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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

THE RISE OF DECEPTIVE TITLES AND ADVERTISING ON WALL STREET.

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

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

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

YET, MANY CLIENTS REALIZE THE HARM

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

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

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

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

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

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

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

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

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

Could regulators stop all of this nonsensical misrepresentation? Yes. However, in recent years we have seen a simple ignorance by the SEC and FINRA of the fundamental truth that “to provide biased advice, with the aura of advice in the customer’s best interest, is fraud.” [Angel, James J. and McCabe, Douglas M., Ethical Standards for Stockbrokers: Fiduciary or Suitability? (September 30, 2010), at p.23.  Available at SSRN: http://ssrn.com/abstract=1686756.] 

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

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

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

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

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

Even the National Association of Securities Dealers (NASD) (now known as FINRA), in an early pronouncement shortly after its creation, confirmed that brokers were fiduciaries: “Essentially, a broker or agent is a fiduciary and he thus standards in a position of trust and confidence with respect to his customer or principal. He must at all times, therefore, think and act as a fiduciary.  He owest his customer or principal complete obedience, complete loyalty, and the exercise of his unbiased interest. The law will not permit a broker or agent to put himself in a position where he can be influenced by any considerations other than those to the best interests of his customer or principal ….” – from The Bulletin, published by the National Association of Securities Dealers, Volume I, Number 2 (June 22, 1940).

Additionally, the U.S. Securities and Exchange Commission (SEC), early on in its history, commented in its official report to Congress that the manner in which brokers hold themselves out is often determinative of their fiduciary status. In its 1940 Annual Report, the SEC noted: “If the transaction is in reality an arm's-length transaction between the securities house and its customer, then the securities house is not subject to a fiduciary duty. However, the necessity for a transaction to be really at arm's-length in order to escape fiduciary obligations, has been well stated by the United States. Court of Appeals for the District of Columbia in a recently decided case:

[T]he old line should be held fast which marks off the obligation of confidence and conscience from the temptation induced by self-interest.  He who would deal at arm's length must stand at arm's length.  And he must do so openly as an adversary, not disguised as confidant and protector.  He cannot commingle his trusteeship with merchandizing on his own account.…”

Seventh Annual Report of the Securities and Exchange Commission, Fiscal Year Ended June 30, 1941, at p. 158, citing Earll v. Picken (1940) 113 F. 2d 150.

A short time thereafter in its annual report to Congress the SEC summarized a court decision finding that the furnishing of investment advice by a broker was a “fiduciary function.”  The SEC stated: “In the Stelmack case the evidence showed that the firm obtained lists of holdings from certain customers and then sent to these customers analyses of their securities with recommendations listing securities to be retained, to be disposed of, and to be acquired … The [U.S. Securities and Exchange] Commission held that the conduct of the customers in soliciting the advice of the firm, their obvious expectation that it would act in their best interests, their reliance on its recommendations, and the conduct of the firm in making its advice and services available to them and in soliciting their confidence, pointed strongly to an agency relationship and that the very function of furnishing investment counsel constitutes a fiduciary function.” [1942 SEC Annual Report, p. 15, referring to In the Matter of Willlam J. Stelmack Corporation, Securities Exchange Act Releases 2992 and 3254.]

The early principles that a broker providing investment advice was a fiduciary, and that holding out as a trusted advisor should only be undertaken by fiduciaries, were further confirmed and elaborated upon by the SEC in 1963.  In discussing the issue, the SEC noted that it “has held that where a relationship of trust and confidence has been developed between a broker-dealer and his customer so that the customer relies on his advice, a fiduciary relationship exists, imposing a particular duty to act in the customer’s best interests and to disclose any interest the broker-dealer may have in transactions he effects for his customer … [BD advertising] may create an atmosphere of trust and confidence, encouraging full reliance on broker-dealers and their registered representatives as professional advisers in situations where such reliance is not merited, and obscuring the merchandising aspects of the retail securities business … Where the relationship between the customer and broker is such that the former relies in whole or in part on the advice and recommendations of the latter, the salesman is, in effect, an investment adviser, and some of the aspects of a fiduciary relationship arise between the parties.” 1963 SEC Study, citing various SEC Releases.

THE INVESTMENT ADVISERS ACT NEVER NEGATED BROKERS’ FIDUCIARY STATUS.

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

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

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

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

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

For example, in discussing the decisions of two early cases, the NASD said it was “worth quoting” statements from various court opinions:  “In relation to the question of the capacity in which a broker-dealer acts, the opinion quotes from the Restatement of the law of Agency: ‘The understanding that one is to act primarily for the benefit of another is often the determinative feature in distinguishing the agency relationship from others … The name which the parties give the relationship is not determinative.’ And again: ‘An agency may, of course, arise out of correspondence and a course of conduct between the parties, despite a subsequent allegation that the parties acted as principals.’” - from N.A.S.D. News, published by the National Association of Securities Dealers, Volume II, Number 1 (Oct. 1, 1941).

A BETRAYAL OF CLIENTS’ TRUST

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

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

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

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

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

INDIVIDUAL INVESTORS FLEE FROM THE CAPITAL MARKETS

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

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

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

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

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

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

WHERE DO WE GO FROM HERE?

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

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

Will the Consumer Financial Protection Agency step in?

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

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

More to come.

To receive word of my next blog post, please subscribe to my Twitter feed: @140limited.  Thank you.

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

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

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.