What Would Adam Smith Say About the Fiduciary Standard?

In 431 days at the Securities and Exchange Commission, Joseph P. Kennedy reformed America’s capital markets. Even though Kennedy had profited handsomely during the tumultuous 1920s and the early 1930s from financial manipulation, from 1934 to 1935 Commissioner Kennedy led the effort to adopt rules, nearly all of which were opposed by the securities industry at the time. These rules restored individual American’s trust in our capital markets, leaving an enduring legacy far beyond his accomplishments as a financier, Ambassador to Great Britain, or father to a future U.S. President.

Gordon Gekko Meets Adam Smith

“The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind.”

So stated Michael Douglas in Wall Street (1987) as the infamous Gordon Gekko, a character that has defined Wall Street for a generation. More recently, in Wall Street 2: Money Never Sleeps (2010), Michael Douglas reminisces: “Someone reminded me I once said ‘greed is good’ ... But here’s the kicker, now it seems it’s legal.”

Some observers might opine that Adam Smith, the early champion of capitalism, would surely agree with some of what the character Gordon Gekko espoused. After all, Adam Smith generally held the capitalistic opinion that most persons are motivated by his or her own interests.

Adam Smith, however, recognized the difference between self-interest and greed, and he wrote that steps ought to be taken to keep the former from turning into the latter.

Actions based on self-interest lead to positive forces

The undeniable truth is that capitalism runs on opportunism, a fact long known in our country. Long before economics became a science of economic models, in the late 18th Century Adam Smith in his landmark work, The Wealth of Nations, posited an economic system based upon self-interest. This system, which later became known as capitalism, is described in this famous passage: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”[1]

As Adam Smith pointed out, capitalism has its positive effects. Actions based upon self-interest often lead to positive forces that benefit others or society at large. As capital is formed into an enterprise, jobs are created. Innovation is spurred forward, often leading to greater efficiencies in our society and enhancement of standards of living. Indeed, a person in the pursuit of his own interest “frequently promotes that of the society more effectually than when he really intends to promote it.”[2]

However, even Adam Smith knew that constraints upon greed were required. While Adam Smith saw virtue in competition, he certainly recognized the dangers of the abuse of economic power in his warnings about combinations of merchants and large mercantilist corporations.

Adam Smith also recognized the necessity of professional standards of conduct, for he suggested qualifications “by instituting some sort of probation, even in the higher and more difficult sciences, to be undergone by every person before he was permitted to exercise any liberal profession, or before he could be received as a candidate for any honourable office or profit.”[3] In essence, long before many of the professions became separate, specialized callings, Adam Smith advanced the concepts of high conduct standards for those entrusted with other people’s money.

What would Adam Smith, if he were alive 250 years later, observe regarding the modern forces in our economy? He would likely opine, given the economic forces that led to the recent (or current) Great Recession, that unfettered capitalism can have many ill effects. Indeed, he would observe that for all of its virtues, capitalism has not recently been a very pretty sight.

Consumers flee when trust is betrayed

The effects of greed in the financial services industry can be profound and extremely harmful to America and its citizens. Participation in the capital markets fails when consumers deal with financial intermediaries who cannot be trusted. As Tamar Frankel, a leading scholar on U.S. fiduciary law, observed: “I doubt whether investors will commit their valuable attention and time to judge the difference between honest and dishonest … financial intermediaries. I doubt whether investors will rely on advisors to make the distinction, once investors lose their trust in the market intermediaries. From the investor’s point of view, it is more efficient to withdraw their savings from the market.”[4]

I can personally confirm the foregoing observation. I have seen in my 25 years of practice, as an estate planning attorney and then as an investment adviser, a large number of individual Americans withdraw from the stock and bond markets after discovering the inadequacy of the conflict-ridden “investment advice” they received from many securities firms. These individuals had placed trust in their broker – a trust that was fostered by large marketing campaigns in which the offer of a close relationship with a “financial consultant” or “financial advisor” was promoted. Yet, they found that, in the end, any dream of a beachfront home had disappeared, as much of the returns of the capital markets were diverted into the pockets of the very person who, so often, appeared at their child’s soccer game to cheer. Was the cheer for the child, or for the opportunity to undertake more greedy endeavors with the client?

Many millions of American citizens who left the capital markets not because of disappointing returns – but because the trust which was requested of them by their “financial consultant,” and reasonably placed by the citizen in his or her advisor, was subsequently betrayed. It will be many years, before most of these individuals return to the capital markets. Some will never return, choosing instead to maintain their savings in depository accounts earning little interest, or even worse have their savings “stuffed in the mattress” or “hidden in a can.”

The counter to greed: the fiduciary standard of conduct

The fiduciary standard counters unfettered capitalism, by operating to restrain greed. This necessity to so restrain opportunism was reflected in a U.S. Supreme Court decision describing the fiduciary standard embraced by the Investment Advisers Act of 1940: “The dangers of fraud, deception, or overreaching … motivated the enactment of the [Advisers Act] ....”[5]

The fiduciary standard of conduct operates to restrain greed, where other measures of constraint are generally believed to be ineffective. Stated differently, fiduciary status operates to constrain the otherwise-permitted actions of the financial advisor, in order to not usurp the opportunities presented to the client due to the information asymmetry present. In essence, the fiduciary standard constrains conduct, where trust reasonably placed by the client in the advisor would be subject to betrayal.

The underlying question before the U.S. Securities and Exchange Commission (SEC) is how to bring into effect the Congressional intent that the fiduciary standard of conduct be applied to investment advisory activities. How will the SEC deal with current Congress’s current authorization to the SEC, under the Dodd Frank Act provisions, to extend the fiduciary standard to brokers’ investment advice to retail customers?

Will the “best interests of the client” – a phrase so often used by Goldman Sachs executives, even as they admitted betting against the success of the very investment products they promoted – become once again synonymous with a true fiduciary standard of conduct, in which the client’s ends are adopted as the advisor’s own? Or will “acting in the best interests of the client” become forever intertwined with a far lower standard of conduct, suitability, which permits the sale of “sh***y products” to clients.

It has been just a couple of months since Chair Mary Jo White took over the helm of the SEC. Will Chair White be able to restore to Wall Street, through regulation, high standards of ethical conduct?

[An earlier version of this article was published by RIABiz]

Ron A. Rhoades, JD, CFP® serves as Program Director for the Alfred State College Financial Planning Program. This article represents his views only, and not necessarily the views of any organization to which he may be affiliated.

To follow Ron’s articles, connect with him on LinkedIn or follow his Twitter posts (@140ltd).

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[1] Smith, p. 14, Modern Library edition (1937)

[2] Smith, p. 423.

[3] Smith, p. 748, see also pp. 734-35. As seen, “Smith embraces both the great society and the judicious hand of the paternalistic state.” Shearmur, Jeremy and Klein, Daniel B. B., “Good Conduct in a Great Society: Adam Smith and the Role of Reputation.” D.B Klein, Reputation: Studies In The Voluntary Elicitation Of Good Conduct, pp. 29-45, University of Michigan Press, 1997. Available at http://ssrn.com/abstract=464023.

[4] Tamar Frankel, “Regulation and Investors’ Trust In The Securities Markets,” 68 Brook. L. Rev. 439, 448 (2002).

[5] Lowe v. SEC, 472 U.S. 181, 210, 105 S.Ct. 2557, 86 L.Ed.2d 130 (1985)

On the Future Size of Investment Advisory Firms Under a Fiduciary Standard

This morning I opened my e-mails to find another article about how advisors must "consolidate" their practices with other advisors, in order to survive. While there are some valid economic arguments here - economies of scale, for example - I believe the future of the investment advisory and financial planning professions is quite different, if a fiduciary standard is applied to all providers of personalized investment advice.

IS THERE AN ECONOMIC IMPERATIVE FOR CONSOLIDATION? First, permit me to posit an opposite economic view, centered around the themes of technology outsourcing, portfolio management outsourcing, and compliance outsourcing.

Technology outsourcing is enabling small firms to access software solutions at reasonable cost. From customer relationship management (CRM) software, to outsourced Portfolio Management Systems (PMS) (including services to reconcile the data downloaded), to investment policy statement software, to online data storage and document management software. Several integrated solutions also exist. Research software from Morningstar and other sources is also available online. All of these are available for reasonable fees to small, independent RIA firms.

I do believe that investment security and product due diligence takes time, and expertise. Yet, here again, outsourcing is available. For example, many independent RIA firms utilize the investment strategies and mutual funds / ETFs available from firms such as Dimensional Funds Advisors (www.dfaus.com) and Vanguard (www.vanguard.com). The use of mutual funds enables broad diversification among and within various asset classes, a requirement (in my view) under the Prudent Investor Rule. Substantial educational resources on portfolio strategies and portfolio management are available from these firms. The cost to the advisor? - None, at all. Discount brokers, such as TD Ameritrade, Schwab, Fidelity, and many others, offer not only custodial services but also sophisticated software solutions for online access to client accounts and trading within such accounts. While delegation of the duty of due care (and, within in, due diligence on product selection) cannot completely be undertaken by the independent advisor, the time spent to update due diligence research (typically annually, with quarterly interim reviews) is not substantial. Advisors can also attend educational conferences to learn of new investment strategies and products. For those advisors who do not desire to undertake any due diligence on their own (they may feel that they lack the ability to conduct same), outsourced solutions exist for reasonable fees.

While the use of discount custodians and low-fee mutual fund complexes may rule out investment opportunities which require greater due diligence expertise and greater time to conduct due diligence (including but not limited to the use of options to hedge portfolios, hedge funds, oil and gas partnerships, IPOs, etc.), the academic research supporting the inclusion of these asset classes in a portfolio is mixed, at best. (Just because an investment strategy is complicated, illiquid, or non-transparent does not make it good.)

Compliance can also be outsourced. As the owner of a small RIA firm myself, I discovered the benefits of compliance outsourcing a year ago. For a reasonable fee my compliance consulant (Cindi Hill of Hill Advisors, www.hilladvisors.com) monitors my IARD filings, prepares or reviews my Form ADV Part 2A and 2B, and reviews other forms utilized in my practice. Many other similar compliance solutions exist.

Other online software solutions exist, including financial planning software, document management, online storage solutions, and more. Even financial plan development can be largely outsourced today Payroll and bookkeeping services can likewise be outsourced; many vendors exist. Virtual office assistants can provide telephone answering and other services.

Of course, a brand new advisor, with very limited capital, may find it difficult to commence an RIA firm, even with the outsourcing set forth above. First-year fees and costs for outsourcing may well be $30,000 or greater (with E&O insurance, office space if needed, etc.). Yet, even then, solutions exist for new advisors. For example, Garrett Investment Advisors, LLC (www.garrettinvestmentadvisors) enables new financial planners and investment advisers to start work, under supervision, for a reasonable monthly fee, with full compliance, operational support, CRM and financial planning software, and much more. And Garrett Planning Network members are well-known for their sharing of knowledge with newer advisors. In fact, most financial planners freely provide advice to new planners, often through online discussion forums such as those maintained by the National Association of Personal Financial Advisors (www.napfa.org) and the Financial Planning Association (www.fpanet.org).

To summarize, with the availability of online software solutions and various means of outsourcing, no huge economic advantage exists for firms of very large size, when providing personalized investment advice, in my view. In fact, smaller firms may possess far lower overhead (especially when advisors work out of their home, perhaps renting office space by the hour if and when needed).

This is not to say that there are not some marketing advantages to possessing a larger firm. Yet, even with larger advertising budgets, the advisory business is all about building trust. This can be done by any size advisory firm. In fact, I would submit that building trust is nearly all about person-to-person interactions. And prospecting remains best done through niche marketing and networking.

THE COMPARISON - LAW AND CPA FIRMS.

If and when the fiduciary standard of conduct is provided to the delivery of all financial planning and investment advisory services, we shall become much closer to a true profession. And we need only look to other professions for the likely type of firms which will emerge.

Most lawyers and certified public accountants practice in small firms. Why? First, because economically they can. Second, because like so many Americans, they are entrepreneurial.

This is not to say that large law firms and CPA firms exist. The primary reason for the existence of such large legal and accounting firms is the existence of large clients - corporations. In the delivery of personalized investment advice, large clients exist in the form of multi-family office structures and retirement plan sponsors. Yet, investment advice can be delivered to these clients by smaller firms (with some outsourcing, such as plan participant education). And the delivery of investment advice and financial planning advice is, for most Americans, a one-on-one experience.

While large firms may emerge, I suspect that given the entrepreneurial spirit and independence sought by many financial and investment advisors, smaller firms will continue to dominate the RIA world.

IMPLICATIONS FOR BROKER-DEALER FIRMS AND INVESTMENT PRODUCT MANUFACTURERS

Of course, broker-dealer firms know that the application of the fiduciary standard of conduct is the "extinction event" which is long overdue to the outdated system of  the "sale" of investment products. I have previously written extensively about the increased complexity of the financial markets, evolving investment theories, and other imperatives for a shift away from caveat emptor (let the buyer beware) product sales, and toward trust-based advice (which consumers need and desire). [See http://scholarfp.blogspot.com/2013/01/changes-in-financial-services-industry.html.]

The effects of the transformation will be pronouced.

• No longer will expensive investment products be hyped and sold. The fiduciary standard of conduct requires that fees and costs be taken into account. This does not mean that the lowest-cost product must be sold; there may be valid reasons why a more expensive mutual fund or other pooled investment vehicle is worthwhile. But the expenditure of client funds must be undertaken with due care, by the advisor, on behalf of the client.
• Variable (or differential) compensation structures fall by the wayside. No longer will various back-door means of compensating brokerage firms be permitted, such as the insidious payment for shelf space, soft dollar payments, and sponsorships of marketing and educational seminars by investment product providers for broker-dealer firms and their registered representatives.
• 12b-1 fees will disappear. They are simply indefensible in a fiduciary environment. [See http://scholarfp.blogspot.com/2013/03/12b-1-fees-rias-and-registered.html].
• Initial public offerings will not be "hyped" so much. Much academic research suggests that the returns, on average, of investments in IPOs of common stock underperforms (over the subsequent 2-3 year period, and longer) the returns of the overall market. Due diligence will require greater scrutiny by investment advisers of the prices paid for newly issued securities. This will, in turn, drive down investment banking fees, thereby eroding the large bonuses paid to so many on Wall Street involved in the investment banking industry.

In essence, the business model of current broker-dealer firms must adapt to the fiduciary model. With such adaption, a much lower extraction of rents from customers occurs, which results in the individual consumer getting a far greater (and more equitable) share of the returns.

As the number of fiduciary advisors grows, so does the pressure on product manufacturers (insurance companies, mutual fund complexes) to lower fees. As this army of "purchaser's representatives" expands, so will their scrutiny of investment products.

Additionally, greater competition will exist among fiduciary advisors. This will continue the downward trend of advisory fees. AUM fees may go by the wayside, unless the investment adviser is actively managing a portfolio of individual securities for a client. Professional-level compensation, in the form of project fees, annual retainers, and hourly fees, will grow to dominate the marketplace.

In essence, through the application of a fiduciary standard to all investment and financial advisory activities, regulators will create a much more efficient and competitive marketplace, and a far greater share of the returns of the capital markets will flow to investors.

THE FUTURE ADVISORY FIRM

Hence, if the fiduciary standard is applied, I see the continuing demise of the large wirehouses. Aided by technology and outsourcing, hundreds of thousands of small investment advisory and financial planning practices will exist. Larger regional and national firms will also exist, but - lacking customers which are very large in size - they will not likely grow as large as the largest law firms and CPA firms of today.

Do we desire this evolution to occur? From the standpoint of larger broker-dealer firms, the answer is clearly "no" - as it disrupts their business model and leads to their demise.

From the standpoint of independent RIAs of today, the answer might appear to be "no" - for who in their right mind would want a great deal more competition? Currently fee-only RIA firms have a marketing advantage as true fiduciaries, which would evaporate if a bona fide fiduciary standard is applied to all providers of financial planning and investment advice.

Yet, most advisors I speak with acknowledge that the evolution - the embrace of a bona fide fiduciary standard for all personalized investment advice, and the resulting move toward a true profession - is the right one. It will increase the demand for financial planning and investment advisory services, once consumers know that they can actually place trust in their advisors. It will lead to lower levels of compensation among fiduciary advisors, driven by increased competition, as the shift toward professional-level compensation takes place.

Why should we embrace such a change? Because it is right for our fellow Americans, who struggle to find trusted advice as they deal with the complexities of planning for their future retirement and other future financial needs. It is right for America itself, as greater levels of trust will lead to greater trust in our financial markets, leading to greater capital formation, lower cost of capital, and newfound economic growth. Moreover, if our fellow Americans are better enabled to provide for their own retirement security, the burdens placed on governments to step in and assist will be reduced.

In conclusion, I foresee that the future investment and financial advisory firm landscape will not be dominated by large firms, resulting from consolidation. Rather, if a fiduciary standard is applied, small professional service firms will dominate, as they do in the legal and accounting professions.

Let us move in that direction, by urging the DOL/EBSA and the SEC to adopt a true fiduciary standard for all providers of financial and investment advice to our fellow citizens.

"Professionalism" - Dick Wagner's 1980 Article Relevant to Today's Fiduciary Debates

The Journal of Financial Planning published Dick Wagner's seminar article, "To Think...Like a CFP" in 1980. The article calls for financial planning to become a true profession, and upon reading this article nearly 10 years ago I was spurred on to assist financial planners to achieve that goal.

As part of the article, Dick Wagner wrote: "A true profession and its standards are important enough that its principles generally will prevail—often at the expense of apparent self-interest. Certain types of employment will be refused, certain procedures will be unacceptable under any circumstances. Financial sacrifices will be made in the course of these decisions. However, the ultimate financial impact will be positive because consumers will know what to expect and will have made the informed decision to pay for it!"

There are two important dimensions of the foregoing statement by Dick Wagner.

First, a true profession, which embraces the fiduciary principle, imposes restrictions upon business models. No longer should a financial planner, or an investment advisor, or anyone else providing "personalized investment advice" about securities - whether it be to plan sponsors, plan participants, or retail clients, put himself or herself in a situation in which the client's best interest is not kept paramount. This may require avoidance of certain conflicts of interest. This may compel certain business models, or at least certain business practices, within the securities industry, to fade to the background.

Second, Dick notes that should a profession adhere to the professional standards of conduct, "consumers will know what to expect and will have made the informed decision to pay for it." In a sense, Dick Wagner is suggesting what all true professionals know - if you keep the standards of the profession high (such as the embrace of a strong fiduciary standard), then consumers will trust the profession more, which will lead to greater usage of the profession's services.

Richard B. Wagner, JD, CFP(r)'s article is just as relevant today, as we discuss the application and implementation of the fiduciary standard upon all providers of investment advice (whether such advice is provided to retirement plan sponsors, retirement plan participants, IRA account holders, or other retail customers).

Often I hear the securities industry state: "Don't disturb our business model. Don't limit consumer choice."

Yet, if we want to become a true profession, we must recognize the professional principles at play, and demand of our industry organizations, and through them state securities regulators, the SEC, and DOL/EBSA, that the standards of conduct applied to investment and financial advisory activities be at the level deserving of a true profession - i.e., bona fide fiduciary standards of conduct.

The securities industry must recognize that the fiduciary standard operates as a constraint on greed. Through its application certain insidious business practices - such as payment for shelf space, the receipt of soft dollar compensation far in excess of the value of research supplied to mutual funds, and "double dipping" of fees, are prohibited under such a standard.

We must all recognize that true professionals are experts (and receive substantial training before practicing as such, and pass licensure exams, etc.).  With such a high level of expertise professionals deserve professional-level reasonable compensation.

Of course, the emergence of a true profession is what Wall Street fears most. The imposition of a fiduciary standard of conduct, through its restraint on greed, prevents Wall Street from extracting excessive rents. More of the returns of the capital markets flow through to the individual investor. And Wall Street's core business model, based upon the selling of expensive products, and/or excessively touting IPO's from which large investment banking fees are generated, largely disappears. IPO's receive greater scrutiny, from expert "purchaser's representatives." All investment product manufacturers, and their distributors, face increased pressure to lower management and other types of fees and costs associated with pooled investment vehicles.

For the entire article by Dick Wagner, please visit: http://www.fpanc.org/new/fpanc/To%20Think.pdf?advisorid=331188. It remains just a compelling read, today, as it was 33 years ago.

To receive updates of new blog posts, follow Ron Rhoades on Twitter (@140ltd) or connect with him via LinkedIn.  Thank you.

"The Retirement Gamble" - The Producers Reverse Course and Embrace Wall Street's Claims

A documentary which was more than a little critical of the financial services industry, the PBS Frontline episode The Retirement Gamble, has generated a storm of controversy. Today, in a stunning reversal, the producers of the PBS’ Frontline episode have reversed their views and now agree with their critics (Wall Street firms and insurance companies). These producers now agree that the focus of the documentary on fees was misplaced.  The producers now embrace the view that higher fees and costs nearly always lead to better investments, as Wall Street currently attests.

Said the producers in a recent interview, “Most illuminating to us is the discovery of group annuity fees, often 1% a year or greater. Imagine the huge benefits such additional fees must be generating for investors in 401(k) accounts. We can only speculate at the many advantages investors must be accruing from such costly ongoing fees.”

This is not to say that economies of scale are not possible in 401(k) plans. In fact, several Wall Street executives were heard to say, in response to the PBS Frontline show: “Of course, there are economies of scale. The more Americans put into their 401(k) accounts, the greater our personal economies get. Our fees go up and up, and we rarely are pressured to cut them.”

Fortunately for the producers, in an interview at www.FiduciaryNews.com, a popular web site covering the retirement investment industry, Craig Morningstar, Chief Operating Officer at Dynamic Wealth Advisors in Scottsdale, Arizona was quoted as saying that “the show only covered 1/3 of the typical hidden fees.” The producers felt relieved, as they now have even greater belief that the even-higher-than-suspected fees must result in “SUPER INVESTMENTS.” The producers added, “We are so glad that we omitted discussion of the '28 hidden fees' which Neda Jafarzadeh, a Financial Analyst at NerdWallet Investing, San Francisco, observed were present, in the article posted at www.FiduciaryNews.com.  [For the entire article, visit http://fiduciarynews.com/2013/04/exclusive-interview-frontline-producer-explains-controversial-401k-documentary-the-good/]. All of these fees must ... must ... be good for investors."

Of course, the strong negative correlation found in academic research between higher fees and  long-term investment returns has not gone overlooked. The producers of the PBS Frontline documentary have agreed with Wall Street, “Statistics, of course, never  speak the truth. Active management must trump low-fee, low-turnover passive index investing. It’s just common sense. For if that were not the case, why would we spend all that money advertising actively managed, high-cost investment strategies?”

The lack of academic evidence supporting the superior returns of index funds over actively managed funds, on average, over time, has not deterred the producers. The producers now cite Christine Marcks, President of Prudential Retirement, who was asked in the documentary about the overwhelming evidence that exists on indexing beating expensive active investing. Her response, with a straight face, was, "Yeah, I haven't seen any research that substantiates that. I mean, it – I don't know whether it's true or not. I honestly have not seen any research that substantiates that." The fact that one of the largest providers of retirement plans in the country has not done due diligence on this issue, by examining the academic evidence, does not deter these tireless producers, who were heard to state: “When a Wall Street executive speaks, the public must believe her. We all know that we should place blind trust in Wall Street and the insurance companies, especially after the financial crisis of 2008-9 and the great actions taken by Wall Street firms thereafter to restore faith in the securities industry, by returning to high levels of profitability so soon while individual investors and small businesses continued to suffer.”

The producers of the PBS documentary are now working tirelessly on a sequel, “The Retirement Gamble II: Why We Should Ensure the Bonuses Paid to Wall Street’s Executives and Analysts, To Ensure Their Retirement Succeeds.” Stated one of the producers, “It is so important that at least a few Americans have a successful retirement. In that way the rest of us can applaud the success of the few, who took so much from us. We have to have someone to cheer about, when we are in our used trailer in Florida watching old PBS documentaries on over-the-air television, while sweltering in the oppressive heat because we cannot afford to run the air conditioning. Financial security is, of course, so over-rated; the anti-depressive effects of cheering on in retirement those early-retired Wall Street and insurance company employees who profited so much by their greed should not be underestimated.”

The producers are also relieved that 85% of “financial advisors” were found, in the original documentary, to not be fiduciaries. (As stated in the original PBS Frontline documentary, only 15 percent of advisers are “fiduciaries” — advisers who by law must operate with the best interests of the plan sponsor or plan participant in mind.) The producers stated: “We are so glad that there are so many choices available. We would never want to limit the many business models, nor reduce the number of non-trusted advisors from which we can choose. Wall Street and the insurance companies should be able to extract excessive fees and costs from us in many different ways ... Why? Because it's what they do best!”

The producers added: "Is it too much to ask that financial advisors act in the best interests of their clients? Yes, of course it is, for that would destroy the high extraction of rents which occurs by Wall Street from the overall U.S. economy. Isn't it great that over 35% of the profits generated by the U.S. economy now occur in the financial services sector ... and that doesn't even count the huge bonuses awarded to Wall Street's executives! We certainly don't want to disrupt the high profits of our Wall Street firms and executives, just for the sake of the expectation of a consumer that his or her advisor is acting in the consumer's best interest. Let's not sacrifice Wall Street profits for some nebulous 'principle'!"

Asked about the fiduciary standard, the producers now question their earlier promotion of a higher standard for all retirement plan advisors, stating: “Who cares about a standard that consumers can’t even spell?” When asked about the huge potential benefits, in terms of lower fees and costs, which would result for 401(k) and IRA investors if ERISA's strict fiduciary standard were to be applied, the producers replied, "We should never interfere with a centuries-old business model. The dinosaurs that are Wall Street's proud institutions need not face an extinction event, simply because consumers desire trusted advice."

Upon hearing of the PBS Frontline documentary producers’ “change of heart” and their embrace of all of the hype promulgated by Wall Street, some industry observers were more than a little perplexed. Then again, an explanation soon became apparent. It was overheard that the producers' next documentary would be funded by a generous donation from FINRA, SIFMA, FSI, and many broker-dealer firms and insurance companies, with huge salaries to be paid to the producers along the way. When questioned regarding their objectivity in response to these new sources of funding, the producers brushed aside such concerns. “Of course we need higher salaries. This permits us to save more for retirement, as we have and will continue to promote. Only in such way can we ensure the high extraction of rents from our retirement accounts by Wall Street. Even though Wall Street is paying us a lot to do this next documentary, we are certain they will get their money back, and then some, over time. It will all balance out."

This interviewer then questioned the producers. "What about the trust of individual Americans in our financial services system? Without trust, investors have and will flee the capital markets, depriving American business of much-needed capital, and driving up the cost of capital. This will impose a brake on U.S. economic growth, leading to lower standards of living for all Americans than what could have been obtained." The producers responded, "We are so glad that we never paid attention in our college Macroeconomics class."

Stay tuned for more in "The Retirement Gamble" documentary wars. Wall Street and the insurance lobby are gearing up for "the next big show," confident that their message of "high costs, high fees, speculative products, and ensuring the financial security of Wall Street firms and their executives by preserving archaic, conflict-ridden business models" will resonate conclusively in the halls of Congress.

FINRA's Failure: It Is NOT a "Professional Regulatory Organization"

I was recently asked to provide the distinctions between a professional regulatory organization and a self-regulatory organization.  The distinction is a fine one, but an important one.

A PRO serves the public interest. An SRO, as we have seen through the prominent example of FINRA, only gives lip service to serving the public interest, while in reality it keeps the standards of conduct observed by its members ("suitability") so low as to permit the firms to extract excessive rents at the expense of the consumer.

FINRA'S REPEATED FAILURES TO ADOPT HIGH STANDARDS OF CONDUCT

FINRA (formerly known as NASD) fails the important test of serving the public interest. As Tamar Frankel, America’s leading scholar on fiduciary law as applied to the securities industry, wrote in 1965:  “NASD … [does] not, as do the professions, consider the public interest as one of [its] goals … Let us consider the attitude of the professions toward the public interest. The goal of public service is embedded in the definition of a profession. (Pound, The Lawyer from antiquity to modern times 5 1963). A profession performs a unique service; it requires a long period of academic training. Service to the community rather than economic gain is the dominant motive. We may measure the broker-dealer’s activities against these criteria … Although at least part of his trade is to give service, profit is his goal. The public interest is stated in negative terms: he should refrain from wrongdoing because it does not pay. This attitude is the crux of the matter, the heart of the difference between a profession and the broker-dealer’s activity … The industry emphasizes its merchandising aspect, and argues that the broker-dealer is subject to the duties of a merchandiser even when he is also acting is his advisory capacity … the NASD [has] proved incapable of establishing accepted standards of behavior for the activities of the trade … Past experience has proved that it is unrealistic to expect the NASD to regulate in the public interest ….” (Tamar Frankel, f/k/a Tamar Hed-Hoffman, “The Maloney Act Experiment,” 6 Boston College L.R. 186, 217 1965).

Nearly half a century has passed since Professor Frankel's article appeared, and FINRA's failure continues. In fact, FINRA's failure goes all the way back to 1942, when FINRA first adopted Rules of Conduct for its members which omitted any reference to the broker's fiduciary duty when in a relationship of trust and confidence with a client (despite, as my earlier blog post observed, the application of state common law fiduciary duties which existed at such time). 

Going back further, to 1945, FINRA (f/k/a NASD) stated: “The entire program of [our SRO] is based upon the principle of self-regulation and self-discipline.  We believe the standards of business ethics in the business are as high as in any other business or profession.  It is the purpose of NASD to keep them high and to seek improvement.” - N.A.S.D. News, published by the National Association of Securities Dealers, Volume VI, Number 1 (May 1945). Of course, anyone who believes that the failed standard called "suitability" is "as high as any other ... profession" is simply off their rocker. And, unfortunately, the basic requirements of the suitability standard have not changed since the Maloney Act of 1938 authorized the creation of the SRO now know as FINRA.

Going back even further, FINRA (f/k/a NASD) commented upon the necessity of raising the standards of conduct, when the Chairman of the NASD early on opined: “[T]he time may come when we can arrive at a more professional status and we can give more of our attention as to who should be in the investment business ... The principal by-product [of formation of the SRO], which I don’t believe the founding fathers of this Association ever thought of, is that for the first time in history the securities dealer begins to see what he looks like and it hasn’t been altogether a pleasing sight.”  - statement of NASD Chairman Robert W. Baird in an address before the convention of the National Association of Securities Commissioners, as quoted in N.A.S.D. News, published by the National Association of Securities Dealers, Volume II, Number 1 (Nov. 15, 1941).  [Emphasis added.]  Of course, FINRA has failed miserably to attain "professional status" for the "securities profession," primarily because it has never raised its standards of conduct for its members and has never put the interests of the consumer first.

Why is a true Professional Regulatory Organization for financial planners and investment advisers important as a long-term goal? 

By maintaining and enhancing the professional standards of its members over time, the services of its members become more attractive to the public, fueling demand for the services of its members. The standards that are adopted must serve the public interest. They must be high enough to protect the consumer from the utilization of the professional's superior knowledge in a way adverse to the interests of the client. This is especially so in today's modern age, where the complexity of financial instruments, the ever-developing knowledge of investment strategies (both as to those shown to work and those shown to not work), and the emergence of new understandings with respect to risks faced by individual investors, demands that nearly all individual investors would be served by having a trusted, expert guide to navigate through the many shoals existing in the financial markets.

The key ingredient of a true profession is that the needs of the client always come first – i.e., a bona fide fiduciary standard is maintained. Without a bona fide principles-based fiduciary standard of conduct a true profession - bound to serve the public interest - cannot be created.

It should also be emphasized that members of a professional regulatory oganization must be individuals, not firms. Why? Because individuals, not bound to represent the commercial intersts of their firms when elected to membership of the professional organization, are far more likely to keep professional standards at high levels.

FINRA THE FAILED SRO vs. WHERE WE WANT TO BE

Permit me to contrast FINRA with my vision for a PRO for financial planners (including all those providing personalized investment advice):

	FINRA	PROFESSIONAL REGULATORY ORGANIZATION (PRO)
Members	Broker-dealer firms (i.e., business entities, which possess commercial interests)	Individuals (not firms) who are qualified to become members of the profession (see educational qualifications below; also, character requirements exist)
Mission	To protect its firms (and, by its charge, the public)	Primary mission is to protect the public. Also, to maintain a proper discipline of the members of the PRO accordance with the principles of the profession as a public calling. Also, to initiate and supervise, with the approval of the SEC and/or state securities regulators and/or other oversight body, appropriate means to insure a continuing high standard of professional competence on the part of the members of the PRO.
Initial Education	Series 6 or 7 licensure (for registered representatives)	4-year college degree from accredited institution is required, plus an advanced course of study in financial planning and investments; passage of comphrensive entrance exam is required for licensure to provide "personalized investment advice" to "consumers"
Continuing education	As necessary for licensure	30-80 hours of continuing education (CE) are required every two years, as determined by overseeing body
Standard of conduct applicable	Suitability + other specific rules; regulations are enumerated in FINRA’s “Rules of Conduct”	Principles-based bona fide fiduciary duties of due care, loyalty, and utmost good faith are applied at all times; principles are enumerated (while still quite broad) through “Professional Standards of Conduct” similar to the Model Rules of Professional Conduct for attorneys. While "scope of the engagement" can be defined, core fiduciary duties are incapable of "waiver" by the client.
Peer review upon receipt of a complaint	None	Initial investigation by PRO representative; Can initiate legal action to protect investors; can initiate disciplinary proceedings in certain cases where judgment of the member in adherence to his or her duties is not the issue; Otherwise, peer review of a complaint is required, and complaint is regarded as confidential until probable cause is found. Then hearing proceeds before a hearing officer; if an appeal is undertaken therefrom, the appeal is heard by a different peer review panel, and all decisions of such panel are published for purposes of educating members as to future actions.
Inspections and examinations	Periodic and upon receipt of a complaint	Generally, upon receipt of a complaint. However, periodic inspections occur of all firms relative to custody (i.e., ensuring safety of client investments) would occur, using a focused process designed to detect instances of actual fraud.
Governing body	FINRA, consisting of “public” members and industry members. However, most "public" members possess strong ties to member firms.	Board of Governors.  Initially, appointed individuals by state securities regulators (subject to SEC approval), consisting of professionals committed to the fiduciary standard. Transitioning to election over time (with elected members subject to state securities regulator and/or SEC approval)
Legal authority to control entrance into, and expulsion from, the organization	Act of Congress (Maloney Act) and SEC rules	Act of Congress + (for states to participate) legislative actions over time by state legislatures + federal/state enabling rules. Or, alternatively, authorizing legislation in specific states (usually accomplished through a "Model Act" which is first drafted, then adopted over time by the many states).
Funding sources	Fees imposed on securities transactions and on FINRA’s members, and additional revenue secured via fines	Professional annual membership fees only; all fines paid to U.S. Treasury and/or the states, to avoid the inevitable conflict of interest arising from using fines imposed upon members of the expenses of the professional organization. (Also, fines should not indirectly benefit the very persons who are fined, by providing revenue to the professional organization which, in turn, permits it to reduce its membership fees.)
Pro bono	Not required	Required: either hours of service to individuals and/or the community every year, or monetary donation to an organization that serves such purpose, in order to ensure access to the services of its members by all members of the  public

Can You Legislate Morality?

A reader to my blog post on the fiduciary duty of brokers, already existing under state common law, writes: "You can't legislate morals."  Here's my reply:

I often here the phrase (often made by those opposed to the application of the fiduciary standard) "You cannot legislate morality." In one sense this statement is true, in another sense this statement is not true.

The law - whether developed over the centuries through the "common law" (judicial decisions) or via legislative dictates (statutes) - reflects the morals of our society. The great jurist Oliver Wendell Holmes once wrote: " The law is the witness and external deposit of our moral life. Its history is the history of the moral development of the race. The practice of it, in spite of popular jests, tends to make good citizens and good men." The Path of the Law, by Oliver Wendell Holmes, Jr., 10 Harvard Law Review 457 (1897).

At times we deem it important enought to specify, through laws, that a breach of something "wrong" is grave enough to warrant either a prviate remedy (i.e., damages for breach of contract, or damages for a tort - such as breach of duty of due care) or a public remedy (fine, loss of licensure, imprisonment, etc.). In essence, the law sets forth minimum moral standards that everyone is expected to follow.

There are many instances where breach of fiduciary duties can result in fines (i.e., public discipline). Attorney disciplinary proceedings are just one example. In the professional setting, more often breaches of the duty of care result in a private cause of action, and professional disciplinary proceedings occur only after "probable cause" has been found through a review of the advisor's actions by his or her peers.

Hence, can we legislate "morality"? Yes, in the sense that we can define, in the law, principles-based standards which we expect of professional advisors, and all professional advisors are expected to adhere to these baseline standards.

No, we cannot legislate "morality," in the sense that we cannot assure that everyone adheres to such standards. Yet, of course, no enacted law provides such a guarantee.

Moreover, one aspect of integrity is doing what is "right" even if it meets minimum legal standards. This aspect of morality - subscribing to even higher standards than the law should require (as a minimum standard) - cannot and should not be legislated. But it should be encouraged as a "best practice" by professional societies.

I don't think it is too much to ask that all financial advisors and investment advisers adhere to a legal standard to "act in the best interests of their clients." This is clearly what consumers desire, and expect. It would resolve the great deal of confusion that consumers possess at present. It would help restore trust in our financial services system.

And I would observe, if we are to become a true profession, the baseline standard for the delivery of investment and financial advice must be grounded in a bona fide fiduciary standard of conduct.