The Fiduciary Landscape in 2013 ... And a Wish List

WHAT’S AHEAD FOR 2013 AND BEYOND:

THE APPLICATION OF FIDUCIARY DUTIES TO

INVESTMENT AND FINANCIAL ADVICE

As we approach the New Year, I offer a look at the issues likely to be of most concern to pro-fiduciary advocates.  I also offer my own personal “wish list” for 2013 and beyond.

The Major Issues in 2013.

Department of Labor – Major Extension of Fiduciary Standards Forthcoming. The biggest development in the expansion of fiduciary duties, at least in the short term, will be the DOL/EBSA's release of a revised “Definition of Fiduciary” rule.  Recent reports indicated that the new proposed rule will be released in early or mid-2013. Backed by a substantial economic analysis, Assistant Secretary of Labor Phyllis Borzi, who heads up the U.S. Department of Labor's influential Employee Benefits Security Administration, will likely apply the strict ERISA fiduciary standard to nearly all those who provide investment advice to either plan sponsors or to plan participants.  Even more dramatic will be the extension of ERISA's fiduciary standard to cover IRA rollover accounts.  With these moves, ERISA's standards will apply to well over $15 trillion of financial assets held by individuals and in retirement plans in the United States – a significant portion of the overall universe of publicly traded securities held by individual Americans.

The EBSA's re-proposed rule on “Definition of Fidcuiary” will endure intense opposition, but I believe it will be adopted.  The extension of fiduciary status to nearly all those who provide investment advice to plan sponsors and plan participants will be the third leg of what I call the “Big 3” EBSA rule initiatives - the first two being the fee/cost disclosures required to plan sponsors, and then to plan participants.  The effect of the first two rules is already being seen in tens of billions (if not more) in savings for retirement plan participants.  There is no doubt that these first two rules have already impacted in a positive way the retirement security of millions of Americans already, and will continue to do so.

Yet disclosure is not the greatest disinfectant, despite assertions to the contrary.  Already reports have been heard of plan sponsors ignoring the drawbacks of high-cost products in order to obtain a “better relationship” with a chosen advisor.  Hence, the last peg of this triad of rulemaking – the extension of the definition of fiduciary - will bring forth far more good news for participants over the long term.  Over time plan sponsors, and their fiduciary advisors, will realize that all fees and costs matter, and that lower-fee alternatives must be explored and evaluated.  Greater care will be taken in the design of retirement plan portfolios, and greater due diligence will be undertaken by advisors (now bound by a fiduciary duty of due care) in reviewing all of the risk, fees, costs, and other attributes of investment products.

Securities and Exchange Commission – Any Action Likely on Section 913 of Dodd-Frank?  The ongoing influence of the state courts on the fiduciary obligations of those who provide investment advice should not be underestimated.  State common law continues to apply the fiduciary standard to many registered representatives who provide financial or investment advice, under a facts and circumstances test, as it has for well over a century.  Too many investment advisers and financial advisors ignore the state common law imposition of fiduciary standards upon their advisory activities, at their peril.  Moreover, with a growing consensus among behavioral economists that disclosure-based regimes are an inadequate response for consumer protection, and with the ongoing influence of economic theory upon the law, additional cases will likely emerge from the courts and in arbitration proceedings which apply the fiduciary standard to those who hold out as trusted advisers [such as by using titles that denote relationships of trust and confidence, such as 'financial consultant' or 'CFP(r)'] or who actually provide investment advice.  While anything can happen, I would not be surprised if we don't see a proposed rule from the SEC until 2014, or even later.

Self-Regulatory Association for RIAs – The Danger Is Greater Than Many Think

Despite the assertions of the likely new head of the U.S. House Committee on Financial Services that the SRO bill for RIAs is on the back-burner, the influence of FINRA, SIFMA, FSI, the insurance company lobby, and the Wall Street broker-dealer and investment banking lobby should not be underestimated.  As seen recently with its offer to act as arbitrator in RIA proceedings, FINRA continues to position itself as the solution for RIA oversight.  This is the same FINRA (f/k/a NASD) that, in 1942, failed to incorporate the fiduciary standard of conduct into its Rules of Conduct for brokers.  FINRA's failure continues to this day, and, in fact, FINRA in 2005 opposed the application of the fiduciary standard to ongoing investment advice provided to retail consumers.  Despite the progress likely to be made at the DOL in 2013, FINRA's move to oversee its members' competitors would, in my view, be the death knell for the fiduciary standard, and a huge blow to the ever-growing investment adviser community.

Continued Growth of the RIA Business Model.  Turning to the RIA profession, there will continue to be a slow migration of registered representatives and dual registrants away from the large Wall Street broker-dealer firms and into the hands of independent broker-dealers.  This will be an intermediate step for some, for many will likely move to RIA-only status just a few years later, abandoning their Series 7 licensure.  A few intrepid souls will move directly from larger BDs to RIA firms, or they will start their own RIA firms.  This movement toward the RIA model is fueled only in small part by the desire to escape from FINRA's rules-based regulatory regime.  In a much larger part, it is fueled by the attractiveness of being removed from the pressure to sell products which may not be in the best interests of clients.  The transition to RIA status is motivated by advisors' desire to be 'on the same side of the table' as that of their clients, and by consumers' ever-greater knowledge that less conflicts of interest equals better advice.

The Ongoing Rise of the CFP® Certification – But Will the CFP Board Lead the Profession, or Not?  The financial planning profession, while still diverse, has increasingly become centered around the CFP Board's certification process.  The rise in the number of CFP certificants will continue, although the pace may vary over time.  With its increased stature, the CFP Board of Standards will likely face closer scrutiny of its own application of the fiduciary standard upon its certificants.  The question remains ... 'Will the CFP Board lead financial planners toward a true profession bound together by a bona fide fiduciary standard, or will it merely follow and, in doing so, risk losing its chance for preeminance as the consumer mark of choice in the years to come.

(My recent blogs, found at http://scholarfp.blogspot.com/2012/10/will-cfp-board-move-ball-forward-or.html and http://scholarfp.blogspot.com/2012/11/a-reply-to-ceo-of-cfp-board.html, and Michael Kitces' recent blog at www.kitces.com, and Andy Gluck's articles on this subject at www.Advisors4Advisors.com, discuss the issues surrounding the CFP Board's Standards of Conduct in greater detail.)

A Wish List for 2013 … and Beyond

FINRA acknowledges that all brokers providing personalized investment advice are already fiduciaries, and incorporates fiduciary standards into their Rules of Conduct.  What is “personalized investment advice”?  Just about anything other than a description of the product or security – including advice regarding strategic or tactical asset allocation, “whether this security is right for you,” etc. – is advice. Interestingly enough, FINRA (formerly known as NASD), over seven decades ago, undertook such a statement in one of their first bulletins to their broker-dealer members, stating:  "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 … A broker may not in any way, nor in any amount, make a secret profit … his commission, if any, for services rendered … under the Rules of the Association must be a fair commission under all the relevant circumstances.” – from The Bulletin, published by the National Association of Securities Dealers, Volume I, Number 2 (June 22, 1940).

The broad range of fiduciary status is amply illustrated by the SEC’s 1942 discussion of the Stelmack decision.  The SEC summarized this decision, stating 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.”  From the 1942 SEC Annual Report, p. 15, referring to In the Matter of Willlam J. Stelmack Corporation, Securities Exchange Act Releases 2992 and 3254.

FINRA’s Aspiration to Become SRO for RIAs Is Soundly Rejected by Congressional Leaders.  FINRA’s continued refusal, in recent decades, to acknowledge the fiduciary status of brokers providing individualized investment advice, and its seven-decade-old failure to incorporate fiduciary standards into its Rules of Conduct, are evidence enough of why FINRA should never have its jurisdiction extended to cover the RIA community.  (If they reversed seven decades of opposition to fiduciary standards, and endorsement of the failed suitability standard, I would reconsider my opposition to FINRA).

I’ve previously written extensively about the issue of FINRA’s power grab over RIAs, and what a dismal result this would be for advisors and consumers alike, in two articles published by RIABiz: http://www.riabiz.com/a/13586743/why-finras-power-grab-for-rias-needs-to-be-stopped-to-avert-the-death-of-the-profession-part-1 and http://www.riabiz.com/a/13580735/an-in-depth-analysis-of-finras-attempted-takeover-of-rias-and-why-the-group-should-be-disbanded-part-2.

Use of a title denoting a relationship of trust and confidence results in broker’s fiduciary status per se.  Such titles would include “wealth advisor,” “wealth manager,” “investment advisor,” “financial consultant,” “financial advisor,” “financial planner,” and any designation or certification incorporating these or similar terms (such as ChFC, CFP, PFS, etc.).  Why is this important?  Let’s listen to some early musings by the SEC.

In its 1940 Annual Report, the U.S. Securities and Exchange Commission 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 '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 “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.)

Two other professors stated this point much more succinctly: “[T]o give biased advice with the aura of advice in the customer’s best interest — is fraud.” (Professors James J. Angel and Douglas M. McCabe, Georgetown University, Ethical Standards for Stockbrokers: Fiduciary or Suitability? Sept. 30, 2010).  Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1686756

The SEC reverses its September 2007 proposed rule, and understates that “switching hats” (from fiduciary to non-fiduciary status) is permitted only extremely rarely, and that wearing “two hats” at the same time is impossible under the law.  There’s an old adage, from an eloquent Tennessee jurist writing just before the Civil War. This judge stated that the fiduciary 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.’”

Having given this a lot of thought, I don’t think it is possible to “switch hats” from a fiduciary to nonfiduciary one (except in very, very rare cases), or wear two hats at the same time for the same client. The temptation to not act in the client’s best interest is too great. Moreover, the client will never understand the dramatic shift which occurs when the fiduciary hat is removed; if the client did understand it, he or she wouldn’t allow it.

While principal trades may occur, they must still fall within the fiduciary standard of conduct – i.e., the proposed transaction must be in the best interests of the client, measured objectively and taking into account all of the facts and circumstances of the situation at hand.  It must be affirmatively shown that an agency trade, when available, was not better for the client.

The SEC’s Division of Investment Management, and SEC Commissioners, get their act together to enact a broad series of reforms.   These include, but are not limited to;

1. 12b-1 fees phased out, as anti-competitive in nature and contrary to fund directors’ duty to shareholders.  It also amounts to indirectly paid, but still prohibited, "special compensation," in my view.
2. “Portfolio turnover” ratio re-defined as the average of sales and purchases of securities within a fund, rather than the lower of the two figures, in order that investors are not misled by the published, and frequently-referred-to, metric.
3. Absent repeal by Congress, the SEC reviews the payment of soft dollar compensation for reasonableness, and actual substantial use of investment research provided in return for payment of soft dollars.
4. The insidious practice of payment for shelf space terminated.  This is contrary to the fiduciary principle which all brokers must follow.
5. Securities lending revenue is defined to be an asset of the fund, much as has recently occurred in a decision within the EU.  Fees for management of securities lending are included as part of the fund’s investment advisor’s fee.

DOL/EBSA’s “Definition of Fiduciary” Rule is Proposed and Finalized.  A strong ERISA “sole interests” fiduciary standard is applied to all those who provide advice to plan sponsors and to plan participants.  The rule extends to all IRA accounts.  As a result, plan sponsors and participants finally receive advice – from all advisors – that is truly in their sole interest.

A more far-out wish?  Tax simplification for DC and DB Plans.  Congress consolidates all types of defined contribution plans into one form – IRA accounts governed by ERISA, with uniform limits on contributions, with auto-enrollment and auto-escalation features (with opt-out mechanisms), and with self-directed options always available (still governed by ERISA, however).  Substantial limits on loans are imposed, if they are permitted at all.  The IRS works with EBSA to formulate required minimum distribution schedules which provide a more sensible scheme of distribution from IRA and qualified retirement plan accounts over time. And Congress consolidates all types of directed benefit plans, over time, into one type.

Even More Far-Out?  Remove Tax Incentives for Sales of Life Insurance, Annuities as Forms of Investments.  Along the way, I would hope that Congress terminates the tax-deferral feature of nonqualified annuities, and the tax-deferral provided within life insurance contracts as to any withdrawals (including loans) during lifetime.

The CFP Board of Standards Moves to Improve its Standards of Professional Conduct.  The CFP Board’s current application of the fiduciary standard needs to evolve, as I have written previously in two articles found at http://scholarfp.blogspot.com.

In Conclusion.

Opportunities exist in 2013 for a strengthening and expansion of the fiduciary standard on several fronts.  Yet, the immense threat of FINRA remains, and those RIAs and financial planners who ignore this threat do so at their own peril.  If the FINRA threat is abated, significant progress is likely at DOL/EBSA, and this may well set the stage for later action by the SEC to embrace the fiduciary standard for all those who provide personalized investment advice - as was done in the early part of the 20th Century.

Ron A. Rhoades, JD, CFP®

Program Chair, Financial Planning Program

Asst. Professor, Alfred State College Business Department

E-mail: RhoadeRA@AlfredState.edu

(This article reflects the author’s personal views, and are not necessarily those of any institution, organization, or firm of which the author may be part.)

America's Future; Mankind's Future: I'm Optimistic

I'm optimistic.

All one has to do is to reflect on all of the technological changes in the past ten years which occurred to have hope for mankind's future. These include:

• Renewable energy (huge deployments of wind and solar systems, at ever-declining costs), with "grid parity" achieved in some geographic areas already, and much of the world likely to see grid parity within the next decade. (And that doesn't even count the high and often unmeasured costs of carbon, released by carbon fuels.) There are also promising deployments of geothermal systems, tidal forces technology, carbon capture technology, energy efficient buildings and lighting and heating, and so much more. We now have the hope of substantially reducing our reliance on carbon-based fuels, which in turn can lead to saving much of our world from the ever-greater harmful effects of global warming.

• Human genome research, including the incredible ability to map out each person's genes at relatively low cost, and the dramatic new gene therapies just beginning to emerge. Not to mention other major developments in health care, from new MRI techniques promising the ability to better diagnosis illnesses, to new therapies to fight cancer, and even better understanding of factors affecting human longevity. There is renewed hope that, within a few decades, all cancers will be treatable (and/or preventable). Perhaps even an end to the common cold, and all manners of protection against deadly viruses and bacteria, will emerge.

• Materials science, fueling in some measure the foregoing, but also dramatically affecting everything from better battery technologies (think: "low-cost electric car") to computers (think: speed and storage capacities to rise 1,000-fold) to water filtration (think: "clean water for everyone").

• Greater communications at far lower cost throughout most of the world, opening up an exchange of information and ideas in ways many never thought possible. Also leading to profound changes in the delivery of education, and new access to education at all levels by hundreds of millions worldwide.

Also realize that we are still in the midst of the "computer revolution" - which may not be even one-half complete, with more amazing hardware and software technologies set to further transform all segments of our society.

And each week I read of more new and promising scientific and technological developments, many of them from the halls of our great colleges and universities. Of course, I realize that not every discovery will make its way from the laboratories to practical implementation, but the number of innovations is truly outstanding.

Of course, we have major problems in this world. Food shortages in some areas (and higher food costs, generally, than we would like to see). Billions of our fellow citizens of this earth infected with intestinal parasites, and even more with no access to clean water.

And, even in countries with plenty, there is hunger and social injustice. There is war, far too often. The rule of law is not even close to be universally accepted. And the nations of this world have yet to agree to arbitrate all of their international disputes.

There has also been a shift, due in part to the very successes we herald (with applications of computer technology, robotics, etc.), of the source of profits for companies. Human labor has been replaced, to a degree, with the deployment of technology via monetary capital. Fundamentally, this is one source for high unemployment numbers in many developed countries. This change in our economic structure is not discussed frequently enough by the public media, nor even by economists. We must identify how to better distribute the wealth generated by these technological advances in such a fashion as to maintain human dignity and provide a better, not worse, standard of living for our children. New economic theories must arise to guide us in designing sustainable and less disruptive economic systems. With our greater understanding of human emotions, biases, and motivations, we can go far in this area.

We will always possess limited resources. We will always face tough choices. We will always possess disagreements over the correct path to pursue; yet, we need not be disagreeable. We can seek out truth, and through discussion we can overcome the potential for discord. We can keep government within its proper roles and limited, while using government more effectively where it is needed most. And we can better rely on our other social institutions - places of worships, charitable organizations, and our individual love of our fellow man - to effect comfort, care and shelter for those who truly lack the present ability to provide for themselves fully. 

I often read of the "decline of America." Yet, no where else in the world is seen the combination of entrepreneurial spirit, risk-taking, scientific research, idea creation, and capital formation as is seen in this country? With proper policies to maintain and enhance our strengths, America can and will remain a great country. To those who constantly foretell America's decline I say, "Don't tell me what America can no longer do. Tell me what America can do better. And then, together, let's go and achieve it! Deliberately. Intelligently. Resolutely."

Yes, bringing forth positive changes in society often takes leadership. And, no doubt, some structural changes will be required to permit great leaders to emerge, and better enable them to lead. For example, fostering America's greatness will require new policies to end the undue influence of money on politics. Increased statesmanship, and enhanced leadership, would then follow.

It will also take the proper embrace of appropriate principles, which will then serve to guide our great institutions of government, commerce and industry. It will take the further realization that we live in an ever-more-complex and specialized society, in which we all possess the need to depend upon the expertise of others. It will take the realization that, as we turn to these experts, information asymmetry is far to great, which dictates the imposition of principles to safeguard those who rely upon such experts. In such a way, we can restore trust to our financial services system, foster capital investment, and engender a new era of economic growth.

In conclusion, I believe America's future is great. Mankind's future is promising. Let us find ways to discover the right path, to forge ahead, to create and build and explore new frontiers of science and technology and economics. Together let us construct the foundations for a better tomorrow, for ourselves, our children, our grandchildren, and for all of humanity.

I'm optimistic. You should be, too.

Schwab's Forced Customer Waiver of Right to Class Actions Deserves RIAs' Scrutiny

James W. Watkins, III, Esq., a securities litigator of renown, recently posted a blog discussing Schwab's clause, contained in its customer agreements, which mandates pre-dispute arbitration in lieu of participation in securities class action claims. You may recall that a recent decision upholding the use of this clause is being appealed by FINRA.

Mr. Watkins concludes that RIAs should avoid using Schwab. As of now, I can't reach such a conclusion (albeit I'm open to being convinced).  Hence, I opine a bit differently - that Schwab's clause is a significant factor which should be considered in recommending a custodian to a client, and that Form ADV Part 2A disclosures should likely be revised to ensure clients are informed of this material fact (i.e., waiver of their rights).

I would suggest that readers of this blog first read Attorney Watkins' blog, found at http://iainsight.wordpress.com/2013/03/11/has-schwab-opened-pandoras-box-for-rias/, before reading my reply below.

HERE'S MY REPLY to Mr. Watkin's original blog post:

James,

Interesting article. Permit me to comment on a few aspects of same.

Most custodians that work with RIAs offer a range of services for RIAs, including access to trading platform, research, and online connections to facilitate reviewing of client account information. RIAs are seldom charged for these services. Instead, they are paid by clients, as part of the transaction fees charged for a mutual fund trade, for example. Hence, compensation flows to the RIA from the BD firm. While only part of this can be called “soft dollars” (technically), these benefits to RIAs must be disclosed on Form ADV Part 2A.

An RIA’s choice of custodians to recommend to clients is an important decision. Best execution in stock trades is always an issue (though not as big an issue as regulators think, for most firms). The amount of transaction fees charged by mutual funds is also a factor. The quality of BD monthly statements, tax reporting, accuracy in establishing accounts, fees for wire transfer or other services, are all additional factors in the selection of the custodian. Of course, the custodian’s financial strength is a key concern, as well as the availability of private insurance in the event of BD default (the foregoing being larger issues after the Bear Stearns and Lehman Brothers collapses, and continued concerns over mark-to-market avoidance and the continued concerns over the level of capital of many investment banks/BDs).

The author, a securities litigation attorney, opines that recommending a BD which requires a waiver of legal rights (in this case, the right to join a class action against the BD) may violate the RIA’s fiduciary duty. Does this opinion withstand scrutiny?

Generally, under the law an RIA possesses three major fiduciary duties – that of due care, undivided loyalty, and utmost good faith. In this instance, undertaking “due diligence” on choice of custodian is an important function of the RIA, and certainly implicates fiduciary duties. But is the restriction of the legal rights of a client just one of many factors in undertaking the recommendation, or is this single aspect of the relationship so important that it involves crossing the Rubricon for an RIA, with respect to observing its (or his or her) fiduciary duty to the client.

As noted by the author, the waiver of the right to participate in securities class actions is potentially the waiver of an important right. There have been many instances of BD practices being subjected to class action claims. And, as the author suggests, individual claimants could not likely afford to pursue an action, without joinder in such a class action. For example, the Schwab YieldPlus settlement was for $200,000,000 in total settlement funds (including payment of attorneys fees); it is doubtful that many individual investors would have pursued individual claims against Schwab, except for those with very large investments in the fund. Also, a pending class action claim, involving the alleged recordation by Schwab of client telephone calls without customer consent, may be affected by the recent decision upholding the use of the waiver of class action securities litigation provision.

Unlike a private cause of action, which BDs may compel arbitration for as well (and nearly all so do), the denial of a class action claim participation effectively – at least for most customers of the BD, and in most instances of BD misconduct subject to class action claims – denies the customer the ability to seek redress. The costs of arbitration, relative to the damages suffered by each individual customer, simply do not merit the bringing of individual actions. This is the most troubling aspect of the waiver of the right to bring a class action right. While not a de jure denial of the right to seek redress (arbitration is still an option), for most customers of the BD the waiver operates as a de facto denial, due to economic concerns.

In a letter to Schwab, the Commonwealth of Massachusetts’ Secretary of State opined that the recent ruling upholding Schwab’s waiver, “is akin to giving every rogue broker the green light to steal from their clients in small amounts.”

While not directly on point, another letter from the Massachusetts Secretary of State is noteworthy. It has been recently asserted by state securities regulators, in a letter to the SEC from Secretary Galvin, that RIAs who place mandatory arbitration provisions in their own contracts may be violating their own fiduciary duties, stating: “a clause binding an investor to arbitration before the circumstances are known may not be in the client’s best interest nor consistent with the advisor’s fiduciary duty.” Many state securities regulators have long taken the stance that arbitration agreements in RIA contracts breach the fiduciary duties of the RIA.

I would also note that Dodd-Frank provides the SEC with authority to prohibit pre-dispute arbitration clauses, if the SEC finds that it is in the public interest and for the protection of investors.

Yet, under the Federal Arbitration Act, we have a national public policy which promotes alternative dispute resolution. Arbitration serves many purposes. Unfortunately, some of these purposes are not always good. In fact, industry-controlled arbitration, as exists with FINRA, has a history of abuses of participant rights, and may in fact be contrary to the fiduciary duties of an RIA if required by RIAs in their fee agreements. (Hence, a good reason for all RIAs to avoid submitting clients to FINRA arbitration (as opposed to the use of an independent arbitration organization), if they impose arbitration mandates at all.

The U.S. Supreme Court recently heard arguments in a case (AmEx) that could determine the extent to which companies might rely on arbitration clauses to fend off class action lawsuits. Consumer advocates claim the clauses give unfair advantages to companies, and effectively deny consumers the right to bring claims. But in recent years, the Supreme Court has upheld the enforcement of mandatory arbitration clauses under the Federal Arbitration Act, which was intended to encourage their use. However, I would note that this case does not involve fiduciary duties.

So, back to the question – will an RIA violate its fiduciary duty if it recommends a BD which has in its agreement a binding clause waving the right to participate in class action suits (and instead arbitrate claims individually)?

At the minimum, I would suggest that the BD’s agreement term is a significant factor in the RIA’s recommendation of the BD. If other BDs exist which offer the same quantity and quality of services, without imposing such a restriction on the legal rights of the RIA’s client (the BD’s customer), then such an effective (de facto) denial of rights to redress may well result in the RIA’s choice to be another BD (custodian) without such a restriction.

Under the RIA’s fiduciary duty to disclose all material facts, this also appears to be a fact that must be disclosed to the client. Especially given the fact that an inherent conflict of interest exists, because the RIA is receiving compensation (in the form of services) provided by the custodian which are paid for by client funds.

But, the issue remains, is this such an important waiver of rights that the RIA should not recommend the BD under any circumstances? I cannot reach that conclusion. For example, what if the quality and pricing of the custodian’s services are so exceptional (and so beneficial to the client) that these benefits are perceived to outweigh the potential recovery (measured by likelihood of class action claims, and likelihood of the amount recovered) in future class action claims? There is, of course, a great deal of uncertainty in undertaking such a projection.

What if other custodians (such as TD Ameritrade, Fidelity, etc.) follow suit and add similar clauses to their agreements? Must RIAs then choose to work only with smaller custodians, who may possess (although not necessarily the case) less quality or quantity of services for the fees paid by the client, or who may be (although not necessarily so) less financially strong?

Hence, I reach a somewhat different conclusion than the author. I would suggest that RIAs consider, as a strong and SUBSTANTIAL factor in the selection of the custodian to recommend to the RIA’s new clients, the existence of this waiver of the right to participate in class actions, given the very real impact it may possess upon the client at some future time. Some RIAs may well conclude, especially in situations where there is a “close call” between the use of one custodian versus another, that they should go with the custodian who does not impose such a mandatory waiver of the right to participate in class actions.

I would also suggest that all RIAs considering enhancing their disclosures in their Form ADV, Part 2A, to inform clients that such a waiver of legal rights is mandated by certain recommended custodians, and that not all custodians possess such waivers. Also that class actions against BDs for misconduct are somewhat frequent, and often result in recoveries of funds for customers (albeit in relatively small amounts, per customer, in most instances). Also that it is highly unlikely that the client would pursue the legal rights which are effectively waived, such as by bringing a private (individual) arbitration proceeding.

What about existing clients who already have accounts at such a custodian? I would suggest a timely Form ADV Part 2A amendment, with the Statement of Material Changes sent to the client and accompanied by a letter to the client explaining the situation in more detail.

I would also urge the discussion of this issue to continue. What historic data exists as to the amount of recovery, by individual customers of a BD, in class action settlements? If such settlement amounts are found, through research, to be quite large (on a per-customer basis), RIAs may well feel compelled to only work with custodians who do not possess waivers of class action claims – as long as such qualified custodians exist. In other words, while I conclude, for now, that the existence of such a waiver is a strong and substantial factor in the RIA’s recommendation of a custodian to a client, I can be swayed by historical data demonstrating that the waiver could substantially harm the client. Hence, I don’t necessarily disagree with the author’s conclusion. I only opine, for now, that – at a MINIMUM – the existence of such a waiver clause is a significant and substantial factor which should be considered in the RIA’s recommendation of a custodian to the client.

An Allegation of Misleading "Trust-Based Selling" Against "Dick Van Dyke"

In a previous blog (http://scholarfp.blogspot.com/2013/01/wall-streets-deceptions-brokers-as.html) I noted that “trust-based selling” can get a person into trouble, if they don’t accept fiduciary status and fulfill their fiduciary obligations.  Yet, far too often federal and state securities officials and other enforcement arms fail to take action against these fraudulent practices. Hhowever, in a recent case, arising out of Illinois, a financial advisor faces two separate legal actions involving his trust-based selling practices.

The State of Illinois Attorney General has filed an action seeking civil penalties against Mr. Richard Lee Van Dyke, Jr. (a.k.a. "Dick Van Dyke"), a seller of fixed indexed annuities who, in advertising, stated: “If you want a successful financial plan, you need a financial advisor you can really trust … He believes in principles like full disclosure and transparency and he doesn’t sell investments on commission which means he’s on your side so you get to reach your goals first before he does. When’s the last time an investment advisor put you first?” The basis of the complaint is a violation of Illinois’ Consumer Fraud and Deceptive Business Practices Act. Andy Gluck provides commentary and Advisors4Advisors also provides a copy of the Complaint, at http://advisors4advisors.com/compliance/advertising-compliance/article/17314-financial-advisor-in-illinois-accused-in-lawsuit-by-state-securities-regulators-of-advertising-he-acted-as-a-fiduciary-says-hes-done-nothing-wrong.

In addition, the Division of Securities filed an administrative action against Mr. Van Dyke (in the form of a Notice of Hearing, which can be found at:

http://www.ilsos.gov/adminactionssearch/adminactionssearch) in which it is alleged that Mr. Van Dyke violated his duties to his clients as an investment adviser, during the time that he was registered as such.  One of the sections of the investment adviser state statutes cited has been construed to impose fiduciary duties upon investment advisers.

There are allegations of both actual fraud (in the deceptive trade practices action) and constructive fraud (in the administrative action). In both cases, substantial harm to customers is alleged to have occurred.

From the facts set forth in the two actions, one can only wonder why the state insurance commissioner did not pursue a case of churning (a.k.a. twisting) against this seller of fixed indexed annuities. Then again, under Illinois law, unlike the law of most states, fixed indexed annuities are (at present) regarded as securities. Either that, or this is just more evidence that market conduct regulation and its enforcement by state insurance commissioners remains dismal.

While it is unlikely that a case like this will proceed all the way to a trial, much less become the subject of appeals and subsequent written opinions, this may be a case to watch. Far too long those in arms-length relationships, selling securities and/or insurance products, have engaged in “trust-based selling” techniques. They have held themselves out as experts through the use of titles (many of which lack substance) - an act which is a factor in imposing fiduciary status under state common law. Moreover, many of those in the securities industry have inappropriately touted their “objective” advice.

Will all those who hold out as "putting the best interests of the client first" be held to account, as fiduciaries, for such representations? From Goldman Sachs on Wall Street to small sellers of insurance and investments on Main Street, we can only hope so.

Is the tide beginning to turn? Will our regulators stamp out misrepresentations – both through administrative/court actions and also through prudent regulation? Time will tell.

There are many battlegrounds in the war over fiduciary standards - not just in D.C. Stay tuned.

Thoughts on the Inadequate State Funding of U.S. Undergraduate College Education

TO MY FRIENDS AND COLLEAGUES:

I've grown concerned that the cost of an undergraduate education has grown substantially over the past 15-20 years, primarily due to state budget cuts (thereby forcing tuition and other fees up), but also due to other extrinsic factors. As a result, it appears to me that college is much more expensive for students today, yet at the same time college is so much more necessary to train up our workforce to fit the jobs in this modern economy.

So, please permit me to share some thoughts on the increases seen in college costs. Along the way I set forth a small partial solution - the use of discounted textbooks and/or trade publications instead of costly textbooks. I also suggest a few longer-term solutions, addressing greater revenue (and its use) for colleges.  Yet, greater solutions - especially those which drive down current costs - appear elusive.

STATE BUDGET CUTS AND TUITION INCREASES.  While tuition has increased dramatically at colleges, the cause of these increases has often been debated. This study by two economists demonstrates that the primary cause is decreased state funding of public education. (See
http://libertystreeteconomics.newyorkfed.org/2012/09/soaring-tuitions-are-public-funding-cuts-to-blame.html.

Anecdotally, I have observed this over the past 10-15 years - tuition increases are approved within public college systems in response to state budget cuts which occur, it seems, every 5-10 years.

CLASS SIZE INCREASES.  At many universities over the past 10-20 years, class sizes have also soared. One would think this would have resulted in a lowering of the costs of attending college.

However, I would note that class sizes have not occurred, in any substantial fashion, at Alfred State.  Most of the classes at Alfred State College remain in the 20-35 student range. Moreover, the classes are taught by professors themselves, not teaching assistants. I suspect this is a big part of Alfred State's popularity, although its focus on experiential learning also is likely a factor.

ROOM AND BOARD FEE INCREASES.  While I don't possess statistics for New York State, nationally room and board costs at colleges and universities have seen increases of 2% a year, above and beyond inflation, on average. A good part of this may be attributable to food price increases worldwide over the last decade, attributable to many factors (increased consumption of beef, increased energy prices, etc.). Improvements in the meals served at colleges and universities are also likely a factor - I often hear alumni applaud the substantially improved offerings on the buffet, compared to when they were at the college 10, 15, 20 or more years ago.

MAJOR TEXTBOOK COST INCREASES.  Of course, textbook prices have also soared - much more so than other college costs over the last 20-30 years, according to some studies. What I have not seen is an explanation of "why" these cost increases have occurred, during a time when (overall) book publication costs have generally been trending below the costs of inflation.

The somewhat good news is that this high cost is the one thing I can take action on. Starting next Fall, I'll be using a $25 online textbook (customized by me, through FlatWorldKnowledge) for my Business Law I class. Students may access it only online for $25. If students desire a print version it will cost about $50. This is relatively inexpensive, considering that the current book I'm using costs $260 new (print version), or $90 for online access to the 18 chapters we cover in the course.

I'm also using a trade publication - a 760-page new book, "CFP Board Financial Planning Competency Handbook" (Wiley Finance) by CFP Board (Apr 1, 2013) - which costs $71 through Amazon.com (print edition). (I don't know if a Kindle edition will be available for even less)  I'll be using this one book for two courses - the PFP Capstone Course, and Retirement Planning (supplemented with free outside materials). An added bonus is that this new book will likely be an important resources as students prepare to take the CFP Exam, post-graduation.

In a 2011 study, U.S. PIRG found a majority of students admit to not purchasing at least one textbook required for their classes because the price is too high. I have personally observed this occur. While students borrow textbooks, inevitably there are times when they don't have access to the textbook when they need it, and their education (and grades) suffer. At least I can do something about this, for my own students, starting next Fall.

FOUR PARTIAL SOLUTIONS TO THE HIGH COSTS OF COLLEGE. Other than my personal embrace of lower-cost books for students, where available, I'm not yet possessing of solutions for other reductions in cost, to make college more affordable for students today. Some potential solutions, however, on the revenue side of the equation,  include:

• Restoration of state funding of college and university costs, from the 50% or so it is currently, to 75% (as a target) - as it existed about a decade ago. Undertake tuition rate decreases as this restoration of funding occurs. Of course, with state budgets under pressure, still, this is unlikely to occur - at least anytime in the future.
• The creation and funding of better endowments at colleges and universities - perhaps to target student-paid expenses. Imagine an endowment which subsidizes, for deserving students (or all students), on-campus housing and/or food costs.
• The funding of endowments in the form of general scholarship funds, perhaps with the purpose of lowering tuition costs for all students. In other words, let the 5% annual distributions from such a fund lower tuition fees for all students, across the board. In recent years colleges have tended to award much of their scholarship funds to top applicants, with those without high test scores and GPAs left to wrestle with high costs (and/or large student loan debt).
• Better investment of endowment funds is required. Despite the academic research which demonstrates the long-term benefits of a low-cost, passively managed investment portfolio, and the use of a "layer-cake" approach to leveling distributions when market volatility exists, I still see many endowment funds which are poorly managed. Many endowments do not invest to take into account the Fama-French multi-factor model; quite a surprise given the inherently long-term nature of endowment funds and the extremely high probabilities that value and small cap premia will exist over the very long term. Endowment fund managers also need to employ investment advisers for a flat fee, and get away from the percentage-of-assets-managed model.  In summary, endowment fund managers need to wake up!

ONLINE EDUCATION?  There is a large movement toward the use of online education offerings. The advantage is, of course, flexibility (for students who are working full-time jobs, for example) and reduced costs.  Without a doubt, I'm in favor of this trend - for it increases educational opportunities for Americans and for the world population.

Recent innovations to cut down on cheating in online courses (through the use of proctored online exams) may remove most of one of my potential objections to online education, at least for undergraduates. But I continue to possess other concerns.

We must realize that so much of what college provides students is NOT JUST technical education. Rather, it is hands-on, experiential and/or project based learning. Moreover, it is providing tools and an environment to enable each student to mature and expand their comfort zone. In short, it is developing the "total person" - not just equipping them with knowledge. That is what employers desire (and need) today. Far too often I get the sense that online students "miss out" on an important part of their educational experience, if they mainly take online classes.

(As an extreme example, I see students in dire need of improving their public speaking abilities and confidence take an online course in Public Speaking - precisely to avoid the in-person interactions so necessary in a course like this.)

Hence, I worry that online educational offerings are not able to successfully duplicate the overall residential college experience. I personally believe that most students are better served, at least as undergraduates, in a residential college setting. (Provided, of course, that the class sizes remain small, to facilitate interactive learning. And provided, further, that faculty members are dedicated to developing all of the personal traits of a student, as I see with my fellow Business Department faculty here at Alfred State.)

Please don't get me wrong. I believe online education, both currently and in the future, has a large place in our overall educational system. But I worry that the current techniques I've seen used in online education result in a somewhat diminished overall educational experience. Perhaps there are advantages I'm not seeing, that enable a good "trade-off" to ensue. I'm certain I'll be giving this much more thought, as time goes by.

LARGER CLASS SIZES?  Similarly, perhaps larger class sizes may be required. But at what cost? When a class size gets above 30, interactive learning through class discussion becomes much more difficult. And larger class sizes means greater time spent by professors undertaking grading - and less tie spent on all-important advisement and other student support activities.

THREE YEARS OF COLLEGE, INSTEAD OF FOUR?  There is also a move on to reduce the baccalaureate degree in the U.S. to 3 years, instead of 4 years, as it exists in many other countries. Yet, many of these countries achieve this by reducing the amount of general education, and focusing only on technical education. This does not provide for development of the "whole person" - which employers desire.

IN SUMMARY, I'm in search of solutions. The few solutions I set forth are all designed to alter the revenue sources available, in hopes of lowering costs for students. There are means to make education more "efficient," but I worry that such efforts at efficiency may well undermine the best aspects of a U.S. college education. I remain open to learning more, however, and to exploring new ideas in the area of "efficiency."

All my best.
  - Ron

ADDENDUM: NEW YORK BUDGET CUTS HURT RE: CAPITAL EXPENDITURES. Sadly, New York State is cutting out capital expenditures this year - so necessary to refurbish existing buildings over a reasonable time period.

I can attest that Alfred State College, at least, has used funds for improvements quite wisely. Yet, the process is ongoing, and an interruption in capital funding will impact the quality of the educational environment.

Even on my floor of my academic building, for example, there exists old tiles in need of replacement (which are costly to replace, given the asbestos present and the need for safety during removal). Thankfully over the past winter break the Alfred State Administration was able to cull together some funds to replace tiles on the floor below, and stairwells. But more needs to be done, both to keep these older buildings safe, and to keep the buildings up-to-date and functional for a high-quality learning environment.