More On Legal & Compliancefrom The Advisor's Professional Library
- Trading Practices and Errors When SEC-registered investment advisors conduct annual audits of firm policies and procedures, they should pay close attention to trading practices. Though usually not required to, state-registered advisors should look at their trading practices and revise policies that do not fully protect clients.
- Using Solicitors to Attract Clients Rule 206(4)-3 under the Investment Advisors Act establishes requirements governing cash payments to solicitors. The rule permits payment of cash referral fees to individuals and companies recommending clients to an RIA, but requires four conditions are first satisfied.
(In response to ThinkAdvisor’s interview with Ken Fisher that discussed in part the future of RIAs, Ron Rhoades posted comments on ThinkAdvisor that formed the basis of a full blog by Mr. Rhoades on the topic. Below is an edited version of his comments.--Ed.)
All the features of the potential fiduciary standard, including mandatory arbitration elimination, are likely to backfire and blow back — maybe fatally — on the naïve RIA world. BDs will likely subsume and exterminate the RIA world because the BDs would like to take it over: Money has been coming out of BDs and going into RIAs for 40 years. The RIA world has been growing rapidly at the expense of the BD world. And the BD world hates that.--Ken Fisher
So is Mr. Fisher correct?
If the SEC, acting pursuant to Sec. 913 of the Dodd Frank Act, imposes broad fiduciary standards upon broker-dealers (BDs) and their registered representatives (RRs) who provide "personalized investment advice," is this the death knell for RIAs?
In a sense, probably...yes. In another sense... no.
Since the 1970s the SEC and FINRA have undertaken a series of wrong decisions which permitted brokers to transition from providing trade execution services to providing comprehensive financial and investment advice. I have written extensively on the decisions by FINRA and the SEC and I will not repeat that history here.
Yet, as will be seen, the SEC through its actions has diminished the fiduciary standard of conduct, and the BDs have already subsumed the reputation of all fiduciary advisors.
Whose "Best Interests" Are Being Looked After?
There is no question that BDs today are providing a large volume of personalized investment advice. And there is no question that the vast majority of consumers believe that they can "trust" their BDs and RRs to act in their best interests.
Yet despite assertions by BDs (and even by their industry lobbying organization, SIFMA, and by their membership "self-regulator," FINRA) that they do in fact act "in their client's best interests," nearly any objective observer would dispute such a conclusion. It is clear that most BDs and their RRs continue to sell highly expensive investments, often choosing those products which pay them additional fees (through higher 12b-1 fees, payment for shelf space, receipt of soft dollar compensation and even payment for order flow, although this latter practice is de jure banned).
Indeed, BDs and RRs possess limited obligations to disclose the fees and costs of the products they sell. And their obligations to disclose and quantify their compensation are even more limited.
In essence, massive fraud occurs. While many BD firms and their RRs state that they act in their client's best interests, the reality is that most act only in the self-interest of the BD firm and their RRs.
Contrasting Suitability and Fiduciary Standard of Care
The suitability standard is frequently applied to the provision of such advice, at least in many of the decisions of FINRA-approved arbitrators. This suitability standard relieves BDs and their RRs of the duty of care in recommending mutual funds and other pooled investment vehicles, a duty nearly all other service providers possess. Instead, the obligation of BDs and RRs under the very low suitability standard is, essentially, to not allow their clients to purchase products which are dynamite, i.e., "blowing up" each and every time. The weak suitability standard fails each and every day to protect consumer interests.
In contrast, the fiduciary standard requires extensive due diligence of the firm and individual providing personalized investment advice. While a prudent investment portfolio is not required to be employed for every client, there must be clear disclosure of the fact that a particular recommended portfolio is not prudent. Additionally, a full explanation of the risks, fees, and costs are required of the fiduciary advisor.
Disclosing Away Fiduciary Obligation: Permitted by the SEC and FINRA
In recent years we have seen the rise of the dual registrant, securities industry participants who are registered as both registered representatives and investment adviser representatives.
Under a strange and bewildering 2007 proposed regulation, the SEC permits BDs and their dual registrants to wear "two hats" at the same time, for the same client. This is permitted despite centuries of fiduciary law which indicate that the fiduciary obligation extends to the entirety of the relationship between advisor and fiduciary.
Moreover, the SEC also permitted, in that 2007 proposed regulation, dual registrants to "switch hats" seemingly at will. Of course, few clients understand such a change in role, and such a switch from a fiduciary role (in which trust can be placed in the fiduciary) to a non-fiduciary role (in which caveat emptor - buyer beware - is the mantra customers should observe) often occurs without the understanding and informed consent of the client.
The ill-founded 2007 proposed SEC regulation has found its way into a couple of reported court decisions. In essence, the SEC's rules have influenced, adversely, the development of the federal common law in this area, and these rules and federal court decisions will likely filter down and diminish the fiduciary standard applied to relationships of trust and confidence when state common law is applied.
Even worse, however, is the proposition seemingly accepted by the SEC (as evidenced by the questions posed in its March 2013 Request for Data in connection with Sect. 913 rule making) that "disclosure" of a conflict of interest, without more, is all that is required of a fiduciary advisor. Such a stance may come from a wishful (by BD firms and their legal counsel) misinterpretation of the SEC vs. Capital Gains decision, which I previously written about in my blog.
The result, over the years, has been the facilitation by the SEC and FINRA of the denigration (and potential demise) of the fiduciary standard of conduct applied to those who provide personalized investment advice.
Five Reasons I Concur With Ken Fisher
As Ken Fisher said in the ThinkAdvisor interview: "If you’re an RIA, you’d better get un-naïve: the RIA world is at threat of being taken over by BDs in a regulatory sense. There’s a good chance that the entire RIA world is gone in 10 years. The SEC doesn’t seem to understand what it’s doing."
In a sense, I concur with Ken Fisher. Why?
First and foremost, a huge lobbying effort is underway by Wall Street firms and insurance companies, and their many hired lobbyists, to sway not only Congress but the Administration, the DOL, the SEC and other agencies to their views. Those who seek to lobby for the application of a bona fide fiduciary standard are outnumbered, in terms of visits to Senators, Congressmen and agency representatives, by a factor of at least 20 to 1, and perhaps much more.
Second, Wall Street and the insurance industry is poised to pour a great deal more money at this issue. Wall Street knows that the application of a true fiduciary standard would destroy their highly profitable, high-intermediation-costs business model, and they will throw their full weight behind their opposition to a true fiduciary standard.
Third, the SEC's 2007 proposed rules and the SEC's lack of oversight and enforcement of investment advisory account practices today (particularly those housed with dual-registrant firms), have essentially bought into the proposition that one can negate the application of fiduciary standards through agreement with the client. In other words, the client can, by "consent" (which is altogether neither adequately informed nor evidencing of any real understanding by the client), waive a dual registrant's fiduciary obligations.
What we have now, in reality, is not a bona fide fiduciary standard at all. Rather, it is close to the "new federal fiduciary standard" touted by SIFMA and its many allies, who purport to "manage" conflicts of interest "through disclosure."
Fourth, FINRA, the big gorilla (who only wants to get bigger), lurks. Even if a bona fide fiduciary standard is restored, it remains highly likely that FINRA (with the extensive lobbying by itself, as well as its member firms) will obtain oversight of RIAs. We cannot expect that an organization which has failed, for over seven decades, to raise the standards of conduct of its members will suddenly transform and embrace a true fiduciary standard. Rather, FINRA is an organization which serves not the public, but its member BD firms, and it will use its rule-making powers and influence at every turn to seek to prevent the application of the fiduciary standard, or so weaken it that the fiduciary standard becomes a meaningless footnote in the to-be-written history of securities regulation.
Fifth, what if the SEC does not apply fiduciary obligations upon BDs who provide investment advice, as is certainly possible? What is the result if two different groups provide the same services under different standards of conduct? As explained many decades ago by the Nobel-prize winning research of economist George Akerloff, in his paper The Market for Lemons, a "rush to the bottom" occurs. Simply put, those operating under a lesser standard of conduct are able to extract greater rents from their customers. As a result, securities industry participants who do not possess a strong personal ethos migrate to the non-fiduciary platform. The fee-only, fiduciary advisory community remains small, in comparison.
A New Definition for ‘BFFs’
Yet I foresee that fee-only and other true fiduciary advisors, who seek to avoid (not simply disclose) conflicts of interest, and who receive much-deserved professional-level compensation for their expert advice, will still exist, even if all of the foregoing comes to pass.
True fiduciary investment advisors will have to work harder to distinguish themselves. In fact, they may need to call themselves "BFFs"—not "best friends forever" in the language of instant messaging, but rather "bona fide fiduciaries." Through interview checklists and educational materials these BFFs will continue to educate consumers, and they and the media will guide consumers in increasing numbers to true fiduciary advisors.
Still, forces may arise which will lead to the destruction of bona fide fiduciaries ("BFFs"). As Ken Fisher observed, Wall Street does not like to see its market share decline. Hence, Wall Street's captured regulator, FINRA, will likely (after gaining oversight of RIAs) issue a host of new regulations, making it difficult for any RIA-only firm to survive. And as seen in recent years with the decline of smaller BD firms under the weight of FINRA's rules, smaller RIA firms will find it difficult to stay in business. The cost of entry for new RIA firms will be entirely new high, as well, due to high regulatory costs and high capital requirements imposed by FINRA (even though many RIA firms will continue to not accept custody of client securities).
This, I believe, is the future which Ken Fisher observes.
We can only hope that Mr. Fisher's vision, and the slide of RIAs toward oblivion, does not occur, for the sake of all of our fellow Americans who both need and deserve truly objective, bona fide fiduciary personalized investment advice. For the sake of capital formation unimpeded by dramatically high intermediation costs. For the sake of the future of the American economy, and America itself.
Read Ron Rhoades' complete blog on the topic.