For all of the arguments raised by the Department of Labor’s proposed conflict-of-interest rule — 938 formal comments have been posted online, the preponderance in opposition to the rule — the most obvious, and perhaps most damaging to opponents of the rule, has yet to be fleshed out, according to one RIA.
Not even the DOL has pointed out what Michael Kitces thinks ultimately proves the incoherence of the broker-dealer industry’s core argument — that requiring all brokers to act as fiduciaries will prevent them from offering advisory services to low and middle-income savers.
The catch to that argument from Kitces’ perspective: Brokers are not now advisors, nor can they legally put themselves out as advisors, so how can the DOL’s rule prevent them from offering what they now can’t legally offer?
“The ’40 Act is a clear law. If you are giving advice for compensation, you have to register as an advisor,” says Kitces, a partner at Pinnacle Advisory Group, a Maryland-based wealth manager, and publisher of an award-winning financial planning blog, Nerd’s Eye View.
To Kitces (pronounced Kit’-sis), the Investment Company Act of 1940, which after multiple amendments over the years now has 65 sections, is clear in separating the roles of those who give advice for a living from those who sell products.
Were it enforced, the letter of that law is effective enough to regulate those two components of the financial services industry, believes Kitces.
“The whole point of the rule is to make sure the people primarily in the business of giving advice register as such,” he explained. Doing so, of course, requires those advisors to act as fiduciaries.
“But when the broker-dealer and insurance industries say ‘the DOL’s rule will limit our services, and that will limit investors’ access to advice,’ then they are actually making the case that they should already be registered as advisors,” he said.
And that’s the argument that could get broker-dealers in “hot water,” says Kitces, who could offer no good reason as to why the DOL and its supporters have not been making that point all along.
In effect, it is the brokerage industry’s Catch-22: it is trying to block a rule using an argument that should submit them to the very law it is trying to avoid.
To be clear, Kitces has no quarrel with the fundamental broker model. In fact, he’s for preserving it, another way of saying that he finds the DOL’s effort “unnecessary.”
“Brokers offer completely different services than advisors” when the lines are not blurred, said Kitces.
And the core services a broker offers are good for some consumers, who “should have the choice of doing a one-time brokerage transaction vs. getting, and paying for, ongoing advice.”
The 40 Act’s “solely incidental” clause, which protects brokers from fiduciary responsibility if the information they give is incidental to their core business of selling securities, would be enough of a firewall to protect consumers if it were properly enforced.
It is not the primary reason for why the fiduciary debate has become so frothy, says Kitces.
“How often do you see ‘stockbroker’ on a business card any more? You don’t. You see ‘advisor.’ We’ve allowed the sales people to communicate to the public that they are in the business of giving advice. And then we have not held them accountable for doing so.”
While no fan of the DOL’s proposal, Kitces shares a perspective with those lobbying hardest on Labor’s behalf: after years of the SEC’s failure to adequately enforce the ’40 Act, consumers can no longer tell the difference between broker and advisor.
To make matters worse, technology has allowed brokers to deploy software solutions, in effect allowing them to give customized, personalized advice, which has only further blurred the clear lines the ‘40 Act hoped to establish.
The “blurred lines” theory has been advanced by Labor Secretary Thomas Perez in Congressional testimony he has given rationalizing the proposal.
Ironically, it is also an argument the SEC has historically used to explain why it can’t fully enforce the laws on the books.
In 1999, the SEC proposed the so-called Merrill Lynch rule, which attempted to expand the broker-dealer exemptions under the “solely incidental” clause of the ’40 Act.
The proposal would have allowed brokers to offer wrap accounts and charge a fee based on assets under management, without requiring them to operate under a fiduciary standard.
At the time, it was a boon to the brokerage industry, which held about $300 billion in fee-based accounts that did not require fiduciary stewardship.
A rule was not posted, but the signal to broker-dealers was clear: there was not the will to enforce the fiduciary requirements on fee-based brokerage accounts.
Kitces, who has written extensively of the history of the issue, says that a primary reasoning behind the SEC’s rule was that the roles of broker and advisor had already become so blurry to consumers that attempts to enforce the distinction would be futile.
By allowing brokers to charge fees without requiring them to be fiduciaries, the SEC was aligning investor and provider interests, according to reports at the time.
“In essence they were saying, because we haven’t enforced the rule, the lines have been blurred, and so now the consumer can’t tell the difference anyway, so now we should make a rule that would weaken the original clear lines even more,” explained Kitces.
Ultimately, efforts to post the Merrill Lynch rule were thwarted in U.S. Court of Appeals for the District of Columbia Circuit, after the Financial Planning Association filed suit, alleging the SEC did not have the authority to effectively re-write the Investment Company Act of 1940. In 2007 the court sided with FPA, and the Merrill Lynch rule was put to bed.
In its wake came the rise of the hybrid RIA, says Kitces. “When the FPA won its lawsuit, it would have been a great time to go back to the original law and start to enforce it.”
That didn’t happen, he thinks, an opinion shared by many lobbying for DOL’s latest proposal.
Why not? Some argue it is a matter of the SEC being under resourced. Others claim more “Machiavellian reasons,” like Wall Street’s hold over the SEC, explained Kitces, who was quick to point out the latter claims are unevidenced.
Though he sees the SEC as the primary culprit behind why consumers today can’t tell the difference between a broker and an advisor, he doesn’t think the DOL or its proposal are the solutions.
“It’s too problematic. Let consumers have choice, and let brokers sell their products. That can be cheaper than having to pay for holistic advisory services, which some people may not want or many not need,” he said.
“The best way out of this problem is to go back to the rule we wrote 75 years ago and enforce what is on the books, the way the language was originally written,” said Kitces.
“That would solve all of these problems.”