After the traumatic events of the last few years, some of your clients (and perhaps you, too) may be experiencing a crisis of confidence in our economic system, institutions and leaders. The Wall Street Reform and Consumer Protection Act, aka Dodd-Frank, is intended to promote greater trust and transparency with mandates that include the creation of a new Consumer Financial Protection Agency, but its intended and unintended consequences are still unclear.
To explore this brave new world, I asked some expert observers to weigh in: Investment Advisor columnist Mark Tibergien, CEO of Pershing Advisor Solutions in Jersey City, N.J.; Matthew Lynch, president and CEO of Capital Analysts in Cincinnati; Elliot Weissbluth, CEO of HighTower Advisors in Chicago, and David Tittsworth, executive director of the Investment Advisor Association in Washington, D.C.
Olivia Mellan: How important is transparency in the delivery of financial services. Does it really promote trust? Do we need more of it?
Mark Tibergien: One of the biggest issues clients are wrestling with is whether they can trust their advisors. They’ve discovered that neither religious affiliation, country club membership, nor community involvement is evidence of a trustworthy character. So unfortunately, advisors have to go to greater depths to open up the way in which they do business for their clients.
Matt Lynch: I think there’s a difference between disclosure and transparency. The movement towards transparency serves the purpose of improving financial literacy. The adult population is not financially literate. We’ve taught them to live on borrowed money. So part of what we have to do is to educate our population and encourage accountability. There needs to be a culture of accountability around financial decisions. The most important thing is to do what we can do to improve financial literacy—and transparency serves that objective.
David Tittsworth: Another word for transparency is disclosure—a bedrock principle of U.S. securities law. It’s a very important part of fiduciary duty. The basic notion is that you need to disclose information to your clients so that they understand the transaction or the activities that you are recommending.
OM: What stands in the way of having more transparency?
MT: What stands in the way is legal gobbledygook. More words do not mean more clarity.
ML: A good example is the debate over 12b-1 fees. These fees, and a whole host of expenses embedded in mutual funds and in revenue sharing, are essentially hidden from advisors. For an advisor to operate as a fiduciary, he or she has to know about them. But the prospectuses and ADVs are long, detailed and unreadable, so the advisor doesn’t read them, and neither do the clients. Only the attorney and the judge in litigation read them.
Elliot Weissbluth: Let’s focus on the efficacy of transparency. If a doctor gave you the chemical compound of a prescription medication and asked you if this was a suitable drug for you, he would be providing complete transparency—but it would be utterly useless to you. That’s why many professions have the legal doctrine of “learned intermediaries” or “fiduciary duty.” It’s not just a high-sounding marketing idea or slogan; it’s a legal obligation that creates liability. Many health care patients don’t have full transparency. The doctor says, “You have a condition; take this pill or undergo this surgery and we believe it will help you.” But you don’t understand how the pharmacology actually works. In fact, it’s probably mostly opaque to the doctor, too, who gets his information from the pharmaceutical company. Drug companies have a duty to the doctors, and the doctors have a duty to their patients. And patients, when they go to their doctors, understand that the doctor puts the patient’s interests first. We see a similar dynamic between investors and financial advisors who are legally bound to put their clients’ interests first.
CLIENT RIGHTS AND RESPONSIBILITIES
OM: Some advisors have always kept their clients informed in writing about how and where their money is invested, but a large percentage of clients don’t read this detail or care about it. Their attitude is something like, “Hey, I trust you. You don’t have to tell me all this stuff.”
ML: Transparency involves giving your client enough information so they know whether you are serving their needs well. But even when advisors subscribe to the idea of transparency, the information they provide can be unreadable and filled with technical jargon.
Today, even the wealthiest clients don’t know what they don’t know about their advisor, and what he or she is doing. So at the end of the day, advisors are borrowing credibility to build trust, and they tend to leverage the brand equity of the national institution they work for; or in more independent channels, they borrow the prestige or trust of other clients.
MT: At some point, investors need to bear some responsibility for going along with unrealistically high returns, not asking questions and not educating themselves.
ML: It’s a two-way street. You have these psychological contracts between the client and the advisor, and within that there is trust that might exist. But this is conditional trust, based on whether the client feels that the advisor is meeting the client’s needs. The movement towards transparency will give everybody a chance to re-evaluate their business model in terms of whether it’s truly aligned with their goals. Does it serve me? Does it serve my clients? We should all be able to align our interests so that everybody does well.
DT: Studies indicate that people tend to engage people whom they trust. If I trust you, I don’t want to have to read all the details. But with the transparency argument, part of what investment advisors should be doing is to educate their clients so that they understand the basics and know whether they are being well-served.
MT: I think it’s prudent to develop a “Client’s Bill of Rights and Responsibilities.” Clients need to know what their rights are, but they also need to take responsibility for verifying and understanding what their advisor is doing for them. If your doctor told you your child was sick, you’d do as much research as possible. When it comes to money, people claim they’re mathophobes, or just incapable of understanding it. They say, “Well, that’s why I go to an investment professional.” But even though you go to a doctor for a diagnosis, you still do all kinds of fact-finding. You don’t abdicate—except when it comes to your money.
OM: What we are saying, then, is that in some contexts, transparency is meaningless. If clients don’t understand how complicated financial vehicles work, giving them information that they don’t know how to interpret and process is useless. Complete transparency, if it means divulging details that the client has no way of interpreting or understanding, isn’t really what builds trust. It’s educating your clients so that they can partner you in the process.
FIDUCIARY DUTY VS. SUITABILITY
OM: How do you see the debate over fiduciary duty vs. the suitability standard?
EW: I see it in terms of trust, not transparency. It’s important for people to understand the duties that are owed to them as a consumer. Many people confuse a relationship with a broker and a relationship with an advisor. I don’t believe that one is intrinsically good and the other is intrinsically bad.
Here’s a simple analogy: When I go to a butcher, I expect him to recommend the best cuts and types of meat. I don’t expect him to say, “You have high cholesterol; I’d recommend going to the fish salesman over there and ordering salmon.” I’d go to a dietician or nutritionist for that kind of advice. The current regulation, which proposes to convert brokers into financial advisors, is like trying to make butchers into dieticians. It’s not their job and it’s not consistent with their training or their core business.
DT: Fiduciary duty requires that you act in the client’s best interest at all times. The suitability standard means that you will recommend appropriate investments. The fiduciary standard is a higher standard—in addition to recommending suitable investments, you have to disclose conflicts of interest, including whether or not you will personally benefit from a recommendation. If brokers do any aspect of financial planning or give investment advice, they should be held to the same fiduciary standard as investment advisors.
ML: I think most financial advisors at wirehouses believe they already function in the best interest of their clients. They are good people who want to serve their clients well. It’s not like “better” people become RIAs and “worse” people become registered reps within broker-dealers. Fundamentally, nobody enters the business thinking they would do a better job for clients in one role or the other; they just enter the way they enter.
The problem is with the institutions that are trying to preserve the status quo. Their way of doing business goes back to the 1940 Investment Company Act. They’ve evolved their financial models over generations, with products and services that were not necessarily designed to serve the best interests of their clients. It’s an inherent flaw in the design of the industry, not a problem of bad people.
EW: Many consumers don’t see any difference between financial advisors and brokers. Regardless of your education or sophistication, when someone goes to a doctor, they understand and expect that the doctor will place the interest of the patient in front of the interest of the doctor. That clarity of duty needs to be brought to our industry. Suitability is a minimum-threshold standard, while serving as a fiduciary requires a maximum-threshold standard. You always have to be a fiduciary; you can’t be a fiduciary only some of the time.
DT: The goal for all of us is to have both sides of the equation—both brokers and investment advisors—being transparent in their practices, and educating clients so they know whether they are being well-served.
ML: One of the things that’s important about Capital Analysts is that we really embrace transparency and support the new regulatory changes. About a year and a half ago, we launched a new type of affiliation model that for the first time provides for transparency between the broker-dealer and the advisor.
THE SEC AND DODD-FRANK
OM: David, I know you were involved in hearings about Dodd-Frank. Now that the debate is shifting from Capitol Hill to the regulators, what can advisors expect?
DT: It will take at least one to two years to determine whether the effect of the legislation is a net positive or a net negative. The 2,300-page bill has plenty of provisions that will keep us busy—more regulation, more scrutiny of investment advisors—depending on how the SEC interprets the law. The details do matter.
OM: Some examples?
DT: After 2011, Form ADV Part 2 will have to be sent to clients, making the investment advisory process fully transparent. The form is supposed to be in plain English; but if it isn’t as readable as hoped for, it will be the investment advisor’s job to make it readable and understandable. Mutual fund companies will also need to shorten their prospectuses and simplify the language so people understand what they’re buying.
OM: I think a very difficult part of this task would be overcoming clients’ resistance to learning new things. I also wonder about advisors’ resistance to learning complicated new compliance rules, and concern about the onerous burden it will place on their staff.
DT: The high costs of compliance may put smaller firms out of business. But this remains to be seen.
ML: If you take this idea of trust and transparency to the endgame, it requires saying to the client, “Here’s the services I provide; here’s how I get paid for those services,” and so on. If there’s no clarity in the value exchange, the notion that regulatory change will address that is a false notion. It’s a good step in the right direction, but there’s a whole lot of detail that needs to be fleshed out. The big institutions who want to preserve the status quo are not doing anyone a favor. What they are trying to do is to maintain what they are comfortable with, and not embrace innovation—fear of the unknown.
MORE TRANSPARENCY FOR ALTERNATIVE INVESTMENTS
OM: Speaking of innovation, part of the challenge for advisors has to be keeping up with the proliferation of new investment vehicles—derivatives of derivatives, and so forth. What happens when you have a client who’s been given a hot tip to invest in a particular hedge fund, but the advisor doesn’t really understand how it makes money?
ML: I think the guy needs to find out whether that hedge fund is a good investment. There’s nothing wrong with saying, “I’m out of my area of expertise. You don’t want a dermatologist to do orthopedic surgery.” But going out and getting answers to those questions will serve the client better.
MT: Going out of his comfort zone is just uncomfortable for him, but it can be destructive to his client. I would say, “Either learn your business, or stay within what you know.”
EW: This advisor doesn’t know whether the hedge fund is a scam or a fund managed by sophisticated, legitimate traders. More transparency might let him ferret out a scam, or it might just give him data that he wouldn’t understand.
So I challenge the notion that transparency is an absolute good. People talk about “If we only had more transparency, things would be better.” I think that’s nonsense. For example, there are very few people in this industry who understand the derivatives market; and I doubt that any of them work for any regulatory agency. If the regulators had perfect transparency into the derivatives market, would they have been able to avert the financial crisis? I think the answer is no. I’m not faulting their intelligence; after all, these are very sophisticated and complex securities. To expect a government agency to hire enforcers at government salaries and expect them to face off against some of the smartest minds in the business is not a fair contest. And remember that this market is nearly opaque.
OM: I hear you all saying—and I second your view—that more transparency in itself is not the answer in a situation like this. The one clearly bad choice is to pretend to understand what is either a highly sophisticated investment or a scam, just to keep the client and avoid feeling like an ignoramus.
IMPACT OF THE CFPB
OM: How much of a difference will the new Consumer Financial Protection Bureau make?
MT: The pendulum tends to swing whenever there is a crime or a mistake of epic proportions. We saw it with Enron; we saw it with WorldCom; we saw it with the Great Depression. One of the challenges of financial reform is that both clients and investment professionals will be weighed down by very heavy documents and very heavy contracts that, by themselves, do not shape behavior.
ML: I’ve never been a fan of increased oversight, but it should be more prescriptive. If they could spell out how you meet this standard—“You MUST provide your client information in plain English that they can understand, and you must operate in the client’s best interest”—if they could spell out what that behavior actually looks like, then I would support it.
MT: The question is whether or not the people who are affected ever take responsibility for their own actions. My concern with the long arm of the law is that it allows people not to have to be accountable for themselves; yet in the end, it’s their money. What probably disappoints me the most is that for all the money that is going to financial reform, very little is going toward financial literacy.
OM: When I interviewed Dan Ariely of Duke University a short time ago, he said, “Transparency is a very nice flavor of the month. It’s clearly beneficial, but it’s far from sufficient. What we really need to do is to eliminate conflicts of interest. Of course, it’s very hard to do that… but nevertheless, we have to keep trying.”
ML: Criminals will be criminals, whether they’re on the fiduciary side or the suitability side. So the best defense to prevent additional Madoffs is an informed client. If through regulatory reform we can help create more informed clients, armed with the information they need to make good decisions in their own best interest, then I would support it.
MT: There will always be crooks. But if you lack the ability to discern a scam, you will always be a victim.
TRUST, BUT VERIFY
Trust is a core element of every relationship that works well; its absence can destroy a relationship. As Stephen Covey has said, trust is a matter of character and competence. You build trust with honest disclosure (including how you are compensated), and an effort to avoid conflicts of interest. If conflicts are present, you acknowledge and deal with them honestly. Transparently.
When people trust their advisors, they want to be spared the necessity of having to read and understand the fine print. But if there’s one thing I learned from Dan Ariely’s work, it’s that even “good” people in positions of trust are tempted to further their own interests. It reminds me of Ronald Reagan’s famous line: “Trust, but verify.” Clients need to verify that they are being well-served, which means you may need to educate them even if they resist learning.
This discussion has reinforced for me that the notion of transparency in an advisory practice needs to be reframed. Rather than being valued as a benefit in itself, devoid of context, it should be understood as a tool that enables your clients to determine whether you are fulfilling your responsibility to them, while at the same time enabling them to exercise their own responsibilities and rights. The role of financial education and the goal of financial literacy cannot be emphasized enough.
In an era when loss of trust is rampant, a new kind of transparency is needed—where documents are simpler, more jargon-free, and easier to understand; and professional relationships are spelled out as clearly and as honestly as possible. Trust can then be built and strengthened over time until the relationship stands on a firm foundation, solid and steady even in times of financial and emotional upheaval.
Olivia Mellan, a speaker, coach, and business consultant, is the author with Sherry Christie of The Client Connection: How Advisors Can Build Bridges That Last, available through the Investment Advisor Bookstore at www.invest-store.com/investmentadvisor. She also offers money psychology teleclasses and facilitates intergenerational retreats for wealthy families. E-mail Olivia at firstname.lastname@example.org.