An SEC Broker Fiduciary Standard May Undermine the ’40 Act

In my March 25 blog on ThinkAdvisor.com, “Will She or Won’t She? Mary Jo White and the Broker Fiduciary Standard,” I voiced some concerns about SEC Chairwoman White’s recent remarks at SIFMA’s Legal and Compliance Seminar in Phoenix pertaining to the SEC’s plans to move forward with a fiduciary standard for brokers. In her speech, White said some encouraging things, including that the SEC “should act” on a new broker standard, and that it should be “codified, principles-based and rooted in the current fiduciary standard for investment advisors.” But then she qualified each of those points to the extent that, at least to my mind, it raised serious doubt about her support for a broker standard that would include even a glimmer of the investor protections provided by the current ’40 Act standard that applies to RIAs.

It’s been nearly six years since President Barack Obama voiced support for a broker fiduciary standard and five years since he signed the Dodd-Frank Act into law. Among other things, Dodd-Frank Section 913 includes a mandate for the SEC to create a broker fiduciary standard “at least as stringent” as the ’40 Act standard. During the intervening years, watching the SEC drag its collective feet on the broker standard—while increasingly adopting the rhetoric of the brokerage industry on why requiring brokers to act in the best interests of their clients would be a bad idea—I, like many others, have slowly come to a disappointing conclusion: that any action by the SEC on its Dodd-Frank mandate will likely result in a broker standard that is so watered down that it will decrease investor protections while increasing investor confusion about the loyalties that brokers owe them, and the differences between those loyalties and the loyalties required of full-time RIAs.

As bad as many of us believe the situation at the SEC is, a new white paper by the Institute for the Fiduciary Standard reveals it’s much, much worse. (See Melanie Waddell’s “SEC’s Ability to Deliver True Fiduciary Standard in Doubt: Report.”)

In “Conflicts of Interests and the Duty of Loyalty at the Securities and Exchange Commission,” author Knut Rostad, president of the institute, offers chapter and verse on how the SEC has quietly watered down the ’40 Act fiduciary standard into little more than the suitability standard currently applied to brokers. While it’s not yet clear how the courts will react to the SEC’s gutting of the RIA standard, should the SEC’s reinterpretations stand, the brokerage industry won’t have any trouble plugging them into business as usual.

The gist of Rostad’s paper is that over the years, in its decisions and comments, the SEC has morphed the ’40 Act requirement of loyalty to advisory clients—which includes the duty to avoid conflicts and the duty to act in the client’s best interest—into simple disclosure.

Before we get to the SEC statements that brought Rostad to these conclusions, here’s a little history. He offers four examples of how, until recently, the SEC has viewed advisors’ conflicts:

1. “As a fiduciary, you also must seek to avoid conflicts of interest with your clients and, at a minimum, make full disclosure of all material conflicts […].”—SEC Form ADV, Part 2, Page 1

2. “You should not engage in any activity in conflict with the interest of any client […]. You must eliminate or at least disclose all conflicts of interest […].”—SEC’s “Information for Newly-Registered Investment Advisors”

3. “An advisor must act solely for the benefit of its client and must not place itself in a position of conflict with its client. An exception is made (emphasis added), however, when the advisor makes full disclosure to its client and obtains the client’s informed consent.”—Robert Plaze, “The Regulation of Investment Advisors,” Nov. 22, 2006

4. “[…] Investment advisors could not completely perform their basic function—furnishing to clients on a personal basis competent, unbiased and continuous advice regarding the sound management of their investments—unless all conflicts of interest between the investment counsel and the client were removed.”—SEC v. Capital Gains Research Bureau, the 1963 landmark case that recognized a fiduciary duty in the Investment Advisers Act of 1940

Seems pretty clear, right? “Seek to avoid conflicts,” “should not engage in any activity in conflict with the interest of any client,” “must not place itself in a position of conflict with its client” and “unless all conflicts of interest between the investment counsel and the client were removed.” Seems to me, all this adds up to: conflicts = bad.

Now, let’s fast forward to what Rostad tells us the SEC is saying about advisor conflicts of interest today:

1. “Only through complete and timely disclosure can advisors, as fiduciaries, discharge their obligation to put their clients’ and investors’ interests ahead of their own.”—Julie Riewe, Co-Chief, SEC Division of Enforcement Asset Management Unit

2. “Disclosure and client consent will always satisfy the advisor’s duty of loyalty.”—Robert Plaze, former SEC Deputy Director of Investment Management

3. “Total Wealth and Cooper breached their fiduciary duties to their clients by failing to adequately disclose the material information about the revenue sharing fee arrangements and the conflicts of interest posed by these arrangements.”—2014 SEC administrative decision in the case of Total Wealth Management

Notice what’s missing? According to Rostad, the SEC has shelved any concerns about advisors acting in the best interests of their clients in favor of that one-size-fits-all remedy: disclosure.