Clark At Large

In the comments that he’s posted to this blog (for example, in this blog posting , Steve Winks raises some important issues that warrant further discussion. I’ve known Steve since he was a due diligence officer at a financial planning B/D in Atlanta in the ‘80s, and in more recent years I’ve heard him articulate his analysis of the implications for a fiduciary duty, much of which he’s been kind enough to share with us in his postings.

Steve does an excellent job of capturing the concerns that I’ve heard many registered reps express about the impending financial services regulation, particularly regarding the extension of a fiduciary duty to all financial advisors. Steve, like the many RRs he’s worked with over the years, comes from a brokerage environment, in which FINRA and then the B/Ds’ compliance departments lay down clear, concrete rules for the activities of their reps: which Series licenses they have to hold to conduct specific types of business, what disclosures they need to make to their clients, how to determine which products are suitable for which clients, and even what they can say about those products, etc. etc. Virtually every aspect of an RR’s business day is covered by some rule or regulation for the appropriate conduct.

As you can imagine, such a tightly controlled working environment also creates an overall sense of comfort and safety: play by the rules and no matter what happens to your clients’ portfolios, or what claims they might make against you, you and your firm won’t be held responsible. That’s not to say registered reps don’t care about the well-being of their clients—most of the RRs that I know do care. It’s a system that enables them to sell financial products secure in the knowledge that they’ve done what they’re supposed to do, and no one can say otherwise, regardless of the ultimate outcome of any transaction. Who would want to give that up?

Unfortunately, it’s also a system that’s based on an illusion. For should a registered reps’ actions ever be called into question, the matter isn’t resolved by a jury of laypeople, or even an elected judge—it’s referred to a securities industry arbitration panel, whose job is to determine whether the rep in question broke the rules, not whether the client was treated fairly. These securities industry rules—the ones that create such a comfortable safe harbor for registered reps everywhere—are never called into question. The rules themselves are never subjected to a judicial review of whether the client’s rights or interests were violated.

I don’t have any factual basis for this, but it’s my suspicion that if arbitration cases went instead to a real court of law, the brokers would lose a lot more of those cases. And that, if you read between the lines of Steve Winks’ postings, is what RRs are really afraid of. Steve attempts to solve this problem by calling for “hundreds of rules and regulations” that would recreate the current rules-based system to tell advisors exactly what they need to do. But it doesn’t work that way in the real world: most of us don’t have a set of rules we abide by. We have principles that we live by, that mostly boil down to “do the right thing:” don’t steal, don’t cheat, do what you say you’ll do, and don’t kill or maim. It’s not really that complicated. If a true fiduciary duty is imposed on all advisors, they’ll be subject for the first time to all the judgment calls that the rest of us make every day. Scary? I’m sure. The end of civilization as we know it? Probably not.

Much is being made of SEC Chair Mary Schapiro’s testimony in front of the Financial Crisis Inquiry Board on January 14 regarding her comments about the reregulation of financial advisors. About a fiduciary duty for advisors, Ms. Schapiro said: “When investors receive similar services from similar financial service providers, it is critical that the service providers be subject to a uniform fiduciary standard of conduct that is at least as strong as exists under the Investment Advisers Act [of 1940], and equivalent regulatory requirements, regardless of the label attached to the service providers.”

To be fair, her remarks do sound a lot like the position that I and other observers have been advocating, namely, that simply eliminating the “broker exemption” to the ’40 Act, would greatly benefit the public. Without that exemption, brokers would have to register as investment advisors, and become subject to all the obligations that RIAs currently have, including a fiduciary duty to their clients. This would indeed be the most beneficial advance in protection for financial consumers in 70 years.

But don’t be fooled: Just because a quick read of Ms. Schapiro’s remarks sounds like a win for consumers doesn’t make it so. To my mind, the most important part of her testimony comes in those three little words: “receive similar services.” In other words, brokers should be regulated as RIAs “when they give advice,” and conversely, not held to an RIA standard when they don’t.

This is, not surprisingly, hauntingly similar to the position of SIFMA and FINRA: brokers should be subject to a fiduciary duty “when they give advice.” That will lead to great parsing of  when brokers actually give “advice” and, if the brokerage industry has its way, will lead to brokers sometimes having and sometimes not having a fiduciary duty to the same clients. This, of course, is hard to distinguish for the current state of affairs in the brokerage world, because it is exactly the same—business as usual. When brokers give you advice, they have a duty to put a client’s interests first. But when they implement that advice by selling a high-priced, and/or heavily loaded, and/or proprietary, and/or mediocre product, they have no such duty.

A genuine fiduciary standard would require financial advisors to always put the clients’ interests first. Anything less is a sham. Unfortunately, Ms. Shapiro, like the rest of the securities industry, doesn’t seem to be on board with the highest level of financial consumer protection.

It’s my observation that many advisors have concerns about the “fiduciary standard” that in one form or another appears to be a fait accompli in the looming reregulation of financial services on Capitol Hill. This less-than-sanguine group appears to comprise primarily registered reps, who until now have been wrapped in the safety of compliance rules handed down by their broker/dealers’ compliance departments.

The new reality of having to make—and stand by—their own determinations of what’s in the clients’ best interest is understandably troubling to them. One advisor recently put it this way in an e-mail: “Now we have the idea of a fiduciary standard, a subject to which many leaders are passionately devoted, but the passion is directed toward an intangible, undefined, out-of-control concept that cannot and will not be defined in a tangible manner.”

As you can see, there’s considerable emotion involved in this issue. Before we give in to complete panic, let’s take a deep breath, and see if we can put the fiduciary issue in a more realistic perspective, one that turns out to be way more optimistic than doom and gloom.

Contrary to the implication of the above e-mail—and the belief of many RR advisors—the fiduciary standard under consideration in Washington is not a new concept. In fact the Investment Advisers Act of 1940 (yes, that’s 70 years ago) established a duty for RIAs to put the interests of their clients first. The only reason that registered reps haven’t had that same duty in the intervening years is because the so-called “broker exemption” specifically excluded RRs from such a duty. It seems as if the securities industry lobby was just as powerful then as it is today.

The point is that RIAs have been operating quite successfully, and seemingly unmolested, for nearly three-quarters century under the obligations of a fiduciary duty. In fact, they’ve been so successful in competing for client assets in the past 20 years that Wall Street retail brokers haves largely adopted the RIA business model: providing investment advice on managed client portfolios for fee compensation. But even though registered reps are now doing business like RIAs, they still balk at accepting the same duties and responsibilities as RIAs. The reregulation will likely end this discrepancy.

What’s more, the notion that the RIA fiduciary duty has somehow skated through the past 70 years as “an intangible, undefined, out-of-control concept” couldn’t be further from the truth. There are many sources today that provide RIAs with all the legal know-how they need to do the right thing by their clients and stay out of fiduciary jail, including compliance attorneys, compliance consultants, and organizations such as Fiduciary 360. In fact, last year a number of the leading lights in the RIA fiduciary duty area formed the Committee for the Fiduciary Standard (http://www.investmentadvisor.com/News/2009/8/Pages/Committee-WM-Talk-Standards-With-SEC-Commissioners.aspx?k=committee+for+the+fiduciary+standard) to help nudge the current rereg in the right direction. Their “Five Core Principles” for an advisor’s fiduciary duty are simple, concise, and undeniably in the best interest of advisory clients:

• Put the client’s best interests 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; and 
• Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.

If advisors are not inclined or capable of meeting these five principles, maybe they ought to revisit their career choice. I’m just sayin’.