Scholarly Financial Planner

Part 3 of a Series on the Regulation of Financial and Investment Advice, and Thoughts About the Future of Our Profession

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

Part III: The S.E.C. Protects Brokers, Not Investment Advisers, and Not Consumers 

by Ron A. Rhoades

The S.E.C.’s blunders extend beyond its recent Reg BI and Form CRS proposed regulations. The S.E.C. has taken actions over the past several decades that have sought to lessen the fiduciary standard of conduct, as it has favored the commercial interests of broker-dealer firms over the interests of consumers and independent investment advisers.

There was a time when the U.S. Securites and Exchange Commission was a respected government agency. But, under the heavy influence of monied Wall Street lobbying, and staffed largely with Wall Street insiders due to its revolving door, common sense has long been overruled by recent S.E.C. Chairs. Even when the S.E.C. staff acts, such as recommending the application of fiduciary duties for brokers in its 2011 Study of investment advisers and broker-dealers, S.E.C. Chairs lack the courage to oppose Wall Street interests. In this Part III on the regulation of investment advice, Ron looks deeper into S.E.C. rule-making, and he reveals a disturbing pattern in which brokers are permitted to do virtually any activities, yet they are never subjected to higher standards of conduct that are warranted when investment advice is provided.

  

The Battles Over “Special Compensation” and “Solely Incidental”

Two decades ago the S.E.C. sought to eviscerate the line altogether with “fee-based brokerage accounts.” Fortunately, the so-called “Merrill Lynch Rule” was overturned by the D.C. Court of Appeals in Financial Planning Association vs. S.E.C., which correctly held that fee-based accounts amounted to “special compensation” for brokers, thereby rendering the broker-dealer exception from registration of the Advisers Act unavailable. In response, hundreds of thousands of brokers became dual registrants – licensed as both registered representatives of broker-dealer firms and as investment adviser representatives. And approximately $300 billion in one million fee-based brokerage accounts were switched – either to investment advisory accounts or to commission-based brokerage accounts.

But the 2007 court decision did not address the requirement for the broker-dealer exception that any investment advice given by a broker be “solely incidental.” This led the S.E.C. to infamously continue to take the position that the phrase “solely incidental” – despite its plain language meaning – imposes virtually no restriction on the amount of investment advice a broker can provide. As long as the advice is “reasonably related” and “in connection with” a securities transaction, the advice can be provided.

12b-1 Fees are AUM Fees

With the rise of Class C shares and their often 1% per annum compensation payments to brokers, which inexplicably the S.E.C. calls in one breath “relationship-based compensation” and “AUM fees.” (The final rules for the “broker” exemption for banks continue to list all 12b-1 fees that are paid on the basis of assets under management and attributable to a trust or fiduciary account as examples of AUM fees that are relationship compensation. Yet, in another breath the S.E.C. states that 12b-1 fees are not “special compensation,” but rather commissions, and hence the S.E.C. permits brokers continue to receive ongoing fee-based compensation.

In fact, in the S.E.C.’s 2010 open meeting on 12b-1 fees, broker-dealer executives time and again testified that 12b-1 fees compensated brokers for “advice.” Yet, not surprisingly, and despite the fact that 12b-1 fees don’t serve their initial stated purpose, are confusing to consumers, and don’t provide benefits to existing shareholders in the fund, the S.E.C. failed to act to end 12b-1 fees.

All of these acts by the S.E.C. ignore an old adage under the law – you cannot do indirectly what you cannot do directly. As well as the requirement that regulations be consistent and rational. But the S.E.C., substantially influenced by broker-dealer lobbyists, found a way. And, hence brokers, not bound by a fiduciary standard but by the much lower suitability standard, provide a substantial amount of investment advice, even monitoring investment portfolios periodically for changes and rebalancing. It’s as if the FPA vs. S.E.C.decision never happened.

The Problem of Trying to Wear Two Hats

Recently I met with a prospective client. She had been urged by friends to ask her current “financial consultant” if he was both a fiduciary and a Certified Financial Planner™. His response? “I am a fiduciary to you, under the law. And I possess substantial training equivalent to the CFP® designation.”

Yet, neither of these statements was wholly true. The broker – a dual registrant – was only a fiduciary with respect to less than one-fourth of the client’s accounts, termed “investment advisory accounts.” The remaining accounts – including three very large variable annuities held in IRA accounts that had total fees and costs of 3-4% a year, or higher, and which were not managed by the dual registrant in a manner that would qualify for the often-illusory GMWB benefits at some future time – were all held in brokerage accounts. And in reviewing the dual registrant’s education, I discerned that most of his training was in how to sell securities and insurance products, with very little training – if any – in the broad and deep curriculum required by the CFP Board of Standards.

In the aftermath of the FPA vs. S.E.C.decision, in late 2007 the S.E.C. came out with a proposed rule, called “Interpretive Rule Under the Advisers Act Affecting Broker-Dealers,” which – while never finalized – forms the basis for dual registrant practices today. In this rule the S.E.C. expressly permitted dual registrants to “wear two hats” at the same time, for the same client/customer, and to “switch hats.” 

The S.E.C.’s 2007 proposed rule stated that “a broker-dealer is an investment adviser solely with respect to accounts for which it provides services that subject it to the Advisers Act.” While the S.E.C. referenced Advisers Act Release No. 626 (1977) for authority for this language, a close review of this Release only stands for the proposition that “a broker or dealer would still be excluded from the definition of an investment adviser to the extent he could meet the statutory standards in Section 202(a)(11)(C) relating to the furnishing of advisory services solely incidental to the conduct of his business as a broker-dealer and without special compensation therefor.” Nothing in Release No. 626 supports the view that an individual can wear “two hats” at the same time for the same client – i.e.,act as a broker with respect to some accounts, and act as an investment adviser with respect to other accounts.

It is hard to imagine the conversations that must (or at least should) take place when a dual registrant operates as both a broker and investment adviser for the same customer/client. The dual registrant, to uphold the duty of utmost good faith as a fiduciary, must ensure that the client understands when the dual registrant is providing advice as a fiduciary, and when the dual registrant is acting as a salesperson. The roles are wholly different. As Professor Arthur Laby explained: “When acting as a dealer, the firm seeks to buy low and sell high – precisely what the customer seeks. It is hard to see how any dealer can act in the ‘best interest’ of his customer when trading with her.” Arthur B. Laby, Reforming the Regulation of Broker-Dealers and Investment Advisers, 65 BUS. LAW. 395, 425 (2010).

Furthermore, as the Virginia Supreme Court long ago stated: “It is well settled as a general principle, that trustees, agents, auctioneers, and all persons acting in a confidential character, are disqualified from purchasing. The characters of buyer and seller are incompatible, and cannot safely be exercised by the same person. Emptor emit quam minimo potest; venditor vendit quam maximo potest. The disqualification rests, as was strongly observed in the [English] case of the York Buildings Company v. M'Kenzie, 8 Bro. Parl. Cas. 63, on no other than that principle which dictates that a person cannot be both judge and party. No man can serve two masters. He that it interested with the interests of others, cannot be allowed to make the business an object of interest to himself; for, the frailty of our nature is such, that the power will too readily beget the inclination to serve our own interests at the expense of those who have trusted us.” Carter v. Harris, 25 Va. 199, 204; (Va. 1826)

12b-1 Fees in Investment Advisory Accounts: A Two-Hat Problem

A recent example of the difficulties dual registrants possess, when trying to wear the hat of a product seller and that of a fiduciary at the same time, is evident from the S.E.C.’s recent enforcement initiatives on 12b-1 fees. Section 206 of the Advisers Act imposes on investment advisers a fiduciary duty to act for the benefit of their clients. That duty includes, among other things, an obligation to seek best execution for client transactions – i.e., “to seek the most favorable terms reasonably available under the circumstances.” The S.E.C. has brought several settled enforcement proceedings against investment advisers for failing to seek best execution when the advisers caused clients to purchase a more expensive share class when a less expensive share class was available. As the S.E.C. states, “when there is a lower-cost share class available that does not charge a 12b-1 fee (or charges a lower 12b-1 fee), it is usually in the client's best interest to invest in the lower-cost share class rather than the 12b-1 fee paying share class because the client's returns would not be reduced by the 12b-1 fees.”

In essence, when dual registrants receive an investment advisory fee, they should not be “double-dipping” – receiving product-based compensation at the same time. At a minimum, any product-based compensation should be credited against advisory fees agreed to by the client. As a result, the receipt of revenue-sharing or other compensation by dual registrants with respect to investments held in investment advisory accounts – whether 12b-1 fees, payment for shelf space, payments for prospecting seminars, and even soft dollars – should be avoided.

“Two Hats” Should Not Exist: Fiduciary Status Extends to the Entire Relationship

But there is a larger issue present. Fiduciary is a “status relationship” under the law. Once a person is a fiduciary, under the common law there exists the general principle that such fiduciary status extends to all aspects of the commercial relationship between the advisor and the client. There is no “carving out” of the brokerage account as not being subject to the fiduciary standard. For once trust and confidence is given by the client to the advisor, we know that disclosures – such as might exist during hat-switching – are even far less effective than they would be in an arms-length relationship. The client is trusting, and can easily be taken advantage of, even when disclosures occur that the dual registrant has switched from her or his “fiduciary investment adviser hat” (i.e., representing the client) to her or his “brokerage arms-length relationship hat” (i.e., now representing the manufacturer of a product, as a distributor, or functioning a direct seller of a security as a dealer). 

Think about it. Why would any consumer of investment advice, who was knowledgeable about the distinctions between the tough fiduciary standard of conduct and the low suitability standard – ever choose to have their financial advisor be anything but a fiduciary?

While some might argue that Class A mutual fund shares, which charge an up-front commission, are less expensive for consumers, than investment advisory arrangements, when held for the long term, I doubt this is true. It has not been my experience, from reviews of hundreds of brokerage accounts of prospective clients over the years, for several reasons. First, the average holding period of mutual funds is only 3-4 years. Second, the commission has a very large impact upon the fund’s returns, even over 5-year and 10-year periods. Third, Modern Portfolio Theory, which forms the foundation for proper management of an investor’s portfolio, requires some type of rebalancing occur – which in turn necessitates the redemption of a mutual fund’s shares and purchase of another fund’s shares – thereby triggering another commission. (Although some fund complexes have adopted structures to avoid this, in recent years.) Fourth, most mutual funds with Class A shares sold to customers of brokers possess ongoing 12b-1 fees (as high as 0.25% a year), higher management fees (which in turn funds the often-seen payments for shelf space and other of revenue sharing, and higher commissions for transactions arising within the fund due to payments of soft dollars. In most instances, the total fees and costs of Class A mutual fund shares exceed the total fees and costs of an investment adviser using far less expensive no-load, no 12b-1 fees mutual funds and ETFs, even over a 10-year time period. Fifth, the comparison attempted to be made is an apples-to-oranges one. Many investment advisers provide a broad array of services and advice throughout the length of the relationship, including financial planning, tax planning, estate planning reviews, and even life coaching, for the advisory fees they receive. At a minimum, the receipt of an ongoing investment advisory fee triggers the obligation to monitor the investments by the investment advisor. The duties and responsibilities assumed are wholly different and distinct.

There is another reason, under the common law, why fiduciary status extends to the entirety of the relationship, and “two hats” should not be attempted to be worn at the same time. Simply put, if two hats can be worn, over time an individual will find a way to justify an improper action. This was explained more than seventy years ago by the late Professor Louis Loss, when he served as the S.E.C.’s Chief Counsel of its Trading and Exchange Division: “[W]hen one is engaged as agent to act on behalf of another, the law requires him to do just that. He must not bring his own interests into conflict with his client's … As the Supreme Court said a hundred years ago, the law ‘acts not on the possibility, that, in some cases the sense of duty may prevail over the motive of self-interest, but it provides against the probability in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.’ Or, as an eloquent Tennessee jurist put it before the Civil War, the doctrine ‘has its foundation, not so much in the commission of actual fraud, but in that profound knowledge of the human heart which dictated that hallowed petition, 'Lead us not into temptation, but deliver us from evil,’ and that caused the announcement of the infallible truth, that 'a man cannot serve two masters.'”

The SEC Takes a Limited View of the Fiduciary Obligation

Broadly understood, the fiduciary relationship is a relationship of trust and confidence in which the entrustor (client) is entitled to rely on another (the fiduciary). The distinguishing obligation of the fiduciary relationship is the obligation of loyalty, in which the client is entitled to the single-minded loyalty of his fiduciary.

This duty of loyalty has several facets. A fiduciary must act with utmost good faith – i.e., with complete candor and honesty. He must not make a profit out of his trust (called the “no profit” rule). He must not place himself in a position where his duty and his interest may conflict (called the “no conflict” rule). And, as a result, the fiduciary may not act for his own benefit or the benefit of a third person without the informed consent of his client. The practical reality of this principle is that no client of a fiduciary would ever consent to be harmed; clients are rarely so gratuitous toward their advisers. 

These proscriptive rules – against the making of a personal profit and entering into a position of conflict – are “at the core of the classical fiduciary obligation.” Under the “best interests” version of the fiduciary standard (in contrast to the “sole interest” fiduciary standard found under the modern law of trusts, and under ERISA), conflicts of interest need not necessarily be avoided. But any conflicts of interest not avoided must still be properly managed to ensure that the client is not harmed.

The classic example of an unavoided conflict of interest is when principal trades are undertaken between a dealer who also serves as investment adviser to a client. When the ’40 Act was enacted, and even to a limited extent today, certain bonds (mainly municipal bonds, in certain limited geographic areas) are not available except through particular dealers. In such instances, the Advisers Act provides a set of guidelines that must be followed to ensure that the motivations behind this “sales transaction” – in which the dealer otherwise would desire the highest price for itself – does not cause the investment adviser’s fiduciary duty – in which the investment adviser seeks the lowest price for its client) – to be breached.

The “best interests” standard under classic fiduciary law is, indeed, a very tough standard. And, since the academic research is compelling that – all things being equal – higher fees and costs associated with investment products (such as mutual funds) result, on average (especially over longer time periods) in lower returns to the client, it is rare that higher-fee and higher-cost products can be justified. A fiduciary’s duty of due care requires close attention to fees and costs. (And the prudent investor rule, when it is applicable, imposes the strict requirement that a client’s assets not be wasted.) Higher compensation to a broker often results when higher-fee products are sold – whether such higher fees and costs result from 12b-1 fees, payment for order flow (paid typically from a fund’s higher management fees), soft dollars (paid from a fund’s higher brokerage commissions for transactions within the fund), or other forms of revenue-sharing payments.

The Source of the S.E.C.’s Limited View: Capital Gains Research Bureau

When the Investment Advisers Act of 1940 was enacted, it was well-known within the S.E.C., and in administrative proceedings and judicial proceedings, that these broad classical fiduciary duties were imposed thereby. The U.S. Supreme Court’s 1963 decision in S.E.C. vs. Capital Gains Research Bureau only confirmed this long-standing view. Yet, some in the securities bar (i.e., securities law attorneys, most of whom naturally work for Wall Street firms) cling to the belief that the Advisers Act’s fiduciary duties are limited, as they are only “implied” by the Investment Advisers Act of 1940, and are not expressly set forth in the language of the Act.

Commentators sometimes seek to assert that the U.S. Supreme Court approved, in its Capital Gainsdecision, of “disclosure” as the sole means of satisfying a fiduciary’s duty of loyalty, when a conflict of interest of present. But, such commentators choose to ignore these words in the decision – which cannot be ignored: “It is arguable -- indeed it was argued by ‘some investment counsel representatives’ who testified before the Commission -- that any ‘trading by investment counselors for their own account in securities in which their clients were interested . . .’ creates a potential conflict of interest which must be eliminated. We need not go that far in this case, since here the Commission seeks only disclosure of a conflict of interests….” [Emphasisadded.]

These words from the Supreme Court are often ignored by commentators, most of whom are employed either directly or indirectly by broker-dealer firms and hence, it may be assumed, are engaged in what can only be considered “wishful thinking.” Yet, their desired interpretation of the decision – that all that is required when a conflict of interest is present is disclosure of the conflict, followed by “mere” (not “informed”) consent – has no foundation in the law.

The words of the U.S. Supreme Court – “in this case” and “we need not go that far … since here the Commission seeks only disclosure of a conflict of interests” – show the Court’s judicial restraint only. The U.S. Supreme Court’s holding was to apply a federal fiduciary standard to the conduct at issue; the Court was not called upon to delineate the many requirements imposed upon investment advisers as a result of such federal fiduciary standard.

It must be understood that in the SEC vs. Capital Gainsenforcement action, where the Commission sought injunctive relief, the Commission only sought a breach of the fiduciary duty for the adviser’s failure to disclose. This limited nature of the enforcement action by the Commission is understandable. Failure to disclose a conflict of interest, when present, is clearly a violation of the fiduciary duty of loyalty. Proof of failure to disclose is easy to provide. In contrast, other requirements that exist (as are set forth in more detail in my edits to the proposed interpretation, set forth later herein, and specially as to the requirements of informed consent and continued substantive fairness), often require expert testimony, greatly complicating and making more expensive enforcement actions.

The 1933 Securities Act and the Securities and Exchange Act of 1934 both adopt a “full disclosure” regime as a protection for individual investors. But, as made clear by the U.S. Supreme Court, the Investment Advisers Act of 1940 goes further. It recognizes the long-standing understanding that the fiduciary standard exists because disclosure is inadequate as a means of consumer protection in situations in which there is a great disparity in power or knowledge.

In point of fact, long ago the S.E.C. itself disagreed with the notion that all that is required to satisfy one’s fiduciary obligations, when a conflict of interest is present, is “disclosure” and “consent,” stating: “We do not agree that an investment adviser may have interests in a transaction and that his fiduciary obligation toward his client is discharged so long as the adviser makes complete disclosure of the nature and extent of his interest. While section 206(3) of the Investment Advisers Act of 1940 requires disclosure of such interest and the client's consent to enter into the transaction with knowledge of such interest, the adviser's fiduciary duties are not discharged merely by such disclosure and consent. The adviser must have a reasonable belief that the entry of the client into the transaction is in the client's interest. The facts concerning the adviser's interest, including its level, may bear upon the reasonableness of any belief that he may have that a transaction is in a client's interest or his capacity to make such a judgment. It has long been the Commission’s position that the an investment adviser must not effect transactions in which he has a personal interest in a manner that could result in preferring his own interest to that of his advisory clients.”

Furthermore, while some commentators have advanced the argument that the Advisers Act’s purpose was “to substitute a philosophy of full disclosure for the philosophy of caveat emptor,” a closer reading of the decision reveals that this purpose was set forth as a “common” purpose of all the federal securities acts enacted in the 1930’s and in 1940. This does not lead to the conclusion that the Advisers Act’s only purpose was to require disclosure; it was merely one means by which Congress sought to protect clients of investment advisers. The Investment Advisers Act of 1940 goes further; it imposes fiduciary obligations upon investment advisers. Indeed, if disclosure alone were all that was required of an investment adviser when a conflict of interest was present, there would be no need for the fiduciary standard – and there would have been no pressing need for the enactment of the Advisers Act itself.

Fundamentally, the fiduciary standard of conduct changes the character of the relationship; instead of representing the product manufacturer, the fiduciary becomes the purchaser’s representative, acting on behalf of the client. The law permits the client to trust the fiduciary, as the law recognizes that the fiduciary standard of conduct is imposed in situations where public policy dictates and where disclosures are likely to be ineffective. And the Advisers Act’s “best interests” fiduciary standard is a tough one. It is the classical fiduciary standard, under which no client would ever be found to have provided truly “informed” consent where the client would be harmed.

In Conclusion

There is nothing wrong with being the seller of products. But, to hold out using a term that denotes a relationship of trust and confidence, such as “financial consultant” or “wealth manager” or “financial planner,” and to not accept the duties which flow therefrom, is inherently wrong. And not understanding the deep core of the fiduciary obligation – the duty of loyalty and its “no profit” and “no conflict” rules, can easily lead to a breach of one’s fiduciary duties as an investment adviser.

For decades the S.E.C. has diminished the line between “product sales” (broker-dealer activities) and “investment advice” (investment adviser activities). Without court intervention, there would be no line at all. And, even then, the S.E.C. refuses to draw common-sense lines, and to apply fiduciary standards of conduct to relationships that are advisory in nature.

In my next article in this series, I’ll suggest some common-sense reforms that the S.E.C. could take. Or, more likely, given the S.E.C.’s apparent regulatory capture by the brokerage industry, actions that state securities administrators can instead adopt to protect their citizens. As will be seen, reasonable lines can, and should, be drawn between “sales” and “advice.”

Ron A. Rhoades, JD, CFP® is the Director of the Personal Financial Planning Program at Western Kentucky University’s Gordon Ford College of Business. A professor of finance, tax and estate planning attorney, investment adviser, and Certified Financial Planner™, he has long written about application of fiduciary law as the delivery of financial planning and investment advice. This article represents his personal views, and are not necessarily the views of any institution, organization, nor firm with whom he may be associated.