions and Links with Trust: Cross-Country Evidence (2001) (“We use a new World Bank data set that provides the most comprehensive coverage of financial development and structure to this date. We find that trust is correlated with financial depth and efficiency as well as with stock market development.”)

Available at http://www.iadb.org/res/publications/pubfiles/pubWP-444.pdf.]

The result – some individual investors fleeing from stock market investing - should have not been unexpected.  Nor should it be a surprise that lack of trust in Wall Street will translate to lower economic growth in future years. “It is well documented that public trust is positively correlated with economic growth … and with participation in the stock market … we develop a two-period theoretical model in which investors entrust their wealth to a continuum of heterogeneous agents and rely on the agents to honor their fiduciary duty … Trust that arises from the law evolves because investors can rely on the government to make sure that agents honor their fiduciary duty to clients … we consider the effect that professional fees have on the trust that forms in markets … We show that when the value to social capital is relatively low and/or the growth potential in the economy is low, it is never optimal to institute a Coasian plan (absence of government regulation). We also show that ceteris paribus there should be more government intervention in a low-trust equilibrium than in a high-trust equilibrium.” [Carlin et. al., supra.]

WHERE DO WE GO FROM HERE?

On the day this blog post has been written, President Obama has nominated highly respected attorney and former federal prosecutor Mary Jo White to be the next Chair of the U.S. Securities and Exchange Commission.  Will the SEC, with a full contingent of five commissioners, use its newfound authority, provided under Dodd-Frank Act Section 913, to clear up the confusion individual investors possess and to mandate fiduciary status for brokers at all times when providing personalized investment and financial advice?

Will the Department of Labor, and specifically the Employee Benefits Security Administration, undertake action first – by re-promulgating a proposed rule which would expand the definition of “fiduciary” to include many providers of investment advice to plan sponsors, plan participants, and to IRA account owners?

Will the Consumer Financial Protection Agency step in?

Will federal-registered investment advisers remain under the oversight of the S.E.C., or will Congress enact legislation enabling a professional or self-regulatory organization for investment advisers? Will FINRA’s attempt to secure that role be successful?

Who are the courageous actors, in the halls of the buildings found in our nation’s capital?

More to come.

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Ron Rhoades, JD, CFP(r) is the Program Director for Alfred State College's Financial Planning Program. He also serves as 2013 Chair of the Steering Committee for The Committee for the Fiduciary Standard. 

To discuss these matters in person with Ron, visit with him at the TD Ameritrade National Conference in San Diego, Friday, Feb. 1, 2013, after a panel discussion on this subject that day.