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Fiduciary Best Practices, Part Deux: Bigger, Better, Maybe More Client-Centered

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Recent activities in Congress and at the Securities and Exchange Commission to curtail a fiduciary standard for brokers indicate, at least to this writer, that any meaningful advances in investor protections will be driven by independent fiduciary advisors publicizing what fiduciary advice really looks like. Toward that end, the Institute for the Fiduciary Standard’s Best Practices Board recently released revised best practices for fiduciary advisors.

In this iteration, the Institute has tried to balance the importance of requiring “certain conduct that may be reasonably expected by investors who, almost always, consider their advisor trustworthy against the costs [and] challenges of complying.”

In the introduction to the proposed best practices, the Institute wrote that “in today’s distrustful climate, the key is practices that are required and verifiable.”

The paper stressed that fiduciary duty requires advisors to serve their clients’ best interests first, and the Institute said that its proposed best practices “spell out what this means.”

Here are the 12 revised standards, along with a bit of commentary:

1. “Affirm that the fiduciary standard under the Advisers Act of 1940 and common law principles govern the professional relationship at all times. This language is placed in the engagement agreement.”

This is good as far as it goes, but to my mind, that isn’t quite far enough. On the positive side, stating in writing that fiduciary principles apply to a client relationship “at all times” appears to close the existing loophole of advisors acting as fiduciaries when they propose a portfolio allocation or financial plan, but as salespeople when recommending the actual financial products involved in both. (However, I do foresee some “advisors” and their lawyers arguing that they were acting as fiduciaries “at all times when I was subject to the ’40 Act standard, but not when I was subject to the suitability standard.”)

The bigger problem with this standard is that it appears to allow an advisor to act as a fiduciary at all times for some clients, but not for all clients. One foresees some advisors meeting the “fiduciary at all times” standard for one or two clients and advertising whatever certification this enables, while advising dozens or even hundreds of other clients under the suitability standard. As I’ve written before, I believe a fiduciary-only standard, requiring an advisor to act as a fiduciary for all clients at all times, affords the greatest investor protection while eliminating legally protected abuses.

2. “Establish and document a ‘reasonable basis’ for advice in the best interest of the client. A ‘reasonable basis’ is the justification for the advice (not the standard of conduct applied to the advice). The documentation for the advice includes relevant facts, analysis and circumstances.”

Frankly, I would be inclined to see guidelines or safe harbors, within which a reasonable basis is assumed and outside which the documentation of a reasonable basis is required—e.g., low-cost ETFs might be within the safe harbor, while products with front-end loads might require some explanation of how they meet the client’s best interest. Still, the above standard, provided it doesn’t prove too costly or cumbersome, is much better.

3. “Communicate clearly and truthfully, both orally and in writing. Do not mislead. Make all disclosures and important agreements in writing.”

This calls to mind the “truth, the whole truth and nothing but the truth” instructions to witnesses in court. This practice is clearly intended to revive the “good faith” and “loyalty” standards that the SEC and FINRA have been actively exorcising from the ’40 Act fiduciary standard (seeAn SEC Broker Fiduciary Standard May Undermine the ’40 Act,” Investment Advisor, May 2015). Client-centered advice should not be a legal game in which an advisor can meet his or her duty by disclosing how he or she is not acting in the client’s interest in opaque or obscure language that the client doesn’t understand.

4. “Provide, or instruct clients how to obtain, a written statement of total fees and underlying investment expenses paid by the client. Include any payments to the advisor or the firm or related parties from any third party resulting from the advisor’s recommendations.”

The paper goes into considerable detail about how these fees and expenses might be determined: “Certain expenses (mutual fund expense ratios) are readily available. Other expenses are not so available but can be calculated, while other expenses will be difficult to calculate but may be estimated. Finally, there are some expenses that may not be either calculated or reliably estimated. Consequently, an annual investment expense report may include expenses that are simply reported, those that are calculated and those that are estimated.”

Yet while “challenging,” it seems to me that this requirement is more of an effort to ensure that advisors are diligent in their duty to see their clients’ money is spent wisely than to inform clients about fees. After all, clients usually don’t have a basis to determine whether a given expense is reasonable. I suspect that all too often, advisors themselves assume that all fees and expenses are fair, rather than digging to confirm that they are.

5. “Avoid conflicts and potential conflicts. Disclose all unavoidable potential and actual conflicts. Manage or mitigate material conflicts. Acknowledge that material conflicts of interest are incompatible with objective advice.

“A conflict of interest disclosure document is created as an addendum with the engagement agreement. The document includes a sufficiently detailed description of each conflict—a description that communicates the harm of the conflict so as understandable to the ordinary investor. It also describes how unavoidable conflicts are managed or mitigated to the client’s benefit.”

Again, this practice attempts to reverse the SEC’s trend toward requiring mere disclosures of conflicts (which I suspect are usually ignored by clients or, if read, not understood) by requiring that conflicts be avoided, managed or mitigated.

This practice is fine as far as it goes. Yet as it is clearly part of the Institute’s efforts to create practices that apply to brokers as well as independent fiduciary advisors, I have reservations that this treatment of conflicts may misleadingly elevate investors’ confidence.

As the recent U.S. Supreme Court ruling in Tibble v. Edison revealed, brokerage firms generate substantial revenues via revenue sharing and 12b-1 fees, which are not disclosed to investors. While brokers may not directly benefit from these revenues, their BD’s control over their payout percentage can create a powerful incentive to “recommend” products that are beneficial to their BD. In my view, the complexity of the relationship between brokers and their BDs makes full disclosure of all the material conflicts extremely problematic.

The next three best practices (“Abstain from principal trading unless a client initiates an order to purchase the security on an unsolicited basis.”;Avoid compensation in association with client transactions.”; and “Avoid gifts or entertainment that are not minimal and not occasional. Avoid third-party payments, ‘benefits’ and indirect payments that do not generally benefit the firm’s clients and may reasonably be perceived to impair objectivity.”) attempt to manage various conflicts inherent in a broker-client relationship. Good as far as they go, but in light of my previous reservations, I have concerns that they may further the illusion of client-centeredness, rather than actually increase it.

Finally, the last four practices pretty much speak for themselves:

9. “Ensure baseline knowledge, competence and ongoing education appropriate for the engagement.”

10. “Institute an investment policy statement (IPS) or an investment policy process (IPP) that is appropriate to the engagement and describes the investment strategy. Have access to a representative universe of investment vehicles that provide ample options to meet the desired asset allocation and in consideration of generally accepted criteria.”

11. “Consider peer group rankings in ensuring underlying investment expenses are reasonable.”

12. “The advisor affirms in writing adherence to Best Practices, and attains written affirmation from the firm that these business practices have been reviewed.”

Taken together, this revision is a marked improvement over the Institute’s initial release, both in detail and in practicality. Yet in my view, the Institute’s ongoing efforts to create a standard attainable by brokers as well as RIAs requires considerably more work. Otherwise it runs the risk of obscuring the distinction between fiduciary advice and securities sales, which the investing public desperately needs.