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.
- Client Communication and Miscommunication RIA policies and procedures must specify what type of communications should be retained. The safest course of action is for RIAs to retain all communicationsto clients, from clients, and about client accounts. To comply with fiduciary obligations, communications must be thorough and not mislead.
Ever notice how the way some questions are worded can greatly affect the way they are answered? The classic question, of course, is the one that defines the whole: “When did you stop beating your wife?” Attorneys, marketers and salespeople are well-aware that leading questions can often elicit a desired response, such as: “What color do you want your new car to be?” or “How did you want to pay for those shoes?”
What’s more, studies have shown—and pollsters know—that providing hints within questions can skew the answers: Asking how tall a person is will more often than not get a larger estimate than a question about how short he is. Then there are more subtle questions that are not, in reality, questions at all. For instance, as every married man quickly learns, “Honey, do I look fat in these pants?” is not a request for an objective assessment.
These musings were prompted by the SEC’s March 1 release requesting “data and other information […] relating to […] the standards of conduct and other obligations of broker-dealers and investment advisors.” That’s Washington-speak for yet another round of comments about how the commission might go about acting (or not) on the already much-debated Dodd-Frank mandate to create a uniform fiduciary standard for brokers and possibly “harmonize” the way both industries are regulated.
What’s different about this request is that its wording has seemingly tipped the SEC’s hand a bit about the direction its deliberations are leaning, setting off a firestorm of responses. Perhaps the most articulate and pointed of those came from Institute for the Fiduciary Standard founder Knut Rostad, who wrote that if the positions “set out in the [SEC] release were adopted in rulemaking, the fiduciary standard would effectively be removed for brokers and advisors giving investment advice to retail investors.”
The central focus of Rostad’s and many others’ concerns about the SEC release is a list of 11 guidelines (some general and others specific to the “Duty of Loyalty”) that the Commission included “to establish a common baseline of assumptions.”
In his April 16 report titled “Fiduciary Reference: Analysis of Investment Fiduciary Issues,” Rostad offered a detailed response to the commission’s release, stating: “The SEC provides a picture of fiduciary duties that are far more restricted and far less stringent than the fiduciary duties required by the Investment Advisers Act of 1940. In a few short pages, this guidance effectively upends established legal precedent developed over 73 years.”
Rostad’s commentary focuses on four of the 11 assumptions outlined by the SEC, which he said “restrict the broad concept of advice implicit in the Advisers Act, permitting the waiver of fiduciary duties, framing disclosure as the optimum measure of loyalty, and omitting the strongest disclosure requirement (of informed consent).”
One of these assumptions redefines who would and would not qualify for fiduciary protection: “Assume that the term ‘retail customer’ […] is a natural person, or the legal representative of such natural person, who receives personalized investment advice about securities from a broker or dealer or investment advisor; and uses such advice primarily for personal, family or household purposes.”
That greatly narrows the kind of clients who are currently protected under the Advisers Act. “For example,” wrote Rostad, “recommendations made to individuals regarding their business or non-profit organization assets would not necessarily be required to be fiduciary advice and, thus, not be required to be in the best interest of the client.”
Then there’s the assumption under which the commission sets out its business neutrality: “Assume that the uniform fiduciary standard of conduct would be designed to accommodate different business models and fee structures of firms, and would permit broker-dealers to continue to receive commissions.” I suspect that for most observers this is reasonable as far as it goes; even those who would prefer to see the conflicts inherent in commissions eliminated altogether probably didn’t expect that to happen. However, the SEC’s assumed remedy for the conflicts of commissions and principle trading are cause for more concern: “At a minimum, a broker-dealer or investment advisor would need to disclose material conflicts of interest, if any, presented by its compensation structure.” [Emphasis added.]
If any? Really? Rostad put it bluntly: “This language seems to suggest that commissions or principal trades should not explicitly be presumed to be conflicts of interest.” It’s a curious statement, to say the least, and calls into question whether the SEC’s concern over business-model neutrality has driven consumer protection into the back seat.
Even worse is the apparent ease with which the SEC assumes a broker or advisor could dispense with a uniform fiduciary duty to a client. Another SEC assumption states that fiduciary duties within the scope of engagement “would depend on the contractual or other arrangement or understanding between the retail customer and the broker-dealer or investment advisor, including the totality of the circumstances of the relationship and course of dealing between the customer and the firm, including but not limited to contractual provisions, disclosure and marketing documents, and reasonable customer expectations arising from the firms’ course of conduct.” [Emphasis added.]
So, whether or not a broker or advisor would be deemed to have a fiduciary duty to a client would depend on a complexity of circumstances that the client is supposed to be able to sort out on his or her own? Said Rostad: “This language suggests that fiduciary duties may be restricted, perhaps effectively removed, with relative ease, without an informed consent requirement. Indeed, clients may not even be aware that fiduciary duties have been restricted or removed at all.”
Finally, there is the “duty of loyalty,” which, as Rostad succinctly put it, “is the very heart of the fiduciary standard under the Advisors Act.” The SEC instructed commenters in Part B, Section 1 to “assume that any rule under consideration would expressly impose certain disclosure requirements,” including all material conflicts of interest. The SEC wrote that depending on the nature of the conflict, those disclosures “largely could be made through the general relationship guide” described in the release.
The problem is the absence of any mention of remedies for conflicts other than disclosure. “As the term is used in this discussion, the duty of ‘loyalty’ effectively is described as ‘disclosure,’” wrote Rostad. “The option of avoiding the conduct is not even mentioned. This exclusion of avoiding conflicts could be interpreted to imply that disclosure is clearly superior to avoiding conflicts as an investor protection measure. Also omitted is any mention of a broker’s duty to obtain client consent, or a duty to obtain informed client consent, or, irrespective of client consent, that the recommendation remains in the client’s best interest.”
The SEC’s view is, of course, a look at loyalty to one’s clients very much from a broker-dealer’s perspective. In an industry rampant with conflicts that are virtually impossible to avoid or even mitigate, disclosure is often the only alternative. Investment advisors, on the other hand, are currently required to eliminate conflicts first and then work to mitigate them, and in any event, to disclose them to clients, obtaining their consent that the advisor’s actions in these measures are acceptable.
This brokerage perspective is pervasive throughout the entire SEC release, which uses FINRA language and remedies to address virtually all consumer protection issues within the scope of client relationships with a broker-dealer or advisor. In essence, it appears to be a not-at-all veiled attempted to shoehorn the current approach to broker regulation into the investment advisor world as well. We can only hope that this approach is reflective only of the SEC staff and not the view of the commissioners themselves.
Knut Rostad summed up his concerns about the March 1 release this way: “Together, these assumptions represent a profound departure from the Advisers Act. If adopted in rulemaking, fiduciary duties would be effectively removed for brokers and advisors giving investment advice to retail investors. The issue of whether such a uniform standard is consistent with the Dodd-Frank requirement that the uniform standard be ‘no less stringent’ than the Advisers Act is clear. It is not.”