Commercial sales rules threaten to redefine fiduciary advice

It looks like the SEC will not require financial advisers to avoid or mitigate material conflicts, merely disclose them

Jan 6, 2018 @ 6:00 am

By Knut Rostad

Securities & Exchange Commission Chairman Jay Clayton says that a uniform standard of conduct for broker-dealers and investment advisers providing advice to retail clients is on the commission's front burner. Some sources say a proposed rule could come as early as next month.

In July, the chairman set out his views on the principles he believes should guide the commission. One section of his remarks is devoted to "Investment Advice and Disclosures to Investors" and another to "Resources to Educate Investors." Here, the chairman speaks eloquently on disclosure in "Standards of conduct that investment professionals must follow in providing advice to Main Street investors."

The chairman's remarks raise an intriguing question on regulating investment advisers, conflicts and fiduciary duty: Are commercial sales rules increasingly redefining the very meaning of fiduciary advice?

In the "Fiduciary Rule" segment, there is no mention of advice in "relationships of trust and confidence" or how fiduciary relationships differ sharply from commercial transactions — where equal knowledge and ability and routine bargaining exist. Instead, we get a warning against investor protections that result in investors "being deprived of affordable investment advice or products."

Emphasis on disclosure

Elsewhere, the chairman bundles interaction with the markets and stresses disclosure: "Regardless of whether investors participate in our markets directly or indirectly, and with or without investment advice, it is clear that they and their advisers must have access to information about potential investments that is easily accessible and meaningful. ... A priority for me is getting the wealth of information that the SEC has into the hands of investors."

Further, the chairman said protecting investors means disclosure and the commission can help investors: "Conduct online background searches on investment professionals and make informed decisions about whether to establish financial relationships." In closing, he said, "I have a short but important message for Main Street investors: the best way to protect yourself is to check out who you are dealing with, and the SEC wants to make that easier."

(More: What to expect on the regulatory front in 2018)

The chairman's emphasis on disclosing information to protect investors — and his lack of discussion of serving clients' best interests — is important. However, it's not new at the SEC. Emphasizing disclosure in relationships of trust and confidence has long been evident in statements by SEC staff and in enforcement decisions.

This emphasis matters. It equates disclosure with a client's best interest. It blurs the sharp difference between avoiding conflicts, and accepting and merely disclosing conflicts. Conflicts are implicitly approved; their impact on advice seems irrelevant. Prospective rulemaking on a uniform standard of conduct raises questions of what exactly are the obligations of a financial adviser:

The obligation to avoid conflicts. What is a financial adviser's obligation — to avoid or eliminate material conflicts of interest? The commission has traditionally said that investment advisers must either avoid or disclose material conflicts. It has also urged investment advisers to avoid such conflicts because conflicts are inherently harmful. In this respect, the former director of the Office of Compliance Inspections and Examinations (OCIE), Carlo V. di Florio, compared conflicts to, "viruses that threaten the organization's well-being."

While no staff member or commissioner speaks for the commission, the question remains: Does the SEC agree it's a breach of fiduciary duty not to avoid conflicts of interest to the extent reasonably possible? Will the SEC ever bring an enforcement action against a financial adviser who fails to reasonably avoid a conflict? If not, why not? Under the law of trusts and in the common law, fiduciaries are required to avoid material conflicts. Why would the SEC not require this?

The obligation to disclose conflicts. In moving to a disclosure-based regime, the SEC is overlaying the values and practices of the commercial marketplace on fiduciary relationships of trust and confidence. To take but one example of the questions that the SEC must address: What specific facts will the SEC require that broker-dealers disclose? The fact that broker-dealers are hired by issuers to offer and sell securities? That they get paid only if they are successful in their sales efforts? That their "advice" must be "solely incidental" to their distribution services performed on behalf of the issuer? That the forgoing means their allegiance is primarily to their issuers?

The obligation to mitigate conflicts. If material conflicts are not avoided, what is the financial adviser's obligation to mitigate them? Disclosure alone is not enough to protect clients in a fiduciary relationship. Clear and complete disclosure must be accompanied by steps to mitigate the harms caused by conflicts. For, it's the advice — and not the disclosure — that determines if the financial adviser actually acts in the best interest of the client.

After all, clients retain, pay and trust a financial adviser to provide competent advice that is in their best interest — not to receive disclosure. When financial advisers provide conflicted advice, they should be obligated to take measures to demonstrate that their advice is not impaired by the conflicts. Any legal standard that does not explicitly require this impairs the interests of investors and cannot be called "fiduciary" in nature.

The rules of the commercial market place. What's ahead for 2018? There seems to be little basis to believe that the SEC will require financial advisers to act in the best interests of clients by requiring their advice (apart from any accompanying disclosure) to be unaffected by the adviser's conflicts. It also seems safe to assume the SEC will not require financial advisers to avoid or mitigate material conflicts and, instead, enable financial advisers to merely disclose their conflicts of interest away. The rules of the commercial marketplace will increasingly seep into the regulation of financial advisers. The era of faux fiduciaries will be inaugurated. Caveat emptor.

Knut Rostad is president of the Institute for the Fiduciary Standard.


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