SEC and the Fiduciary Study: The Process, Part I

By Kate McBride

January 22, 2011 at 07:20 AM

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The SEC on Saturday delivered to Congress its six-month report, "Study Regarding Obligations of Brokers, Dealers, and Investment Advisers," mandated in the Dodd-Frank Act. The report is the next step in the long debate over whether the fiduciary standard should apply to all who provide investment and financial advice to individual investors. The SEC was charged with conducting this study under Dodd-Frank, reporting to Congress on its findings and recommending whether to extend the fiduciary standard to all who provide advice.

In this, the first of a three-part report, we timeline how extending the fiduciary standard to all advice givers has developed.

Extending the standard beyond RIAs could signal a seismic shift in how advice is provided to investors, changing the way brokers and investment advisors conduct their businesses, and what protections the SEC is willing to institute for investors. Not since the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 has there been more potential for re-drawing the rules that govern conduct of brokers and investment advisors toward customers and clients.

Although investment advisors have had a fiduciary duty to clients since the '40 Act, the '34 Act, governing purchases and sales of securities through brokers, mandated a suitability or commercial, fair-dealing standard. Both Acts became law in a very different era: no advice was provided by brokers; banks were separate from brokers and insurers were a wholly different kind of entity. Most investors in stocks or bonds were wealthy.

Now, responsibility for one's own retirement cuts across nearly all income strata in the U.S. and rests with many workers who were thrust into investing not because they have spare dollars to play with, but because they must make investment choices to fund their own retirement, college and other savings. Gone are the 5% or higher guaranteed bank savings accounts. The financial product array is so complex and extensive; and advice is so critically important to investors, that it is a totally different situation today than when those Acts became law.

To top it off, since the elimination of Glass-Steagall, banks, insurers and brokers have merged, and the functions of brokers and investment advisors often look identical—as do titles—leaving investors, understandably, confused about the type of relationship they have with their financial professional (Broker? Investment advisor? Trustee? Fiduciary? Salesperson? How is an investor to know, when nearly everyone's business card carries a financial advisor or similar vague—if important sounding—title?), how that individual is paid, and what other conflicts may exist. This all set the stage for the changes being contemplated at the SEC right now.

A Winding Road

The road to this point has been a long one. As a member of The Committee for the Fiduciary Standard, it has been a privilege to participate in meetings in Washington with regulators and legislators and their staffs. The Committee was organized in 2009 to advocate, on behalf of investors, for extension of the fiduciary standard to all who provide investment or financial advice to investors.

While preserving the confidentiality of private meetings, and without speaking for the Committee, I can report on the process I've observed by which the SEC has arrived at its conclusions, and some of the topics that were discussed in scores of meetings with regulators, lawmakers and other interested groups.

The Committee has met with SEC Chairman Mary Schapiro and each of the SEC Commissioners. We held meetings with Chairman Rick Ketchum and the executive team at FINRA, and senior staff at the Treasury andLabor (DOL) departments. We met with House finance and Senate banking committee members' staffs, and leaders from SIFMA and the Financial Services Institute (FSI), and other groups.

The Committee's founding members, most of whom are still actively involved, came together because we thought that in the aftermath of the financial crisis, there might be a way to advocate for reforms that we thought would be beneficial to investors. We were aware that, according to the SEC's Rand Report and the Tully Report, most investors believe that the advice they get is in their best interests and that many think they pay nothing for the advice they receive.

We understood as well that in financial services and investing now there is a vast difference between the special expertise required of a financial professional and that of an individual investor—much like the difference in knowledge between a surgeon and a patient. The very nature of that uneven level of knowledge is the foundation of the fiduciary relationship—as Boston University Law Professor and expert on securities and fiduciary law, Tamar Frankel, puts it, "when you entrust your money or property to another" because of their special knowledge, that is a fiduciary relationship.

SEC Leaders' Evolution on Extending the Fiduciary Standard

Schapiro (left) has been discussing the SEC's original mandate of investor protection, and the need to put investors first, for some time. For those who think that because Schapiro was CEO of FINRA before becoming chair of the SEC that she would not be interested in extending a fiduciary standard to brokers, remember that Schapiro was an SEC Commissioner from 1988 to 1994, and acting SEC Chairman in 1993—all before going to FINRA.

In the cover story for Investment Advisor magazine in May 2007, when Schapiro was CEO of FINRA, she spoke about looking at the industry "from the perspective of the investor." Schapiro added, "The challenge is going to be developing products that are very sound—I'm not talking about taking out the risk out of investing—we'll never do that nor should we even attempt to do that, but tapping into these changing demographics with products that are really in the investors' best interests and ensuring that they are sold appropriately to people."

In a March 11, 2009, interview for Wealth Manager, when asked if the financial crisis could be the catalyst for a fiduciary standard of care for all advisors, as the new SEC Chair, Schapiro said, "I think it's entirely possible. I've said for a long time that it's really a flaw in our system that investors get different standards of care and different standards of regulatory protection depending on whether they're going to an investment advisor, a registered rep., an insurance agent, or an unregulated advisor of some sort. And it's not fair for us to leave it to investors to figure out what protections they're entitled to depending on which regulatory regime just happens to capture the person they're dealing with."

Schapiro also said, in a speech on April 27, 2009: "An SEC with an agenda that puts investors first—not just through an aggressive enforcement program—though that is essential—but also through effective rulemaking, market structure changes and creative use of the bully pulpit—can be a powerful force for good in our financial society."

Crystallizing the Fiduciary Discussion

Two events in June 2009 raised the volume of the fiduciary discourse from a whisper to a shout and helped crystallize the conversation: on June 17, 2009, The Treasury sent the Obama administration's white paper for Financial Regulatory Reform to Congress. It specified that, "The SEC should be given new tools to increase fairness for investors by establishing a fiduciary duty for broker-dealers offering investment advice and harmonizing the regulation of investment advisers and broker-dealers."

The next day, Schapiro delivered a speech to the New York Financial Writers' Association, noting that the common array of titles used by "financial professionals" and the merging of functions of those advice providers, and the critical need for "investment advice or assistance in accessing the securities markets," underscored the need for extension of fiduciary duty: "I believe that, when investors receive similar services from similar financial service providers, they should be subject to the same standard of conduct—regardless of the label applied to that financial service provider. I therefore believe that all financial service providers that provide personalized investment advice about securities should owe a fiduciary duty to their customers or clients."

In the meantime, the seeds for the Committee were planted at the fi360 conference in Scottsdale, Ariz., in May 2009, when the topic of a fiduciary requirement for all advice providers came up in several conversations that have continued to this day.

By the end of June 2009, the Committee's founders, Blaine Aikin, fi360; Clark Blackman II, Alpha Wealth Strategies, LLC; Gene Diederich, Moneta Group; Harold Evensky, Evensky & Katz; Sheryl Garrett, Garrett Planning Network; Roger Gibson, Gibson Capital, LLC; Matthew Hutcheson, Independent Pension Fiduciary; Gregory Kasten, Unified Trust Co.; Ron Roge, R. W. Roge & Co.; the Committee's chairman, Knut Rostad, Rembert Pendleton Jackson; and this reporter had organized, and announced five core principles of the authentic fiduciary duty:

Put the client's best interest first
Act with prudence; that is, with the skill, care, diligence and good judgment of a professional
Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts
Avoid conflicts of interest
Fully disclose and fairly manage, in the client's favor, any unavoidable conflicts.

Suddenly there was a lot of discussion—in many corners—about the possibility of a fiduciary duty for advice providers.

SEC Commissioner Elisse Walter (left) invited the Committee to the SEC to discuss the five principles and the fiduciary standard. Walter had also spoken publicly of the need for a uniform standard for all who provide advice: "I believe that every financial professional should be subject to a uniform standard of conduct. In my view, that standard should require all financial professionals to act as fiduciaries at all times," she said in a May 2009 speech. Walter went further to emphasize that she would not "start watering down what the fiduciary standard really requires, perhaps to make it more palatable to broker-dealers. I assure you nothing could be further from the truth."

Perhaps the most vigorous proponent of the fiduciary standard at the SEC is Commissioner Luis Aguilar, who stated last May that: "It is in the best interests of investors and our markets for broker-dealers who provide investment advice to be held to the fiduciary standard that is currently applied to investment advisers.I have consistently advocated this view."

Into the Weeds

Over the past 19 months, the Committee has met with many groups whose views concurred with and others whose views differed from our own. The discussions have been frank, and there have been relatively few times when the views were so different that there could be no common ground. Often these meetings, particularly with groups or individuals that held differing views, demystified preconceived ideas and led to more productive or additional discussions.

Most of the members of the Committee's founding group were brokers at some point in their careers and all are investment advisors now (or in my case, have been). As practitioners, the group has in many meetings gotten "into the weeds" about how the fiduciary standard would apply in different situations, including whether or how it applies in discount broker situations and where to draw the line between information and personalized advice.

Serving the Smaller Investor

Discussions with regulators have been thoughtful and thorough on topics concerning application of the fiduciary standard in a brokerage setting. This includes access to fiduciary advice for smaller-net-worth investors, and whether a fiduciary duty requires ongoing monitoring of clients' portfolios, two issues that have been repeatedly raised by the broker and insurance lobbies. To finally put this to bed, many investment advisors have been providing fiduciary advice to modest investors, for many years. It is a client-centric business model that works well—and has since 1940. The scope of engagement defines whether ongoing monitoring will occur or not, and how, clearly spelled out for the investor. In other words, a fiduciary requirement for those who provide advice does not shut out smaller investors.

Compensation and Disclosure

We've also discussed commissions. The fiduciary standard does not preclude commissions. That said, unnecessary costs to the investor need to be controlled under the fiduciary standard, so if a higher-cost product is recommended, there needs to be a reason that this would be better for the investor, and that reason must be documented by the professional.

Disclosures are an area of surprising research findings. While more transparency is, of course, good, disclosures alone do not replace the fiduciary duty of avoiding conflicts of interest in the first place. In a meeting with the SEC's BD-RIA Study group, Yale Professor Daylian Cain presented new research on disclosure that shows how disclosures can yield perverse effects. Cain's research showed that once even a well-intentioned advisor has disclosed to a customer, the advice is worse than without disclosure, and the investor was more likely to take that advice.

By fall 2009, it seemed possible that legislators and regulators might actually come through for investors and enact the fiduciary standard for all providers of advice. All sides continued meeting with decision makers to promote their points of view. The BD-bank-insurance lobby swelled in money and intensity. Sources put the financial services lobby at about $500 million a year during the run up to financial reform legislation (Dodd legacy blog). Advocates for investors, while generally not wealthy enough to lobby with cash, kept up with meetings, comment letters and public discussion of the fiduciary standard in the media.

In Part II of this exploration, we will discuss how the Dodd-Frank reform law was formulated, and where the fiduciary question was put into play in legislation.

In Part III of this series, we will look forward as to how the SEC's recommendations on a fiduciary standard will play out among advisors, broker-dealers and in the public arena.

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