The independent adviser profession–or “investment counseling,” as it was originally called–owes its existence to a convergence of events and influences in the first quarter of the twentieth century. It was shaped by a few tireless, visionary individuals who saw beyond traditional investment services to a new model that valued the client relationship more than the financial product. And it was tested and strengthened by a series of investigations and reforms that grew out of President Franklin D. Roosevelt’s New Deal.
Some background is useful here. In the early years of the twentieth century, corporate America was barely emerging from the era of the robber barons–bankers and industrialists whose great achievements were often matched by equally great abuses of power. As late as the 1920s, investing in most American companies was viewed as a highly risky activity. Pioneering investment adviser Theodore T. Scudder wrote in The History of Scudder, Stevens & Clark that “prior to 1900 corporate morals were so low that common stocks of practically all publicly held companies could be considered nothing more than outright speculations.”
Investment bankers, insurance companies, and professional trustees dominated the investment profession; none allowed individual investors much control over their investments other than to say yes or no to a recommendation. The firms that offered investment advice were the same firms that sold investment products.
In 1912, Ars??ne Pujo, a Democratic congressman from Louisiana, received authorization to form a House committee to investigate the “money trust”–a group of financial leaders who were abusing the public trust to consolidate their control over many industries. The committee’s findings lent support to a number of reforms, including the Sixteenth Amendment to the Constitution, which authorized a national income tax and was ratified in 1913; the Federal Reserve Act, also in 1913; and the Clayton Antitrust Act in 1914. The imposition of the federal income tax in particular stimulated interest in investment counsel.
Then came World War I and a second major influence on investment patterns: the issuance of huge numbers of bonds to finance the war effort. The liberty loans, as they were known, were the largest bond issues of their time; by 1919 more than $21 billion in bonds were sold, in denominations of $100 each. Ordinary Americans who had never been “speculators” responded to the U.S. Treasury’s exhortations to buy them. By 1919 more than eleven million Americans had invested in liberty loans.
A brief, severe recession followed the 1919 Armistice. But by 1922 the United States had made a striking recovery. The country experienced a surge in business activity that raised living standards, generated entrepreneurial wealth, and opened the door to a deluge of securities issuance on Wall Street. Between 1919 and 1929, the annual rate of corporate securities issuance nearly quadrupled. The flood of securities coming to market in those boom years overwhelmed amateur investors. They needed expert help to identify investments with good prospects amid the mass of new issues. Moreover, the boom was playing out against a backdrop of economic uneasiness.
It was in this environment that a small number of independent advisers–then self-styled as “counselors”–got their start. In general, their clients weren’t speculators trying to cash in on a stock tip overheard at a speakeasy. Instead, they tended to be business owners, corporate executives, and members of the professions–knowledgeable individuals of means looking for ongoing advice in a challenging investment environment. Rising prosperity had given them the assets to meet the minimum account size required by independent advisers, typically $1 million or more in today’s dollars. The two new breeds–the independent adviser and the affluent client willing to delegate investment management to a trusted professional–emerged together. Both prospered as a burgeoning economy and a bull market created unprecedented new wealth. Though small in overall numbers–the SEC in its Seventh Annual Report in 1942 reported just 753 registered advisers–independent advisers represented a significant change in the status quo and an influence much greater than their size would suggest.
The new independent financial advisers differed in striking ways from their predecessors and competitors. First, they focused on their clients’ unique needs rather than on selling a particular product. Second, they styled themselves as professional practitioners, emulating lawyers and accountants in the way they dealt with clients. To reduce conflicts of interest, many offered no services other than investment advice. Typically, they helped clients identify investment goals, set priorities, and prepare a formal investment plan. Investments were continuously monitored and supervised. Their fees, usually based on assets under management, were fully disclosed and paid directly by the clients. This method of charging fees required advisers to value client portfolios regularly and helped direct the attention of investment professionals to the performance of the client’s total holdings.
A third innovation was financial planning. As a discipline and a profession, financial planning would not be recognized until the early 1970s. But these early independent advisers pioneered some of the essential tools of the financial planning process.
Above all, independent advisers believed that ethical standards, professional objectivity, and trust were the keys to their success. When the Investment Counsel Association of America (predecessor to the Investment Adviser Association), the industry’s first trade group, adopted its code of professional practice in 1937, an important provision was that “neither the firm nor any partner, executive or employee thereof should directly or indirectly engage in any activity which may jeopardize the firm’s ability to render unbiased investment advice.”
Bright Spots in the Depression
The 1929 stock market crash and the Great Depression that followed brought misery to millions of Americans. In contrast, independent advisers fared relatively well as a group and even managed to expand their business. Because they charged fees based on assets under management and tended to follow conservative investing strategies–with a focus on investment-grade fixed-income securities–independent advisers could keep their clients, and themselves, afloat. Then, as now, asset allocation made all the difference in investing, and asset allocation–not yet called by that name, but known rather as “don’t put all your eggs in one basket”–was what independent advisers specialized in. Whatever pain they suffered from the stock market crash, independent advisers’ clients benefited because their money was being professionally managed.
However, that did not minimize the overall bleakness of the economic landscape. The shrinking economy left one in four workers jobless in 1933. Between 1930 and 1932, industrial stocks lost 80% of their value, and even blue-chip stock investors suffered painful losses.
The nation’s economic woes were not the consequence of unseen global forces, as some apologists tried to argue. Real people and their misdeeds were at fault. In angry response, reformers wanted new laws to regulate the securities markets and prevent fraud. After Franklin D. Roosevelt’s landslide presidential victory in 1932, they got their wish: public investigations and hearings continued throughout the decade and exposed a scandalous record of abuse.
First in the dock were the bankers. In hearings before the Senate Banking Committee, which commanded the whole country’s attention, chief counsel Ferdinand Pecora (see sidebar) avoided economic complexities. Instead, he dragged in top financiers and grilled them relentlessly about Wall Street’s misdeeds during the 1920s.
For weeks, Pecora put on a mesmerizing show while building a copious record to support fundamental reforms being prepared by the new administration. “The Pecora findings created a tidal wave of anger against Wall Street,” financial historian Ron Chernow wrote in his 1990 book The House of Morgan (Atlantic Monthly Press). Congress responded with waves of reform legislation (see sidebar, Depression-Era Financial Reforms).
Independent Advisers: The Next Target
For a while, independent advisers seemed immune from legislative scrutiny. But a young SEC lawyer named David Schenker, who had served on Pecora’s staff, soon stepped into his mentor’s shoes. While not as ferocious or high-profile as Pecora, Schenker was equally determined and savvy. An easy-to-overlook passage in the Public Utility Holding Company Act of 1935 included a congressional command to the SEC to investigate investment companies, known then as investment trusts and today called mutual funds, which had lent a hand in financing utility manipulations. The SEC found that some $7 billion worth of investment trusts had been floated at the end of the 1920s; by 1935 their assets were worth just $2 billion. As Time magazine put it in August 1936, “It became SEC’s job to find out where, how and why the rest disappeared.”
Soon after the probe got under way, Schenker decided to take a look at the investment advisers who managed the trusts’ portfolios. “It became quite obvious to us that there were a great many of them and we felt duty bound to make that study,” Schenker testified before the Senate Banking Committee. When the agency couldn’t come up with the names of advisory firms, it decided it needed legislation to get them to report in on their own.
While acknowledging that most advisers wanted to do good work for their clients, Schenker testified, “they are impeded in doing that job by the fact that there is a fringe of people who do not perform this function, but who, if I may use the expression, cash in on the goodwill of the reputable organizations . . . by giving themselves a designation of investment counselors.”
Realizing that they were in the spotlight and would likely be subject to new federal regulation, independent advisers began meeting among themselves. Some pushed to organize a trade association to represent their profession; after lengthy arguments the Investment Counsel Association of America was formed in 1937.
In its report to Congress in 1939, the SEC discussed four problem areas with investment advisers: “tipster” services masquerading as bona fide investment advisory firms; the use of performance fees to compensate advisers; the lack of solvency standards for advisers with custody of client assets; and the practice of assigning adviser agreements to other advisers without client consent. Although the agency never cited any specific instances of abuse in the testimony presented to Congress, it did include a general declaration implying problems among investment advisers in its draft legislation.
The legislation aroused little interest outside the small coterie of investment advisory firms. Exemptions for banks, broker/dealers, lawyers, and accountants assured that those groups were not going to object. Although the number of individuals offering investment advice–including investment newsletters and tip sheets–was widely (and erroneously) estimated to be in the thousands, no one from those groups came forward. As a result, witnesses were limited to SEC officials and representatives of a small number of advisers. Most of the advisers opposed the SEC’s regulatory plan. The only surprise came during an appearance before the Senate Banking Committee by E. Merrick Dodd, a professor at Harvard Law School. He had been invited to discuss the investment company scandals, but while waiting to testify he heard witnesses testifying on issues related to advisers, and he volunteered to weigh in on that subject as well:
I have been somewhat astonished as I have been listening to the testimony today and read the testimony of yesterday, at the suggestion that because investment advisers, investment counsel, properly enough regard themselves as members of a profession, that is the reason why they should not be regulated. It seems to me quite obvious that just the opposite is the case, that it is the normal practice under our laws, both state and federal, to regulate professions; when people hold themselves out as competent to render professional services to the public we do regulate them.
Dodd’s brief comments helped convince any committee members who still might have had reservations that investment advisers should be included in the reform legislation.
A compromise came when industry representatives opposing the bill began to realize that some legislation was politically inevitable. The new bill had the registration and antifraud provisions sought by the SEC, as well as restrictions on adviser contract assignments and principal trading by advisers with clients. It also featured a measure sought by the industry making it unlawful for registered advisers to use the term investment counsel unless they were primarily engaged in the business of rendering “continuous advice as to the investment of funds on the basis of the individual needs of the client.” The bill was accepted with only slight change by the SEC and passed both the Senate and the House without significant modification. What became the Investment Advisers Act of 1940 took up just three pages when reprinted in the Congressional Record. By contrast, the Investment Company Act of 1940 required thirty pages.
A Course for the Future
For a law that seemed in many respects an afterthought at the time of its passage, the Investment Advisers Act of 1940 has proven remarkably practical and enduring, both for the investing public and for the advisory industry. Several factors have contributed to its success. One is the emphasis on full disclosure. A second factor has been the SEC’s broad and flexible authority to regulate fraud in the industry. Though the final draft of the legislation was written by the Investment Counsel Association of America, the industry’s only trade group at the time, its role turned out not to be a drawback. The ICAA’s standards of practice were exemplary, and the legislation confirmed and codified them. By ceding regulatory power to the SEC, the ICAA demonstrated its commitment to ethical practices and its intolerance for unscrupulous conduct.
Most important in the long run has been the way the law was later interpreted by the U.S. Supreme Court. In SEC. v. Capital Gains Research Bureau, Inc., the high court ruled that the 1940 Advisers Act “reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship.” The court also noted that the 1940 Advisers Act reflects “a congressional intent to eliminate, or at least expose, all conflicts of interest which might incline an investment adviser–consciously or unconsciously–to render advice which was not disinterested” (emphasis added). Further, the court said that every investment adviser owes his or her clients a duty of “utmost good faith, and full and fair disclosure of all material facts” as well as an affirmative obligation “to employ reasonable care to avoid misleading clients.”
Enacted to cover a relative handful of practitioners, the Act today applies to many thousands of investment advisers. It was the first set of regulations to shape the fledgling profession, and a harbinger of the three decades to come, during which investment advisers would begin to assume their modern role.
Copyright (C) 2007 The Charles Schwab Corporation, and published on the occasion of Schwab InstitutionaI’s 20th anniversary serving the independent investment advisor industry.