The role of disclosures is a central point of discussion in applying a fiduciary standard to registered representatives who work in a brokerage setting. How the issue of disclosure is resolved will determine how well — or badly — the fiduciary standard is applied.
Disclosures hold an important and special position in our market economy and democratic republic. Disclosures are central to how voters are informed about elected officials and consumers about the products they buy.
Similarly, disclosures have become a fundamental building block of securities regulation. As SEC commissioner Troy Paredes noted in a 2003 article, “Blinded by the Light,” in the Washington University Law Quarterly, “a demanding system of mandatory disclosure, which has become more demanding in the aftermath of the Sarbanes-Oxley Act of 2002, makes up the core of the federal securities laws.”
In this spirit, the Securities Industry and Financial Markets Association thinks that disclosure is the way that brokers, as fiduciaries, should address conflicts.
When “services involve material conflicts of interest,” disclosures and client consent are the solution, SIFMA said. Further, a standard that doesn't permit “disclosure [of] and customer consent to material conflicts will significantly harm retail investors,” it said.
Yet while disclosure helps with voting and buying choices, the process of selecting investments for a retirement portfolio is much different from voting or buying a car.
How different? Despite the long-standing emphasis on disclosure in financial markets, evidence abounds that many retail investors are inexperienced and poorly informed — as well as subject to behavioral biases that negate the effectiveness of disclosure.
Investors' limitations are central to a point made by SEC commissioner Elisse Walter in her discussion of a harmonized fiduciary standard. In a May 2009 speech to the Mutual Fund Directors Forum, she explained her rationale, in part, for supporting a harmonized fiduciary standard by making this observation:
“When your Aunt Millie [goes to] her local financial professional to ask for advice, she does not need to know whether the person on the other side of the table is a registered representative of a broker-dealer or an investment adviser. She should not be placed at risk by the fact that application of those labels may lead to differing levels — or at least different kinds — of protection. Instead, she should know, or be able to assume — consciously or subconsciously — that regardless of the title held by the person sitting across the desk from her, she will receive an appropriate and comparable level of protection.
In other words, investors shouldn't be expected to understand the legal differences between a broker and an investment adviser. This is a significant acknowledgement of investors' limitations.
The 2008 Rand Corp. report commissioned by the Securities and Exchange Commission is cited for revealing that investors are unaware of the different legal requirements of brokers and registered investment advisers, and that many investors presume that their interests are put first. Some investors even think that they don't pay for financial advice.
Although this finding of investor “confusion” is serious, to think of investors only as confused may understate the nature and scale of the problem. Case in point: In the Rand study, 25% of respondents who reported using a financial services provider said that they paid $0 for their advisory or brokerage services.
The recent Envestnet Fiduciary Standards Study (thefiduciaryopportunity.com) corroborates the Rand findings by looking at this same issue from a different perspective. The Envestnet study characterizes investors as being “foggy” about brokers' and advisers' roles and obligations.
Of particular note regarding investors' knowledge of investment expenses and broker or adviser compensation, 15% of investors said that they can “very well” assess how their adviser gets paid. This compares with 39% who said that they can “well” assess adviser compensation and 53% who rated their skill “not too well,” “not well at all” or “don't know.”
The key question is: What does it mean when just 15% of investors understand “very well” their adviser's compensation? Would just 15% of this same sample of investors know “very well” that of their accountant or doctor?
A Rand finding stated that one in four investors think that their advisory or brokerage services are given to them free of charge. Envestnet's study suggests that 85% of investors aren't really certain how or what their advisers are paid.
To merely conclude that investors are “confused” about the differences between brokers and investment advisers may be to mischaracterize and understate how well many investors are engaged with their broker or adviser and the services they provide.
SEC Chairman Mary Schapiro noted in June 2009 that as the laws governing the regulatory framework were written in 1934 and 1940, “it is time the regulatory regime for financial service providers reflects 21st century realities.”
One 21st century reality is the significant evidence that many retail investors possess only a limited understanding of investing, the role of their broker or adviser and the importance of investment expenses to investment performance. This evidence is material, as it frames the scale of the disparity of knowledge between the broker or adviser and the client — which is a central factor in determining the nature of the fiduciary relationship and, consequently, an appropriate role of disclosures.
Against this backdrop of investor limitations, disclosure shouldn't be presumed to have the same role in a healthy fiduciary relationship as it does in other economic realms.
In a healthy fiduciary relationship that involves personalized investment advice, disclosures shouldn't be viewed as a presumptively effective investor protection tool. They are an aid to the fiduciary relationship, not a substitute for fiduciary responsibility.
Fiduciary status isn't for the faint of heart. Consistent with the record on which the Investment Advisers Act of 1940 was written, it is far more demanding than the commercial standard.
This difference is nowhere more evident than in the responsibility of the fiduciary, as opposed to the responsibility of the salesman, for his or her advice and conduct. In the latter case, the responsibility is shared between the salesman and the consumer.
In cases with such significant disparities of knowledge, the responsibility isn't shared with the investor; it is held by the fiduciary alone.
That an investment fiduciary alone should be held accountable for his or her conduct and advice shouldn't be controversial. After all, no one suggests that either a surgeon or an attorney be relieved of their fiduciary responsibility to put our interests first, merely by virtue of a “disclosure.”
Knut A. Rostad is the regulatory and compliance officer at Rembert Pendleton Jackson, a registered investment adviser, and chairman of the Committee for the Fiduciary Standard. The views expressed here are his own and don't necessarily reflect the views of the committee.