More On Legal & Compliancefrom The Advisor's Professional Library
- The Need for Thorough and Effective Policies and Procedures Whethere an advisor is SEC or state-registered, RIAs must revise their policies and procedures to address significant compliance problems occurring during the year, changes in business arrangements, and regulatory developments.
- Agency and Principal Transactions In passing Section 206(3) of the Investment Advisers Act, Congress recognized that principal and agency transactions can be harmful to clients. Such transactions create the opportunity for RIAs to engage in self-dealing.
Readers of this column know I haven't been a big fan of the CFP Board and its leadership of the Financial Planning Coalition during Washington's attempt at financial re-regulation over the past 18 months. In my view, the efforts of both the Board and the Coalition have been far too focused on the questionable goal of advancing the stature of financial planning (dare I say, empire-building?), at the expense of lending their full support to the most significant consumer-oriented legislation in 70 years: establishing a fiduciary standard for brokers.
Perhaps, then, you can appreciate the lack of enthusiasm with which I greeted an e-mail from the Board's managing director of public policy, Marilyn Mohrman-Gillis, containing the Financial Planning Coalition's Comment Letter on the Securities and Exchange Commission's "Study Regarding Obligations of Brokers, Dealers and Investment Advisers..." Maybe, too, you have some small inkling of what I can only describe as my total shock as I read through the Coalition's letter. In over 25 years as a financial journalist, I can honestly say that I've never been more pleasantly surprised.
To say that the Coalition's comment letter is "good," doesn't begin to do it justice. The Financial Planning Coalition's Comment Letter to the SEC is the best case I've seen for the necessity and consumer benefit of a fiduciary standard for brokers. Even on the problematic issues that I haven't supported--commissions, proprietary products, and wearing "two hats"--it offers solutions that are so reasonable I found myself nodding in agreement. Hopefully, this Letter will go a long way toward convincing the SEC to do the right thing by financial consumers; and will also form the basis for how the Board will define and apply the fiduciary standard to all CFPs as well.
The Letter starts out with the strongest support for a real fiduciary standard that the Coalition (comprising the CFP Board, the FPA, and NAPFA) has yet made: "The Coalition believes that establishing a strong and uniform fiduciary standard of care, consistent with the standard currently applied to investment advisers under the Investment Advisers Act of 1940, for all financial professionals who provide personalized investment advice to retail customers ... is among the most important investor protection initiatives that the Commission could undertake."
What the Coalition is suggesting here is essentially eliminating the broker exemption to the '40 Act, which I've felt would be the simplest and least ambiguous way to level the playing field, or "harmonize" the differing standards for brokers and RIAs. If Congress simply dictated that the currently well-established standards for RIAs would apply to anyone who provides retail investment advice, it would be clear to everyone (especially consumers) who falls under those standards, and what those standards are.
The Coalition letter points out that the current FINRA suitability standard is "ineffective in protecting investors" and rightly cites the 2008 Rand Institute Report to the SEC, which found that "retail customers do not understand the regulatory differences between broker-dealers and investment advisers or the standards of care that apply to each."
The Unsuitable Suitability Standard
While there really isn't any part of the Coalition's Letter that I don't like, one of the best sections is its careful examination of the deficiencies of FINRA's suitability standard when compared to the RIA fiduciary standard under the '40 Act. Here's a listing of a few:
The suitability standard does not require a broker to act in the client's best interest. "In a given situation, several different securities may satisfy the standard of being suitable for the client, and a broker is free (without disclosure of this fact) to recommend the one that is most highly remunerative to the broker, even if the broker believes that other choices in fact would be better for the client."
Consumers have fewer legal rights under the suitability standard.
"FINRA rules such as the suitability rule do not create obligations enforceable in private damages actions. For an unsuitable recommendation to rise to the level of an actionable Rule 10b-5 violation, a client would have to prove that the broker-dealer acted with intent to defraud, while the comparable standard in the Investment Advisers Act for violations of Section 206(1) is only negligence." [emphasis added]
The suitability standard lacks common legal protections, such as precedent, public forum or appeal. "Because suitability cases are ordinarily resolved in an arbitration forum without any written decision and essentially no right of appeal, the law of suitability is not well-developed or consistently applied, unlike the law of fiduciary duty."
The suitability standard is too narrowly applied. "The suitability standard only applies to recommendations of securities, while the fiduciary standard applies to the entire relationship between the adviser and the retail customer. Moreover, the 'provision of investment advice' standard under the Advisers Act is much broader than [the suitability standard's] 'in connection with a purchase or sale' requirement..., and covers (for example) situations in which the investment advice does not result in a transaction at all."
Then the Coalition captures the "big" problem that the SEC studies, and the whole of Section 913, are trying to solve: "In summary, a transaction-based suitability standard is not tailored for an ongoing advice relationship, where the best advice in some situations may be a non-securities product, or not to engage in any transaction. ... And as the Dodd-Frank Act makes clear, that standard should be no less stringent than the existing fiduciary standard under the Investment Advisers Act."
The Best for Last
Finally, the section of the Coalition's Comment Letter that most impressed me addressed the "loopholes" that exist not only in current brokerage practices, but in the CFP Board's own definition of the fiduciary duty for CFPs. But in doing so, their suggestions for the form of the disclosures of all the conflicts involved are so complete, unambiguous, and client-centered, that should they be adopted by the SEC, I'd have no doubt as to the fairness of each:
Commissions. "To the extent a firm or investment professional chooses to use a commission-based pricing model ... the firm or investment professional must disclose that potential conflict of interest to the customer before the beginning of the relationship and at regular intervals thereafter, and obtain fully informed consent to that model from the client. Moreover, the burden must remain on the firm and the investment professional, not the customer, to justify each and every transaction (and the sum total of the transactions) as consistent with the client's best interest. And, if the firm offers both commission-based and asset-based pricing models, the firm and the investment professional have the obligation to recommend to the retail customer the pricing model that is in the customer's best interest, and to monitor regularly to assure that the customer remains in the account structure that is in the customer's best interest."
Wearing Two Hats. "If the customer and the investment professional agree to create an ongoing relationship involving investment advice, then the fiduciary standard must continue throughout the course of that relationship. As the Commission has long held, an investment adviser cannot provide personalized advice to a customer, and then take off the investment adviser 'hat' and act as merely a broker when executing transactions for that client."
Proprietary Products. "The decision to offer only a limited range of products, and particularly the decision to offer a proprietary product, does create a potential conflict of interest with the customer. As a result, the firm and the investment professional must have a duty to make full and fair disclosure of this conflict of interest to the customer, and obtain the customer's fully informed consent, before offering the product in these circumstances. Moreover, an investment professional ... has the 'prudent investor' obligation to inform himself fully about the comparable products available in the marketplace, even if those products are not available through his firm. The burden must be on the investment professional, not the customer, to justify the transaction in these circumstances."
Like I said, really good stuff: justifying every commission transaction to be in the best interest of the client, ongoing services requiring an ongoing obligation, and informing clients of comparable outside products and justifying the use of proprietary alternatives. Talk about client-centered handling of conflicts. I only wish the Board had made this case sooner; perhaps Congress would have included a broker fiduciary standard in the Dodd-Frank Act itself.