From the March 2008 issue of Investment Advisor • Subscribe!

March 1, 2008

The Empire Strikes Back

Wall Street's crafty response to its whipping over the Merrill rule

Well you didn't think they'd take it lying down, did you? I'm referring, of course, to the Wall Street wirehouses, and the drubbing they took from the FPA over the so-called Merrill Lynch rule. Yes, I know that technically it was the Securities and Exchange Commission that lost Financial Planning Association vs. SEC, but it was Wall Street that has to pay for it: Thanks to the ruling, stockbrokers who manage client portfolios for a fee can no longer claim exemption from their fiduciary duty because they were "just salesmen." And who would want that? Consequently, the wirehouses had to radically change the way they do business by converting one million accounts holding $300 billion to either an advisory account or a commission-only account, at what one can only surmise was some considerable cost.

But as I may have mentioned before, and as you probably already know, Wall Street firms are the best marketers on the planet, backed up by the best attorneys that money can buy. They will tell you black is white, and night is day (and fees are commissions, and brokers are advisors, and prospects are clients, and, well, you get the picture), and have most people believing it all. That's why they've been able to roll with some punches that would have KO'd lesser industries and still come out on top: the deregulation of commissions, the death of proprietary products, the replacement of commissions by fees, and the public preference for advisors rather than salespeople, to name but a few haymakers. Indeed, to borrow a line from the PGA Tour: These guys are good.

Yet, I have to admit to a grudging sense of awe for the subtle brilliance of their current ploy, "The Rand Technical Report: Investor and Industry Perspectives on Investment Advisers and Broker-Dealers." First, if you're not convinced that the SEC is pushing whatever Wall Street is selling, I would direct you to what the SEC tried to do with the broker/dealer exemption rule, also known as the Merrill Lynch rule. They attempted to expand the exemption from registration as investment advisors for brokers who manage assets for fees, even though the '40 Act clearly states that the exemption only applies to "any broker or dealer whose performance of [advisory] services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor." As the Court in FPA vs. SEC noted, "special compensation therefor" means anything other than commissions on the sale of securities. You gotta love that kind of chutzpah.

(Why, you might ask, is the SEC in bed with the Wall Street? Well, that's anybody's guess [insert your conspiracy theory of choice here]. But as John Le Carre's George Smiley used to say: "If you want to get to the bottom of something, just follow the money." And when it comes to who benefits from ruling after ruling from the SEC, it doesn't take George Tennant to connect the dots.)

Finding the Flaws

Now, let's get back to the genius of the Rand Report itself. As the only independent advisory organization (that I can find) actually to respond to the Report (the FPA managed only a politely worded request for a roundtable discussion), NAPFA steps up and identifies the report's flaws: The report asks the wrong questions, it tells us what we already know, and it ignores the key difference between brokers and advisors: fiduciary duty. All true. Yet, I don't get the sense from their written response, that the NAPFA writers Tom Orecchio, Diahann Lassus, and Ellen Turf fully appreciate the subtle brilliance of the Report.

As NAPFA points out, the first step the SEC took to control the Report was to alter its stated goals. In a release on April 12, 2005, the SEC noted: "The staff is also to report on options and recommendations for a study to compare the levels of protection afforded retail customers of financial service providers under the Securities Exchange Act and the Investment Advisers Act, and to recommend ways to address any investor protection concerns arising from material differences between the two regulatory regimes."

Seems reasonable. Yet, following the SEC's shellacking in FPA vs. SEC in March 2007, the actual charge for the Rand Institute seems to have taken on a different character, as the Report itself states: "...the U.S. Securities and Exchange Commission (SEC) commissioned RAND to conduct a study of broker-dealers and investment advisers from two perspectives: first, examine investment advisers' and broker-dealers' practices in marketing and providing financial products and services to individual investors; and second, evaluate investors' understanding of the differences between investment advisers' and broker-dealers' financial products and services, duties, and obligations."

So the focus of the report was perhaps not-so-subtly changed from looking at consumer protection under the current regulatory structure to examining how brokers and RIAs are different, and whether consumers understand that difference. This might be called a classic misdirection play. Instead of addressing the uncomfortable (for Wall Street) subject of how well consumers' interests are being protected, Rand looked only at two things that folks in the industry already know: that brokers and independent advisors are offering largely the same services theses days, and consequently, consumers are having a hard time distinguishing the differences between them. No kidding. I don't know how much Rand charged the SEC to conduct this study, but I'm pretty sure I would have done it for half what they paid.

Now, here's the really brilliant part. Even though technically it doesn't seem to be within the scope of their mission in the Report, Rand goes on to offer its own conclusion as to why the gap between brokers and advisors is closing, and why people are confused: "In the past few decades, the functional difference between investment advisers and broker-dealers has arguably become more blurred..." This is what we writers call a "passive sentence." It states that something has happened--differences have become blurred--without making any reference to who or what might have caused such blurring.

In this case it's also pure genius, because it allows Rand to suggest a cause without any support or analysis: "...thereby calling into question the wisdom of traditional definitions and regulatory and legal distinctions between the two types of service providers." In other words, Rand is cleverly implying here that consumers are confused because the law and regulators are trying to distinguish between two things--brokers and advisors--that in reality have become the same. Therefore, said two things presumably should be subject to the same laws and regulated by the same bodies.

How's that for waving Wall Street's banner? Sound hauntingly similar to what the NASD has been arguing for the past 20 years as to why it should take over regulating independent advisors?

The Cause, the Cause

After pointing out Rand's unsupported conclusion, NAPFA goes on to offer its own reason for the current state of affairs: "The Rand Corporation fails to note that the root cause of consumer confusion is the SEC's failure to apply the important fiduciary protections of the Investment Advisers Act of 1940 as Congress intended." I guess as the foremost proponents of the fiduciary duty of independent advisors, it's hard to fault NAPFA for taking this focus. Yet their analysis doesn't really reach to the heart of the all-important consumer confusion issue.

The cause of today's confusion among financial consumers--that Rand, the SEC, and Wall Street have been so careful to avoid mentioning--is the brokerage exemption to the Investment Advisers Act of 1940. The wirehouses were able to get the brokerage exemption into the '40 Act by arguing that treating stockbrokers like investment advisors would be needless regulatory duplication, because brokers were already self-regulated. Somehow that "self-regulation" under the NASD (now FINRA) failed to include the same consumer protections that the '40 Act, such as full disclosure and a fiduciary duty. (These guys were good, even back then.)

So for almost five decades since, Wall Street has been able to use the broker exemption to charge commissions like the salespeople they are, but market as if they were actually giving clients objective investment advice. It was, of course, a formula for making billions of dollars, while confusing the heck out of financial consumers who believed "their" brokers were on their side.

But a funny thing eventually happened on gravy train to the bank: Some brokers started to worry about the financial welfare of their clients, and decided that charging fees and accepting the fiduciary duty under the '40 Act would be more client-centered. Then the technology boom enabled upstart companies like Schwab to support them, and the fee-based advisory business was born.

Gradually, savvy consumers came to realize they had a choice, an alternative to the churn-'em-and-burn-'em wirehouse mentality. Which, of course, to anyone who understands the game, isn't really much of a choice at all. Always last to recognize any innovative trend, eventually the financial media came around to fee compensation as well. This created huge problems for commission-based Wall Street. But once they realized they were holding the short end of the marketing stick, they quickly justified their golden parachutes, and became fee-based "advisors" themselves--all the while, thanking God, Yahweh, and Allah for that convenient brokerage exemption, which enabled their brokers to continue overlooking pesky details like the conflict of proprietary products, ridiculously high loads, and disclosing for whom they actually work.

The Long View

Then along came the FPA, and for the first time in almost 70 years, Wall Street had the brokerage exemption slammed in its face. So what do you do if you're one of the largest empires on the planet, and are suddenly threatened by an inconvenient court ruling? First you alter your product line, to comply with the new environment, by offering packaged portfolios that are managed by investment advisors, but can be sold by, well, salespeople. Then--and here's why these guys make the big bucks--you realize that the FPA case is only the tip of a non-globally warmed iceberg: If the courts are going to start looking into what's actually done under the brokerage exemption, it's time for a new set of laws that will take another 70 years to untangle.

So you set the stage with a report that says the problem is not that salespeople want to, have always wanted to, and will always want to market as if they were advisors if you let them; rather, you suggest that the current laws and regulations make an artificial distinction between advisors and salespeople, who after all, are really just doing the same jobs, anyway. Then you stand by to "help" the SEC write the new laws and create the new regulatory structure that will corral all those zany financial advisors into one understandable industry. And who better to make this happen than the new NASD on steroids: FINRA.

You can just see it coming. The only question is whether the real independent advisory industry has its act together enough to stand up to Wall Street on this one. It's hard to imagine NAPFA with its 1,000 or so members, in spite of its moxy, throwing down with the SIA and the SEC. The FPA, still flush from its court victory, has been curiously silent about the Rand Report and its implications. The CFP Board? Let's not hold our collective breaths.

The big problem is that the financial planning world hasn't really resolved the do-business-like-salespeople-but-act-like-advisors issue either. You don't have to be a fiduciary to be a CFP, the FPA will still take anyone who will fog a mirror, and the majority of financial planners seem to think the scope of the engagement rule is just fine: that is, they're a fiduciary when they give investment advice, but not a fiduciary when selling a product, to the same client. That's a lot of baggage to drag along to a showdown with the A Team from Wall Street. If you had to place a bet today, what are the odds we'll end up with a new consumer protection package that has more holes than the Enron pension plan?


Bob Clark, former editor of this magazine, surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at rclark7000@aol.com.

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