Thursday, January 10, 2019

7th Part of a Series on the Regulation of Financial and Investment Advice, and the Future of the Profession

Part 7: Ron’s 2019 Regulation Wish List

Part A: Have the SEC Alter How the Advisers Act is Applied and Enforced.

  • If a person or firm holds out as a "financial adviser" or "wealth manager" or "retirement consultant" or "financial planner" or otherwise uses a title that evokes an adviser-client relationship, they should be held to the fiduciary requirements of the Advisers Act - at all times and without exception.

  • If the primary role of the person is to provide investment advice, rather than to execute transactions, the "solely incidental" exclusion to the definition of investment adviser should be applied properly and that person should be required to register as an investment adviser and to comply with the fiduciary duties arising from the Advisers Act.
    • Large amounts of broker-dealer advertisements suggest that advice is the primary component of the broker-customer relationship, and it is certainly understood that way from the standpoint of the customer.
    • The process of executing trades no longer requires the skill it took in the 1930's, due to the involvement of automated systems, and the improvements in market liquidity.
    • Registered representatives have been provided education on "trust-based sales techniques," without understanding that the formation of a relationship of trust and confidence with a client leads to fiduciary status under state common law.
    • The recommendation of another investment adviser should be subject to the fiduciary standard of the Advisers Act. This includes recommendations of separate account managers, as well as recommendations of mutual funds. (The doctrine of suitability was originally intended to shield brokers from liability when their primary role was in executing a trade for a customer; the doctrine should have never been extended to the recommendation of pooled investments.)

  • No more wearing of two hats.No ability to switch hats
    • Once you are a fiduciary to a client, your status as a fiduciary continues, and it extends to all aspects of the adviser-client relationship.
    • Say what you do. Do what you say.
    • A fiduciary steps into the shoes of the client, and acts - with all of the expertise required of a professional adviser - with total loyalty to the client's interests.
  • The S.E.C. Should Take the Position that Estoppel and Waiver have Limited Applicability to fiduciary relationships.Sect. 215 of the Advisers Act needs to be properly applied to prevent both "disclaimers" of core fiduciary duties and seeking client "waivers" of them. Even under state common law, which informs the Advisers Act, it is well-known that estoppel and waiver have limited application in fiduciary-client relationships were a vast disparity of knowledge and expertise exists.
  • Don’t Rely on Just Disclosures.The SEC must realize that, although the securities laws generally are based upon disclosures, the Advisers Act went much further. We have fiduciary standards because disclosures are largely ineffective. A huge body of academic research supports this conclusion.
  • Adopt Meaningful Disclosures of the Nature of the Relationship (Broker-Customer vs. Adviser-Client), the Receipt of Compensation, and Whether the Prudent Investor Rule Applies.See a prior article in this series for a form such disclosure might undertake.
  • Let's not keep permitting "particular exceptions" (as the late Justice Benjamin Cardozo opined) to erode the fiduciary standard of conduct.
    • Let's conform the industry to the fiduciary standard.
    • Let’s not diminish the  fiduciary standard at the whims of the broker-dealer and insurance industries.

Part B. The States Should Move to Adopt Fiduciary Standards for Brokers Who Provide Investment Advice.
·    In the prior articles in this series, I have suggested proposed regulations and/or legislation that the states could adopt. Since the SEC is failing to act under the authority given it under the Dodd-Frank Act of 2010, the states need to step up to the plate and protect their citizens.

Part C: Clean Up Mutual Fund Regulation.

  • Europe and Canada have stronger disclosures of mutual fund / ETF fees and costs than the U.S. possesses. We lag behind, again, instead of leading the way.
  • "Portfolio turnover" is measured incorrectly.It should not be the lower of sales or purchases divided by the fund's net assets, but the average of them. This important statistic - as the SEC now permits it to be calculated - can often mislead investors. For ETFs, sales and purchases of securities that occur via the process of redemption units – if they have no negative impact upon the fund’s shareholders – should be excluded from the computation of portfolio turnover.
  • Require in all mutual fund / ETF advertising truthful comparisons to broad-based indexes.No more comparing active funds only against indexes that exclude index funds in their computations.
    • For example, no advertisements should be permitted in comparisons to Lipper indices that exclude, from the index for that asset class, passively managed funds. (Given that passively managed funds, on average, outperform actively managed funds in the same asset class, their exclusion is, in my view, inherently misleading.)
  • Do away with state-based and municipality-based retirement accounts.This is not the essential role of government. And, they are not done well.
    • The federal government’s Thrift Savings Plan is widely admired for its low costs. But, there exists a dearth of asset classes in the TSP, especially with respect to foreign securities and factor-based funds. Governments should step aside.
  • Prohibit the fund company and its investment adviser from receiving compensation from securities lending revenue. Certain funds and ETFs are now advertised as "zero-fee" - when in fact some of these funds generate profits for their fund companies by taking a substantial percentage of securities lending revenue. Investment advisers to funds should receive their compensation for whatever investment advisory activities they undertake from the management fees they receive, which are fully transparent. Securities lending revenue should belong to the fund's shareholder, in its entirety (except for a reasonable fee paid to third-party firms that enable securities lending transactions to occur, and RFPs should be required of mutual fund companies when seeking such services.)
  • Eliminate 12b-1 fees. See discussion below.

Part D: Solve the Problems in Defined Contribution Plans

·     Apply ERISA to all defined contribution plans.Want to see a bad retirement plan? Just look at what teachers are offered in their governmental 403(b) plans, which are not subject to ERISA.

·     Plan sponsors– whether for-profit businesses or governmental entities – are not investment experts. Provide a way, under ERISA, for plan sponsors to be exempt from liability for investment decisions.
o   If a plan sponsor: (1) engages a 3(38) fiduciary; and (2) that 3(38) fiduciary possesses adequate liability insurance (as set forth by rule by the DOL, from time to time), then the plan sponsor should be absolved from liability for the investment recommendations made to the plan.
o   This would encourage more businesses to adopt defined contribution plans, and would shift potential liability for poor investment recommendations to those who undertake investment recommendations - and those who make them should be experts, knowledgeable about all of the requirements of the prudent investor rule, and possess few conflicts of interest.

·     “NIRA” – One Retirement Account to Rule Them All. We have a dizzying array of defined contribution plans and various types of IRA accounts. The numerous regulations create tax and other traps for the unwary, and create higher costs of American business. Let’s consolidate all of them into one plan, that can be adopted by a simple form (such as the form for SIMPLE IRAs, but with more flexibility). This “New IRA” account, which I’ve previously written about, should also be easily portable - if an employee leaves the retirement plan, the employer can just "de-link" the account, and the custodian of the account can just continue it as an individual account. (If the custodian does not desire to provide service to individual accounts, then another custodian could be named to assume the account, with a minimal amount of paperwork involved.)

Part E. Reduce Broker-Dealer Conflicts of Interest.

  1. Eliminate Payment for Order Flow. It interferes with broker's duty to effect best execution. Such payments are largely non-transparent. And current broker-dealer firm practices of advertising "free trades" - when the trades are not, in fact, free, would be done away with. (I know the SEC's Division of Trading and Markets has initiated a pilot program to restrict payment for order flow, which I generally support. But the proposal does not go far enough.)
  2. Eliminate 12b-1 fees. They don't benefit fund shareholders. Investors don't understand them. They often continue for as long as the fund is held. And ... in my view, they are "relationship-based compensation" (as the SEC itself puts it) and hence amount to "special compensation" - which should trigger the application of the Advisers Act.
  3. Cap Compensation for the Sales of Variable Annuities, Non-Publicly Traded REITs, etc. Unlike mutual funds, which are subject to FINRA caps on compensation, and to which breakpoint discounts apply, strong caps and breakpoint discounts don't apply to a host of other products. Why not?
  4. Principal Trades - Put Back in Place the Tougher Requirements. The Advisers Act permitted principal trades by dually registered firms (or affiliated brokers of investment advisory firms) due to the recognition, at the time, that for some securities (mostly municipal bonds) there might only be one brokerage firm or bank acting as the market maker, or agent on behalf of the issuer. Principal trading should be far less than it was in 1940, when the Advisers Act was enacted. In 2007 the SEC enacted rules that relaxed some of the requirements for principal trades; this relaxation of rules should be re-examined. Furthermore, a brokerage firm engaging in a principal trade should bear the burden of proving best execution, and that it is not dumping securities.

Part F. Congress Should Act to ...

  1. Remove the tax break afforded to life insurance contracts that permits FIFO treatment of withdrawals from cash value life insurance. This ability to withdraw basis first contradicts the investment treatment afforded other forms of investment. Moreover, it has led to a huge travesty - the sale of cash value life insurance (which, nearly always, is hugely expensive relative to other investments) for its touted tax advantages, and as a "retirement savings vehicle." The reality - what insurance companies don't want consumers to know - is that significant withdrawals (by withdrawals of basis, followed by loans) from cash value insurance policies (particularly whole life policies, where the death benefit can seldom be adjusted downward) present a very substantial risk of policy "implosion" - and a hugely negative tax consequence to the owner of the policy.
  2. Regulate all fixed annuities - both those with fixed interest rates, and equity indexed annuities (a.k.a. fixed indexed annuities) as securities. Yes, Senator Grassley would have a fit. But the reality is - these are forms of investment, and should be subject to the same scrutiny as other pooled investment vehicles.
  3. Repeal the law that permits payment of soft dollar compensation. This statute leads to millions and millions paid in higher commissions by some mutual funds to broker-dealers, in return for research that is often never utilized. Soft dollar compensation arrangements hurt fund shareholders, and I for one will never recommend a mutual fund that pays soft dollar compensation.

Part G. Work to Reduce Regulatory Overkill.

Standards of conduct can be enhanced, and when they are adopted then conduct will change accordingly. Remedies for violations of the fiduciary standard of conduct exist primarily through the mechanisms for the resolution of client complaints. That’s the beauty of principles-based standards of conduct – they don’t require the adoption of multiple specific regulations – at least as to the regulation of financial and investment advice.

Beyond that, I question the need for much of the other regulations that have been imposed upon registered investment advisers in recent years. Investment advisers are professionals - treat us like such. There is a lot of paperwork generated in RIA firms due to these new regulations, and a lot of costs are incurred in association with meeting these regulatory requirements. Much of this work simply exists to provide examiners with items to examine.
  • Every regulation on the books should be reviewed. Does it work? What is the burden of the regulation, versus its benefit?
  • Increase the number of RIA exams for verification of assets (i.e., custody); but decrease substantially the number of RIA exams for everything else.  Use the SEC's limited resources to combat the most egregious frauds.

Part H. Disband FINRA.

Take a good hard look at FINRA. With hundreds of pages of rules, it still has utterly failed the vision of its creators - Senator Maloney and others - who sought to create an organization that would raise the securities industry's conduct to the highest levels.

In fact, FINRA has opposed raising standards at every turn. FINRA embraces conflicts of interest at every turn, rather than seek to minimize them - even broker-dealer fines levied by FINRA become part of FINRA's budget (thereby lessening the fees assessed against broker-dealer firms!).

Consider whether FINRA's oversight of market conduct regulation should be transferred back to the SEC and to the states.

Or perhaps eliminate FINRA - the worst "regulator" in the world - altogether!

At a minimum, the SEC should conduct a long-overdue comprehensive review of FINRA - and it will find that FINRA has failed miserably to meet the expectations of the enactors of the Maloney Act, which led to FINRA's existence.

Ron A. Rhoades, J.D., CFP® is an Asst. Professor of Finance at Western Kentucky University's Gordon Ford College of Business, where he serves as Director of its nationally recognized Personal Financial Planning program. This article represents his views, alone, and are not those of any institution, organization or firm with whom he may be associated. Follow Ron on Twitter: @280lmtd. To contact him, please email:

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