Other Voices

Preserve the bona fide fiduciary standard of conduct

Dec 6, 2009 @ 12:01 am

The following article was submitted by the National Association of Personal Financial Advisors' Industry Issues Committee.

LPL Financial chief executive Mark Casady's Op-Ed [“With investment advice, one size does not fit all,” InvestmentNews, Nov. 15] correctly notes that the financial services industry may experience “unprecedented regulatory reform.”

However, that is pretty much the only thing we agree with in his statements. He presents a long series of arguments that have already been successfully rebutted by state securities regulators, consumer organizations, law professors and many others who seek to preserve the bona fide fiduciary standard of conduct that currently exists under the Investment Advisers Act of 1940.

The proposed “universal standard of conduct” falls far short of the bona fide fiduciary standard of conduct. Its proponents are trying to convince us that a lesser standard is somehow better.

“Defining” the fiduciary standard of conduct through legislation would be ill-advised. Fiduciary duties, which prohibit constructive fraud, must be free to adapt in order that new fraudulent schemes are able to be identified, prohibited and punished. We can't afford to limit the ability of securities regulators and the courts to police the ever-changing field of investment and financial planning advice.

The recommendation that the Securities and Exchange Commission enhance disclosures ignores the fact that disclosures are largely ineffective. While improved disclosures and financial literacy efforts are important, the knowledge gap between financial advisers and individual investors is simply too great to overcome.

As in medicine or law, it takes many years to acquire the required degree of knowledge and skill to become a competent financial adviser.

Clients vulnerable

It is this very expertise that renders clients of investment advisers vulnerable to abuse of trust and lack of care. Reliance on disclosure alone is misplaced. Academic research has confirmed that consumers generally don't read disclosures — and don't understand them when they do read them.

Mr. Casady also stated that “many investors have virtually no idea how their broker-dealers and investment advisers are paid.” Yet every client of an investment adviser receives a Form ADV Part II disclosure, possesses a written contract stating the precise amount or percentage of the advisory fee and receives statements clearly denoting all fees paid to the investment adviser.

Investment advisers are also bound to disclose all material facts to their clients — including all the fees and costs of investment products they recommend. In reality, it is the customers of broker-dealers who do not realize how much they are paying — both directly (commissions, often hidden in “deferred sales charges”) and indirectly (through 12(b)-1 fees, bid-ask spreads, principal markups and markdowns, receipt of payment for shelf space and soft-dollar compensation from fund companies, and other indirect compensation methods).

While Mr. Casady cited the 2008 Rand report in stating that “investors are generally satisfied with the services they receive from their financial services providers,” the report went on to say that real reason behind investors' level of satisfaction is that 30% of investors believe that they do not pay their financial consultant any fees.

He further suggested that investors should possess “flexibility” so that they may “make informed decisions.”

We concur.

If an investor desires to purchase an investment product from someone who clearly indicates that his or her role is that of a product sales representative — and who does not provide investment or financial advice — such a choice should be preserved. But once investment or financial advice is provided — or a title denoting an advisory role is utilized — then that person is, and should be, bound by the fiduciary standard at all times. Fiduciary duties are “sticky” — they are like wet paint on one's suit pants. The broad fiduciary duties of investment advisers cannot be waived by the consumer, and the fiduciary duties of an adviser must apply to the entirety of the relationship with the client.

Mr. Casady posited that investors be permitted to “set the terms of services with their financial services provider.” This would permit firms to require that their customers sign away the fiduciary standard of conduct by simply “checking the box” in some lengthy, incomprehensible, small-print agreement hidden in a mountain of account-opening paperwork. Fiduciary duties are imposed by law, not by contract, specifically because consumers are unable to negotiate for the standard of conduct the adviser should provide. Clever framing of the issue as one of “consumer choice” is a red herring; the same investment product choices will exist for all Americans. The real issue is the standard of conduct that applies when investment and financial advice is provided.

It has been suggested that the SEC “sort through” these issues. Many consumer advocates believe that today's debate is largely the result of the SEC's failure to adopt a reasonable interpretation of the “solely incidental” requirement of the broker-dealer exclusion from the definition of “investment adviser.” The current fiduciary standard of conduct under the Advisers Act should not be subject to diminishment through SEC rulemaking. The important protections afforded consumers by the act should not be erased through the lobbying efforts of the very firms that in large part caused the “Great Recession” — leading to the current impetus for reform.

Mr. Casady further noted that investment advisory services typically cost more than brokerage services. In reality, the reverse is true. Many clients of investment advisers pay significantly less in total fees and costs (including the many “hidden costs” of pooled investment vehicles) relating to both their investments and the receipt of financial advice. Investment advisers act as true representatives of the purchaser, and they possess a duty to ensure that a client's total fees and costs remain reasonable.

He also suggested that principal trades can be undertaken by a broker-dealer and still be in the “best interests” of the client “as long as there is full disclosure.” Yet this misstates fiduciary law, for much more is required than mere disclosure.

The observance of one's fiduciary duties requires that the disclosure be affirmatively made, that the adviser ensure client understanding and that the client provide intelligent, independent and informed consent. Even then, the terms of the transaction must remain substantively fair to the client. The courts consistently recognize that no client undertakes gratuitous transfers to an adviser, hence no client would consent to an act harmful to that client's best interests. In short, fiduciary law requires proper management of conflicts of interest, not just disclosure. In fact, principal-trading activities are so fraught with danger — difficulties in pricing, problems arising from the dumping of securities on unsuspecting investors, etc. — that engaging in such transactions should not be made easy.

One umbrella

The correct answer is to subject all those who provide investment advice to the Advisers Act's bona fide fiduciary standard of conduct.

The “single, robust standard of conduct” that Mr. Casady seeks already exists. To suggest that there is more than one fiduciary standard for investment advisers is inherently misleading; there is no material difference in the fiduciary standard of conduct once it is applied by the Advisers Act.

Simply applying the existing fiduciary standard would cure the very complaints of those in the broker-dealer industry who mistakenly believe that 51 different standards exist.

The efforts to “harmonize” broker-dealer and investment adviser regulation are in reality attempts to transform the adviser-client relationship into an arm's-length salesperson-customer relationship. The proposed “new federal fiduciary standard” and “universal standard” are not true fiduciary standards. Investors should not be placed in a lower caste or subclass and denied the protections of a true fiduciary standard of conduct afforded to all other beneficiaries of fiduciary duties.

The broker-dealer community should act now to embrace the fiduciary standard of conduct — as it currently exists — for all who provide investment and financial advice. When brokers provide financial and investment advice, they should conform to the law — not the other way around. It would be tragic, indeed, if the very firms that caused the financial crisis succeeded in persuading Congress to lower the fiduciary standard of conduct.

The broker-dealer exclusion from the Advisers Act should be repealed without diminishing the fiduciary standard of conduct. This would go a long way toward restoring the trust of Americans in our capital markets.

The NAPFA Industry Issues Committee consists of five certified financial planners: Susan John (chairwoman), Peggy Cabaniss, Diahann W. Lassus, Thomas Orecchio and Ron A. Rhoades.


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